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While analyzing the fundamentals of a company, most of us look at the balance sheet and profit and loss statement to get insights into how a company has performed in the past. While analyzing both the statements is necessary, there is another financial statement that we often ignore but is of utmost importance, and that is cash flow statement. In this post, we will discuss what is cash flow statement, why is it important and how to analyze cash flow statement and get deeper insights of the company to get the real picture of its financial performance.
What is a Cash flow Statement ?
Cash flow statement (also known as the statement of cash flows) is one of the three key financial statements that reports about the total cash generated and spent by a business during a specific period of time.
Put simply, cash flow statement shows how a company spends its cash and the sources that it receives cash.
Companies usually receive cash from various sources such as cash from its ongoing business operations and external investment sources such as investment made by the business in other companies in the form of equity shares or bonds.
Cash outflows usually takes place when companies buy new assets such as plant and machinery, or makes an acquisition or pays its debt.
Why is Cash Flow Statement Important?
The question however is, why is cash flow statement is so important and why do we need to learn about it? Is it even that important?
If you believe investors like Warren Buffett and Peter Lynch, cash flow statement is one of the most important financial statements. In many instances, Warren Buffett has stated that he focuses on cash flows of a company, not the profit to evaluate the future growth potential of the business. Why? Well, there are many reasons behind it, some of them are as follows:
Cash is the blood of a business:
Sir Richard Branson, a very successful entrepreneur and owner of Virgin Group said, “Never take your eyes off the cash flows, because it is the life blood of the business.”
Every business needs cash flow for various purposes such as to meet its daily expenses, to pay loans, taxes and even purchase new assets.
A cash flow statement helps investors determine if the company has sufficient cash to meet all its requirements. Companies that are unable to meet such expenses using their cash flows have to rely on external borrowing which may become a problem in the future if the company is unable to pay back its dues.
Companies and businesses that have sufficient cash flows do not have to borrow which shows that company has a strong business that is able to generate sufficient funds to meet its needs.
There is another, and even more important reason why cash flow statement becomes even more important from an investors point of view as it gives you a true picture of how much a company is actually earning. What does it mean? Let me explain.
Cash Flow statement separates wheat from chaff:
Apart from the reasons mentioned above, there is another reason why cash flow statement becomes crucial while analyzing a stock for long term investment.
Most of the companies use accrual accounting where revenue is reported as income when the sales take place rather than when the company actually receives payment.
For example, if a company records a sale, the revenue is immediately recognized and recorded in the profit and loss statement of the company, but the company may receive the payment (actual cash) at a later date.
This creates a disparity, where in accounting terms the company is earning a profit and would be paying income tax on it, however, no real cash would have been exchanged. All such sales are recorded as accounts receivables.
On the other hand, since the company has to buy raw material to produce goods, the company has to spend real cash. Because of the accrual accounting the Net income that you see in the profit and loss statement does not necessarily mean that all the receivables were collected and converted to cash. In such cases, if the receivables remain uncollected for a long period of time, the company may run into financial problems of cash crunch.
What is most dangerous in such cases is that look most profitable on paper may fail to efficiently and adequately manage their cash flows and that is why analysis of cash flow statement becomes a critical tool for analysts and investors.
Components of Cash Flow Statement:
Having understood the cash flow statement, we need to understand the components of cash flow statement which are divided into following parts.
- Cash flow from operations
- Cash flow from investments
- Cash flow from financing
- Free cash flow
Let us understand each of these components in detail:
Cash Flow from Operations:
As the name suggests, cash flow from operations (also known as operating cash flows) is the amount of cash that a company brings in from its operations, that is from its core business.
Cash flow from operations does not include cash that a company receives from other sources such as the sale of an asset, or cash received from borrowing.
Operating cash flow is important as it helps you assess the long term liquidity status of the company that is, if the company is able to generate sufficient cash flows to meet its operational requirements and expand its business using its own cash.
How to Analyze Operating Cash Flows?
The best way to analyze cash flow from operations is by analyzing how much cash the company generates against total sales, this ratio is known as cash flow to sales ratio, the formula for which is as follows:
Operating Cash flow to Sales Ratio = Operating Cash Flow / Sales
The ratio gives investors a clear idea on how much percentage of sales is converted to cash flow.
If the sales are rising and the percentage is improving consistently, it shows that company is efficiently convert its sales into cash flows.
If the sales are rising but the percentage is declining, it shows that company is struggling to convert its sales into cash and may face cash crunch in the future.
To understand this in a better way, let us take a look at some of the real life examples.
Example 1: The first example is of ITC. If you look at the past 10 years of operating cash flow, you will find that in the year 2010 the operating cash flow of the company was around ₹4,641 crores which increased to ₹11,749 crores in 2019 a CAGR growth of 10.6% (approx).
During the same period the sales of the company increased from ₹19,126 crores to ₹48,352 crores a CAGR growth of 10% (approx).
The fact that the CAGR growth of both sales and cash flow are almost the same proves the fact that company is consistently is converting its sales into cash flow, which is a sign of healthy cash flow of the company.
As a result of this, the company has maintained the operating cash flow to sales ratio at around 25% for the past 10 years.
Example 2: In the second example, we will look at Zee Entertainment. If you look at the sales numbers of the company for the past 10 years, you will find that company has seen a sales growth from ₹ 2,199 in 2010 to ₹7,933 crores in 2019 a CAGR growth of 15.32%.
However, during the same period, the operating cash flow of the company has declined from ₹706 crores in 2010 to ₹135.2 crores in 2019.
As a result of this, the operating cash flow to sales ratio of Zee Entertainment declined from 19% in 2010 to 2% in 2019.
Cash Flow from Investing:
The second component of cash flow statement that you need to look at is cash flow from investing, this section gives investors details about how much cash has been generated or used in various investment related activities, which includes buying and selling of assets (such as property, plant, equipment), or acquisition of businesses, and investment in various securities such as shares of other companies.
Cash flow from investing activities gives investors an account of where the cash of the company is being invested, as it is used in expanding business by buying non current assets, making acquisitions, which will deliver the value in long term.
So how does cash flow from investing influence overall financial performance of the company? As mentioned earlier, the cash flow from investing is used to buy new assets to expand its business and generate higher profits. Such investments are called capital expenditure or capex. In simple words capital expenditure or capex is the money spent by the business in buying new plant and machinery to expand its business.
An increase in capital expenditure means that the company is investing in future operations, which is expected to deliver future value to the company.
However, there are a few points that you must keep in mind while analyzing cash flow from investing.
While it is positive for a company to buy new assets and expand its business as it adds value to shareholders fund in the future always keep in mind that every capital expenditure should be backed by higher profits and free cash flow in the future to justify the capital spent in acquiring new assets.
In simple words, if capital expenditure is not backed by higher profits it means that the company is unable to utilize newly acquired assets productively and may soon face a decline in its financial performance.
Cash Flow from Financing:
The third component of cash flow statement is cash flow from financing activities. It focuses on the inflow and outflow of the cash that takes place because company has raised some capital from its external sources such as debt or equity or if the company announces a buyback of shares.
Companies that raise capital from external sources will see an inflow of cash, (that is a positive number) on the other hand an outflow indicates payment made by the company which could be in the form of payment of debt, distribution of dividend or buyback of shares.
How to read cash flow from financing?
One of the most accurate and the easiest way to analyze cash flow from investing is to look at how often does a company raise the capital and what are the sources.
If the company is relying heavily on the external sources of capital for its funding and needs frequent capital infusion, its one of the preliminary signs that company’s business is highly capital intensive or company has poor profitability and thus has to rely on external sources to meet its operational expenses.
Free cash Flow:
The fourth and the most important component of cash flow statement is the free cash flow as it is used to measure the true growth of the business.
The free cash flow is calculated by subtracting capital expenditures from operating cash flows.
Free cash flow as the name suggests, is the “free” cash left with the company after paying for all business related expenses.
Think of it as the cash that is left with you at the end of each month from you salary after paying all your expenses(such as EMI, rent, food and clothes, entertainment, etc.)
This is the cash that a company is free to use whichever way it wants. Higher the free cash flows, better it is for the company.
But what makes free cash flow so important? Well, there are multiple reasons behind it, some of them are mentioned below:
Importance of Free cash flow:
As mentioned earlier, free cash flow is the cash left with the company after accounting for all the expenses, this gives you real numbers of profitability that a company actually earns.
Many companies use accrual accounting and other financial shenanigans to boost their profits, giving a false image of good financial performance.
By analyzing the free cash flow numbers you can detect if the profits claimed by the company are real or not.
The question now is how do you calculate free cash flow? Well, the formula for calculating free cash flow is pretty simple. All you need is two data points, first, cash flow from operations, which you can easily get from the cash flow statement of the company, and second, capital expenditure, which you can get from many websites such as morningstar.in.
The formula for calculating free cash flow is as follows:
Free Cash Flow = Operating Cash Flow – Capital Expenditure
By subtracting capital expenditures from free cash flow, you will get how much free cash flow a company is generating.
For example, let’s assume a company X has operating cash flow of ₹1,000 crores and capital expenditure is ₹ 400 crores so the total free cash flow generated by the company is:
Free cash flow of company X = 1000 – 400 = 600 crores
The total free cash flow generated by Company X is ₹600 crores.
Having looked at free cash flow in detail, there are a few important points that you must keep in mind while analyzing free cash flow.
First, do not look at free cash flow numbers from year to year basis, why? Companies often invest their free cash flow in expanding their business by buying new assets called capital expenditure.
If there is a sudden decline in the free cash flow, just look at the capex numbers for the same year, if you find a sudden jump in capex, its evidence that company is investing its free cash in business.
Limitations of Cash Flow Statement:
Even if cash flow statement is one of the best tools to find great companies to invest in, it also has its own disadvantages.
First, cash flow statement is backward looking statement, that is it simply takes into account what has happened in the past and completely ignore the future growth potential of the business.
For example, if a company has invested heavily in Research and Development of its business, it will not reflect in the statements, while in the future, there is a high chance that company may generate huge cash flows from its breakthrough research.
Another disadvantage of cash flow statement is that it is not so easy to interpret, that is you still need company’s balance sheet and profit and loss statement to completely understand the flow of cash.
For example, using solely the cash flow statement its difficult to understand if the company is using its cash in paying off its debt or investing in more assets.
If you want to understand the company and its financial position, you definitely need all the three financial statements. Relying solely on the cash flow statement for analysis of a company may not give you a complete picture. That, however does not mean analysis of cash flow statement is useless.
If a company has positive cash generation, its a strong indicator that the company is able to fund its own business expansion requirements and does not have to rely on external borrowing and weather the hard times.