How to Read Cash Flow Statement in 5 Steps?

The cash flow statement is one of the most important tools of fundamental analysis. It tells the amount of cash a company is actually generating and spending on various activities.

It does not include the sales that are done on a credit basis. Therefore, it gives the details of the cash position of a company. In short, one can say that the financial situation of a company is not so much decided by the profits earned but more realistically by the cash flows or liquidity of the company.

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Also Read:

How to Read a Profit & Loss Statement?

How to Read a Balance Sheet?

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A good cash balance is always considered good for a company as this indicates the ability of a company to grow at a good pace. Let us see how a cash flow statement looks like by having a look at the cash flow statement of Bata India for the year ended March 31, 2017.

Also, let us try to understand how to read a cash flow statement.

 

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Understanding Cash Flows from Operational Activities of a company

Before starting with the discussion of the implications of items in the cash flow statement, let us understand the different kinds of activities that are done by a company and how they impact the cash balances. In the practice to learn how to analyze stocks, this activity is going to be really crucial.

The first kind is:

Operational activities (OA)

They are the activities that are directly related to the daily core business operations of a company. Cash Flows from operating activities show the amount of cash that comes from the sales of the company’s products and services.

Two examples of operational activities and their impact on cash balances are:

Expenditure towards advertisement –

It decreases the cash balance and treated as an asset on the balance sheet.

Expenses in hiring new recruits, etc. – This also decreases the cash balance and treated as an asset on the balance sheet as it is increasing the intellectual capital of the company.

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Understanding Cash flows from Investing Activities of a company

Investing activities (IA) are the activities related to investments that a company makes in order to reap benefits at a later stage. Basically, investing activities reflect the amount of cash the company has spent on capital expenditures, such as new equipment or a new store. Investing activities also include acquisitions of stakes in other businesses.

Two examples of investing activities and their impact on cash balances are:

Investment in a building for opening a new retail outlet – Its impact on the cash flow is that the cash balance gets decreased but treated as an asset for the company on the balance sheet.

Investment of excess money in a fixed deposit – It decreases the cash balance and treated as an asset as it is equivalent to cash.

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Understanding Cash flows from Financing Activities of a company

Financing activities (FA) are the activities related to all financial transactions of the company. Some sources of cash outflow can be the repayment of a bank loan. Two other examples of financing activities and their impact on cash balances are:

Issue of new shares to raise fresh capital for expansion – Its impact is that it increases the cash balance and considered as a liability on the balance sheet as the share capital increases.

Borrow a short-term loan from the bank – It increases the cash balance but treated as a liability on the balance sheet.

Now if we look closely, we will get to know the key concept of creating a cash flow statement. We will find out that whenever the liabilities of the company increases the cash balance also increases. Also, it means that if the liabilities decrease, the cash balance also decreases.

Similarly, whenever the asset of the company increases, the cash balance decreases. It would also mean that if the assets decrease, the cash balance increases.

Cash Flow of the company = Net cash flow from operating activities + Net Cash flow from investing activities + Net cash flow from financing activities

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Identification of Potential Concerns

1. Look closely is there is an increasing difference between a company’s reported earnings and its cash flow from operating activities. If net income is much higher than cash flow, then, the company may be speeding or slowing its booking of income or costs. Most of the profit not getting converted into cash could indicate that the money is tied up in accounts receivables which means that the company is taking too long to generate cash from its sales. Money that is tied up in accounts receivables (and inventory) gives no return.

2. Look out for the company’s use of profits. If it doesn’t re-invest some of the profits in its business, it might show artificially high cash inflows in the current year which may not be sustainable over the long term.
3. Also, beware of situations where a company is not investing its free cash flow in growing its business and instead, funneling it into bad assets like loans and advances. Such investments might indicate fraud – the money may be taken out of the business in loans that will be written off making the company unsustainable in the long run.
4. Sometimes, companies show items from operating expenses in the balance sheet as assets and depreciate (or amortize) them over years. Because of this, the operating cash flows get a boost as some of the expenses are shifted to investing activities. One should be aware of any sudden increases in capital expenses that come with a proportionate increase in cash from operating activities. Further investigation must be done in such cases to ensure everything is going fine in the company.
5. Sometimes, companies report cash spent on inventories in investing activities and amortized over one year, which should have been a part of operating cash flow. Because of this, operating cash flows get a good boost. One should question such practices and try to understand the real intentions behind these misclassifications.

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Calculation of Free Cash Flow

Before understanding how to calculate the free cash flow for any company, let us discuss why one should prefer to invest in companies that have a lot of free cash flow.

Free cash flow usually tells about the ability of a company to distribute dividends, repay its debt obligations, buy back stocks and grow the business easily and expand it.

The free cash flow of a company can be calculated as follows:

Free Cash Flow = Net Income + Amortization / Depreciation – Change in working capital – capital expenditures

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Final Words

By carefully analyzing the cash flow statement of a company, a fair idea about the fundamentals of a company can be obtained. One should prefer to invest in companies where free cash flow is large and the company can pay for the investment amount out of operations without taking help in the form of any loans from banks, etc.

Before making a decision to invest in a company, one should look at:

• The cash flow statement and ask some questions like whether the company has increased or decreased its cash and cash equivalents during the period,
• How much cash was earned through operations,
• How much cash was reinvested in the business,
• Were any assets sold during the period,
• How much cash was spent in distributing dividends to its shareholders in comparison to previous years,
• How much cash was utilized in repaying its debt and
• Whether the company raised any additional cash from issuing new equity in the market or not.

The answers to all these questions will help in knowing the overall cash situation of the company which speaks volumes about the performance of the company.

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