How to read the Cash Flow Statement – Part 2

In last Tuesday’s post, I had covered the first part of the Cash Flow Statement – Cash Flow from Operating Activities. The next two parts will be discussed in this post.

Part 2: Cash Flow from Investing Activities 

To remain in business over the long haul, a company needs to grow. Without growth, a business will stagnate and eventually die or get acquired. But growth has a price. Cash has to be spent to buy land, machinery and related equipment, build factories and offices, acquire other companies, start subsidiaries or joint ventures, and make appropriate investments.

All of the above comes under Cash Flow from Investing Activities. You don’t have to be a genius to guess that this figure will be a (negative) one for most companies. Many mature companies, particularly those in the FMCG sector, don’t have much need for Capital Expenditure (i.e. spending cash on factories and equipment) because their rate of growth has slowed down.

Ideally, the depreciation amount in the Profit and Loss statement should be less than or equal to the amount of cash being spent in investing activities – because depreciation is meant to cover the notional loss due to wear and tear of the existing plant and machinery. If a company does not continuously spend on upgrading and modernising its facilities, it will not be able to compete with newer entrants who may have the latest technology and equipment.

The definition of Free Cash Flow is:

Cash Flow from Operating Activities – Capital Expenditure

This is a (negative) number for companies in their early growth stage, when cash generated from core operations may be insufficient to cover the cost of capital expenditure. But for well-established companies, positive Free Cash Flow is an indication of financial health. The more positive Free Cash Flow a company can generate, the easier it is for them to expand, acquire, pay dividend or buy back shares, and pay off loans.

Part 3: Cash Flow from Financing Activities 

What if a company has (negative) Free Cash Flow, or still worse, has (negative) Cash Flow from Operating Activities? Where will they get the cash to pay their suppliers, interest to banks for any loans taken, and for growing the business?

They can either resort to more borrowings, and/or issue more shares. If such companies are showing a net profit, then they are also expected to pay dividends to their shareholders. All inflows and outflows of cash due to loans, share issues, share buybacks, dividend payments come within Cash Flow from Financing Activities.

Financial prudence should dictate a company’s growth plans. As a thumb rule for selecting good stocks, about 60-70% of the Cash Flow from Investing Activities (Part 2) should be funded by positive Cash Flow from Operating Activities (Part 1); the balance 30-40% should come from Cash Flow from Financing Activities (Part 3).

Many companies forget the simple adage that one should cut one’s coat according to the cloth. They may even have positive Cash Flow from Operating Activities, but their ambitious growth plans require far more cash than they can afford. They resort to frequent borrowings and share issues in the hope of reaching the top quickly. One or two bad years can bring such companies down to their knees. Pantaloon and Suzlon come to mind.

(Note: The financial health of banks and financial institutions can’t be judged by analysing the Cash Flow Statement alone – because they need to borrow cash to give loans, and invariably have negative Cash Flow from Operating Activities. Price to Book Value and Return on Assets are better measures for such companies.)

Related Post

What is the Return on Assets (RoA) ratio?

How to read the Cash Flow Statement – Part 1

Have you heard the statement: Cash is king? A business needs cash like a car needs fuel. If there is no regular generation of cash from the day-to-day operations, the business will need to resort to debt and share issues to survive. Seems logical that investors would first look at the Cash Flow Statement in an Annual Report – right?

Unfortunately, most investors in the stock market – even those who have been investing for many years - do not understand or know how to interpret the Cash Flow Statement. Just looking at the Balance Sheet, Profit and Loss statement and the Management Discussion and Analysis is not enough. The real state of a company’s finances is hidden in the Cash Flow Statement and the Notes on Accounts.

With another accounting year coming to a close on Mar 31, 2011, this is as good a time as any to learn the basics of the Cash Flow Statement:-

The Cash Flow Statement allows you to check the different sources of cash inflows into a company during a particular year vis-a-vis the prior year, how much cash was spent, and what it was spent on. Cash inflows are positive, cash outflows are (negative). The three parts of a Cash Flow Statement enable you to understand what a company’s management is doing with the cash at its disposal, by comparing the figures with those appearing in the Balance Sheet and Profit and Loss statement.

Part 1: Cash Flow from Operating Activities

The Net Profit before tax and exceptional items from the Profit and Loss statement is adjusted with depreciation, interest, provisions, profit/loss on investments, debtors, inventories, creditors to arrive at the cash generated from operations. Tax and exceptional items are then adjusted to arrive at the Net Cash from Operating Activities.

Though it may seem counter-intuitive to non-accountants (like me), depreciation is considered an inflow (it is an expenditure in the Profit and Loss statement, but the cash is not paid to any one and remains within the company); creditors/accounts payable is an inflow (because they haven’t been paid yet); debtors/accounts receivable is an outflow (because a ‘sale’ has been accounted in the Profit and Loss statement but the money hasn’t been received yet).

Net Cash Flow from Operating Activities should preferably be positive, and greater than the previous year’s if the net profit has gone up. Newly set-up companies, particularly those in high growth fields like Information Technology or Bio-technology, often have negative cash flows from operations in their initial years. They need to ramp up operations quickly to meet demand but may not be able to negotiate good payment terms from their clients.

Negative cash flows from operations of established companies, if over prolonged periods, indicate that there is something amiss with the business model, or the management has questionable integrity and is diverting cash to unlisted subsidiaries or to related parties.

Investors need to be particularly wary of companies that show good top-line and bottom-line growth year after year, and pay taxes and dividends but show negative cash flows from operations. Where is the cash to pay the taxes and dividends? It comes from regular borrowings and share issues. If such a situation continues for a few years, the debt burden will eventually sink the company. Many realty and high-flying infrastructure companies, and investor favourites like Bartronics, Cranes Software fall within this category.

(Note: The next two parts of the Cash Flow Statement will be covered in Thursday’s post – so please stay tuned.)

Related Post

Can a growing, profitable company go out of business?