Research Series Part 7 – The Cash Flow Statement

Part 7 of this series will focus on the Cash Flow Statement, another often-neglected financial document. As said previously, most investors simply focus excessively on the Profit and Loss Statement (Income Statement) and totally and completely ignore the Balance Sheet and Cash Flow Statement, to their detriment. The Income Statement can be manipulated to a certain extent through adjustments to fair value instruments and revaluation of properties or intangible assets to show large gains; while the Balance Sheet can similarly be “bumped up” to include “nice” numbers such as healthy receivables and increased assets. However, the cash flow statement makes it difficult to hide such anomalies, because it attempts to “strip” all accruals out and leave just the bare facts behind; which is how the company makes use of cash and liquid resources to run the business.

For those who are unfamiliar, the cash flow statement is a financial document which lists out all the cash flows associated with the company for a period of time (either quarter, half-year or full-year). This is broken down into three key sections; namely operating activities, investing activities and financing activities. Operating activities is the main focus of the company (i.e. its core business) and represents cash flows it receives from carrying on its principle business. All cash flow statements as reported by listed companies have the indirect method format as required by the Financial Reporting Standards, thus all of them start with net profit before tax or loss before tax and then add back all non-cash items such as amortization, depreciation and revaluations. This is the section which lets readers see what has been charged to the Income Statement which is non-cash by nature. Learn more in the section below as I split my explanation into three distinct sections tackling the three aspects of the cash flow statement.

Investing activities are defined as activities which include the purchase and sale of fixed assets as well as investments in AFS (available-for-sale) securities. These activities generally help to bolster the fixed asset base of the company and are long-term in nature. Financing activities include cash inflows from the issuance of shares and bonds, and this category includes methods of financing from the company in order to raise cash, as well as payments for interest expenses relating to loans, convertible bonds and debts. Let’s now take a look at each section to pick out the important points:-

Cash Flows from Operating Activities – The most important aspect of a company is its ability to generate cash flows from its daily operations. This section of the cash flow statement essentially deals with the generation of cash from the normal activities of the company. These include changes in inventory levels as well as levels of debtors and creditors over two periods in order to ascertain the net cash inflow and outflow. Warning bells should start ringing if there is a net operating cash outflow, and though it may not be a signal of any deterioration in the cash generating ability of the company, I would think that it still warrants some investigation. In such cases, it would be prudent to assess the cash conversion cycle of the company and also the credit terms given by creditors and to customers.

Cash Flows from Investing Activities – Normally, companies which are expanding very quickly would see a negative cash outflow in this section; principally due to the increase in the purchases of fixed assets. There may also be a net cash outflow due to the company investing in long-term investments which have yet to yield any cash benefits but which may possibly be earnings-accretive in the short-term. Net cash inflows to this section occur when companies divest fixed assets and sell off investments to generate more cash, but take note that these are usually one-off items which will not recur. Also, note that the sale of fixed assets also creates a corresponding one-off exceptional profit/loss in the Income Statement.

Cash Flows from Financing Activities – This is the section of the cash flow statement which shows how a company raises funds in order to sustain growth and expansion. Companies which are expanding quickly (such as Swiber) and are in need of various forms of financing would have to declare the cash effects here. These will include raising monies through the issue of new equity (shares), issuance of bonds or debentures as well as cash inflows from bank loans. Conversely, the company may also choose to pay down bank loans (reduce leverage) if it has excess cash, or to do share buy backs in order to improve EPS.

Simply put, there is no quick and easy formula for analyzing a cash flow statement as all companies are at different stages of expansion/contraction and require or use up cash differently. What this post hopes to achieve is to allow the reader to better understand the various aspects of the cash flow statement; and to highlight the importance of this financial document in the analysis of a company.

On a final note, please do remember that companies cannot survive without CASH, though they certainly can survive without profits ! Thus, cash generation ability is always a more crucial aspect of a company rather than purely looking at the Income Statement.