Ending my three part fundamentals series, we have the cash flow statement (CFS). Arguably this is the most overlooked of the three. There will be paraphrasing of Investopedia, since the site is good at simplifying financial terms. In case you missed my earlier post on the balance sheet, click here.
The cash flow statement complements the balance sheet and income statements as it summarizes the amount of cash (and equivalents) entering and leaving the company. It shows where money is coming from and how it is being spent.
The main components of the statement are:
- Cash from operating activities
- Cash from investing activities
- Cash from financing activities
Note that the CFS is distinct from the income statement and balance sheet because it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the same as net income, which on the income statement and balance sheet, includes cash sales and sales made on credit.
Cash Flow From Operating Activities
The operating activities on the CFS include any sources and uses of cash from business activities. In other words, it reflects how much cash is generated from a company’s products or services. Positive (and increasing) cash flow from operating activities indicates that the core business activities of the company are thriving.
Cash Flow From Investing Activities
Investing activities include any sources and uses of cash from a company’s investments. A purchase or sale of an asset, loans made to vendors or received from customers or any payments related to a merger or acquisition is included in this category. In short, changes in equipment, assets, or investments relate to cash from investing.
Cash Flow From Financing Activities
Cash flow from financing activities is a section of a company’s shows the net flows of cash that are used to fund the company. Financing activities include transactions involving debt, equity, and dividends. Some examples are: issuance of equity (shares), payment of dividends, issuance of debt (e.g. bonds) and repayment of debt.
As an example of how a typical cash flow statement looks like, below is Amazon’s cash flow statements for the years 2015, 2016 and 2017.
What to Look For…
I prefer looking at the development of companies’ cash flow statements more than the income statement since “creative” cash flow reporting is much harder. What this means is that it’s much easier to fiddle with the income statement in order to make the numbers look better than it is with with the CFS.
Generally, you want to see a steady increase in cash flow from operations. If this number is growing (while debt being in control) at a rate of 10% or more annually, you’ve got something good going on.
Free Cash Flow
One of the most important figures of all is free cash flow (FCF). It is the cash flow available to all the creditors and investors in a company, including common stockholders, preferred shareholders, and lenders (AKA. The real amount of cash your business is producing). As a stockholder, you are the business owner, meaning this number is your baby. Since companies are not obliged to report this number separately, sometimes you need to figure it out yourself. Now, financial literature may have different definitions of how to calculate this number, but we’ll stick with simplicity. FCF = Operating cash flow – capital expenditures (aka. CAPEX). Simply, capital expenditures on the CFS is the line item “Purchase of Property, Plant and Equipment” (PPE). the PPE expenditure is the “maintenance amount” of running a business. Though it says “purchase”, this includes repairing, renewal and/or maintenance of the companies assets.
Notes on Capex
Capex of course varies between industries. You wouldn’t compare a steel mill with an online business when evaluating businesses. Though capex is important, and preferably you want as much free cash flow as possible, a high capex company is not necessarily a bad investment. What’s more important is how a company uses the FCF it has. This is the topic of Capital Allocation, and it needs a completely separate blog post. Rising FCF, while having capex under control (not rising at crazy rates) is usually a great sign. To conclude, I’ll quote my old finance professor:
“Sales is vanity, profit is sanity, cash is reality”
In school, this quote didn’t really open up to me. My thought was “Isn’t sales and profit (the bottom line?!) the most important? How foolish of me. The good news for the intelligent investor is that most of the market adheres mainly to growth in the top and bottom line, ignoring cash flows. They do not see themselves as business owners, and this difference in motivation is what creates opportunities for you.
-IGTSKasimir
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