The analysis of a company is the starting point for investing in stock markets. It is the basis on which investors can build a sound portfolio. The analysis of a company involves studying its profitability as well as its liquidity. A company may be profitable but a cash-strapped company cannot survive conveniently for long. Therefore, analyzing the cash position of the company is crucial to understand its long-term viability. This is where the cash flow statement comes into the picture. The ability to read financial statements includes the way to read cash flow statements which is essential to understand the true and fair view of the company. Given below is how a person can read cash flow statements and how they are interpreted.
Read more: Fund Flow Statement -what is it and how do you use it?
What is a cash flow statement?
The financial statements of a company have three important parts namely the balance sheet, the profit and loss statement, and the cash flow statement. The former two components talk about the net worth and the profitability of a company while the third part, the cash flow statement, is all about the liquidity position of the company. The cash flow statement is the record of all the cash inflow and outflow in the organization on account of various activities during a particular period. Such a period is usually a financial year or an interim period (one or two quarters).
What are the components of a cash flow statement and what do they say?
The cash flow statement is drafted by the management of the company as per the provisions of the Companies Act 2013. This statement is divided into three components based on the nature of the activity through which such cash flow is generated. The two main interpretations from a cash flow statement are where is the major chunk of cash spent and whether is it benefitting the organization. These components and their interpretation is highlighted below
- Cash flow from operating activities
Under this category, cash flow is generated through the routine business operations of the entity. The starting point of analyzing the cash flows from the operating activities is the net income of the company. All the non-cash expenses and non-cash incomes during the period are adjusted back to get the true cash flow during the target period. This will help in understanding if the cash flow from operating activities is positive or negative.
It is always beneficial for a company to have a positive cash flow from operating activities and it should be higher than the net income. This is a sign of a healthy business model as such entities do not have to rely much on borrowed funds to make the business profitable. On the other hand, if the net income is positive but the cash flow from this component is negative, it implies that the earnings quality of the entity is quite poor and it takes a longer time for its sales to convert into actual cash or has a huge load of operating expenses that eat into such revenues. Analysts also review the cash flow statement for consecutive periods to understand if the cash flow situation is improving, stagnant, or getting worse.
- Cash flow from investing activities
Cash flow from investing activities talks about the cash flow generated by the sale of assets or used in purchasing new ones and income from investments. The life cycle of the business or the stage of the business can also be analyzed through this section. A business that is capital intensive and is at a growing stage will have higher cash outflow from this section while a business that is not capital intensive or is at a matured stage of business will have less cash outflow or positive cash flow. A business with an aggressive strategy or in an expansion mode would also have negative cash flow in this section. The key to analyzing though is comparing the cash flow from investing activities for consecutive periods to ascertain if the business is in a better position or not.
In a matured business where the overall cash flow statement is positive only on account of positive investing activity cash flows, may be interpreted as the business having to sell its assets to stay afloat. This is a clear warning sign for the stakeholders that the business is not in a good shape. On the other hand, a growing and aggressive business may have negative cash flows for the time being but the returns from investing activities will yield results in the long run and at such time the cash flow from investing activities will turn positive.
- Cash flow from financing activities
This is the final component of a cash flow statement. Under this category, a business accounts for all the cash flow from its financial operations like dividend outflow, interest and principal payments on debt obligations, cash flow due to the issue of fresh equities, buyback of shares, etc. A company consistently paying dividends as well as having huge debt obligations will have a negative cash flow from this component. But it does not immediately mean bad for the business if the cash flow from operating activities is positive. Such companies can be considered stable as they can generate enough cash flow from operating activities to sustain their business and meet their financial obligations.
On the other hand, if a company is selling assets to meet dividend payments and interest payments, it is a definite red flag. It implies that the company is severely cash-strapped and the only way for them to meet their financial obligations is by the sale of assets. If such assets are key business assets it sells further doom as any business cannot survive long by losing its key assets.
Conclusion
Cash flow statements are known to disclose the bones of the business. Hence, it is crucial for analysts and successful investors to have the ability to read a cash flow statement effectively and answer key questions like is the company using its capital in an optimum manner, or if the business is investing in assets that can help it sustain in the long run. A clear sign of a successful or stable business is that it has enough positive cash flows from operating activities to fund its strategic investments as well as meet its long-term financial obligations. Therefore, in the long run, the cash flows from investing activities and financial activities are more or less equal to the operating cash flows.
FAQs
A business having consistently positive operating cash flows indicates that it uses its resources optimally and the revenues from operating activities are enough to meet its operating expenses which is crucial for the smooth functioning of any business.
A company having high investing cash flow may not always be a red flag. A growing and aggressive business will make more strategic investments that will help it reap benefits in the long term. However, it is important that such investments are backed by proper logic and strategy and are in line with the business model.
A company can issue dividends from its free reserves as per the provisions of the Companies Act, 2013. In a bid to please shareholders and investors as well as showcase a positive picture of the company, it may declare dividends despite losses or lower profits. In such a scenario, the cash flow statement is used to make a correct analysis of the company’s position. A company with consistently negative operating cash flows is a sign of an ailing business and declaring dividends in such a scenario can be interpreted as an act of window dressing by analysts.
Some red flags that can be interpreted from the cash flow statement are consistently decreasing revenues, increasing operating cash outflow, positive cash flow in investing activities on account of the sale of key assets, increasing debt-equity ratio, and increasing interest payments, negative cash flow from operating and financial activities but positive cash flow from investing activities, etc.
