Cash Flow Statement

Cash Flow statement

The cash flow statement (CFS) records the amount of actual money that flows into and out of the company. According to a 2010 Forbes articles entitled, "What is a Cash Flow Statement?" the "CFS allows investors to understand how a company's operations are running, where its money is coming from, and how it is being spent." The cash flow statement helps investors and potential investors determine whether a company can be trusted to spend their money wisely.

Long-term investors in the stock market are betting that the future of companies today will be better than the present or at least as good. The basic idea is that profits drive stock prices and companies that can deliver consistent profits today and are in position to continue delivering profits are prime targets for long-term investors.

There are many keys to determining whether a company is a good long-term investment or not, but one of the most important is free cash flow.

If a company manages its working capital well, then ideally, its CFO should be higher than PAT because of the impact from adding back interest and depreciation. Therefore, when we notice that over 10 years CFO of a company is less than the cumulative PAT it has declared, then it should raise flags. It would indicate that the money is being stuck in working capital.

Money is most commonly stuck in working capital in the form of unrealized receivables from customers, which is indicated by increasing receivables days or in form on increasing inventory levels, which is indicated by decreasing inventory turnover ratio.

If the profits are stuck in working capital and not available as free cash, it would reduce the cash available for running day-to-day operations like payment to vendors, salaries to employees, interest & principal payments on bank loans and capital expenditure for new plants. In such a scenario, the company would have to rely on other sources of cash like equity or debt to fund its cash requirements. This would lead to either equity dilution, thereby reducing stake of existing shareholders or increasing debt levels, which would reduce profitability by higher interest costs and increase the risk of bankruptcy in case of tough economic scenarios

Therefore, conversion of profits into cash is necessary for any company to survive over long periods. If an investor finds that a company is not able to do so, then she should study it in depth and in absence of any satisfactory explanation, she should avoid investing in such a company and look for other opportunities.

Cash from Investing Activity (CFI)

• Purchased capital - An item on the cash flow statement that reports the aggregate change in a company's cash position resulting from any gains (or losses) from investments in the financial markets and operating/adding new subsidiaries, and changes resulting from amounts spent on investments in capital assets such as plant and equipment.
• Purchase/sale of Fixed assets, Purchase/sale of investments, Interest income, Dividend income.

Cash from Financing Activity (CFF)

• Positive cash flow from finance could come by receiving cash from issuing stock and receiving cash from issuing bonds. And from borrowing of funds.
• Negative cash flow from finance could be because of activities like using cash to repurchase previously issued stock, pay debt and/or to pay interest on debt and to pay dividends to shareholders (which is obviously good). So in a nutshell, even negative cash flow from financing activities is also not entire bad, one should understand the nature.
• The negative cash flow in Financing activity is majorly the dividend payouts and bonus issues
• Incoming loan - Loan repayment - Taxes

Net Cash Flow (NCF)

NCF = CFO - (Cash Flow from investing activity + Cash flow from Financing activity)

Free cash flow (FCF)

Free cash flow is not the same as net cash flow

• Now, apart from the above-mentioned expenses, a company also must buy machinery, buildings, tools, and other things. It must invest money in real estate, buildings, and equipment.
• Also, the company needs to buy inputs for its production. It has to buy steel if it wants to produce cars. In financial terms, a firm has to purchase working capital to support its business activities. On top of that, a company must pay income taxes on its earnings. The amount of cash that is left over after the payment of all these expenses, investments, and taxes is known as Free Cash Flow or FCF.

Free Cash Flow = NPAT – Change in Working Capital – Capital Expenditure

• A high and rising FCF generation signals a company’s ability to pay debt, pay dividends, buy back stock and facilitate the growth of business – all important things from an investor’s perspective. When a company’s share price is low and FCF is on the rise, there are great chances that earnings and share value will soon be on the up. By contrast, falling FCF signals trouble ahead. In the absence of decent FCF, companies are unable to sustain earnings growth as they don’t have much of free cash for growth and expansion.

Accumulated cash YOY

You can calculate the net cash retained by a company YOY by adding the net cash flow YOY

Cash Flow Ratio

Price to Free cash Flow

In general, the higher this measure, the more expensive the company is considered. But it is useful also to compare to the company's past levels of price-to-free-cash flow along with comparing the average within its industry. For example, if a company generated $200 million in operating cash flow and spent $50 million on capital expenditure, then it generated free cash flow of $150 million. If the company currently has a market cap of $5 billion, the company trades at 33 times free cash flow ($5 billion/$150 million).

What should investors look for in terms of free cash flow and how should they measure its impact on the company?

• One of most common ways to measure the strength of free cash flow is to look at it as a percentage of sales. If that percentage exceeds 5 to 7% of sales, then it is a good assumption that this company probably has a competitive advantage or economic moat. Financially strong companies often have high operating margins and lower expenses than their competitors. Free cash flow, like all other financial measures makes more sense when viewed in context. Compare it to other companies in its industry and look back to determine if the strong free cash flow has a history or is something new to the company. Although there are many other factors to consider, a history of strong free cash flow is a good indication that the company probably has a competitive advantage and is worthy of a deeper dive into the other factors that determine whether it is in fact a good long-term investment bet.

• Many long-term investors reject companies as investment candidate that do not have a history of strong free cash flow.

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Cash Return On Assets

A ratio used to compare a businesses performance among other industry members. The ratio can be used internally by the company's analysts, or by potential and current investors. The ratio does not however include any future commitments regarding assets, nor does it include the cost of replacing older ones.

Cash Return On Assets = cash flow from operations / Total Asset

A high cash return on assets ratio can indicate that a higher return is to be expected. This is because the higher the ratio, the more cash the company has available for reintegration into the company, whether it be in upgrades, replacements or other areas.

Operation cash flow better than Net Income

Courtesy : Investopedia

Operating Cash Flow is the lifeblood of a company and the most important barometer that investors have. Although many investors gravitate toward net income, operating cash flow is a better metric of a company's financial health for two main reasons. First, cash flow is harder to manipulate under GAAP than net income (although it can be done to a certain degree). Second, "cash is king" and a company that does not generate cash over the long term is on its deathbed.

But operating cash flow doesn't mean EBITDA (earnings before interest taxes depreciation and amortization). While EBITDA is sometimes called "cash flow", it is really earnings before the effects of financing and capital investment decisions. It does not capture the changes in working Capital (inventories, receivables, etc.). The real operating cash flow is the number derived in the statement of cash flows.

Overview of the Statement of Cash Flows

The statement of cash flows for non-financial companies consists of three main parts:

• Operating flows - The net cash generated from operations (net income and changes in working capital).
• Investing flows - The net result of capital expenditures, investments, acquisitions, etc.
• Financing flows - The net result of raising cash to fund the other flows or repaying debt.By taking net income and making adjustments to reflect changes in the working capital accounts on the balance sheet (receivables, payables, inventories) and other current accounts, the operating cash flow section shows how cash was generated during the period. It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important.

Cumulative PAT vs. cumulative CFO:

A company that sells any product today might not receive its payment immediately. However, it is legitimately eligible to receive it. Therefore, accounting standards allow it to report this sale and its profit in the P&L. However, the money received from buyer will be reflected in CFO only when the money is actually received from the buyer.

Therefore, if we compare PAT and CFO for any one year, they would differ from each other. However, over a long time, cumulative PAT and CFO should be similar.

If cumulative PAT is similar to CFO, it means that the company is able to collect its profits in actual cash from its buyers. If CFO is abysmally lower than PAT, it would mean that either the company though legitimately eligible to receive money from buyer, is not able to collect it or the profits are fictitious. In either case, the investor should avoid such a company.

Let us compare cumulative PAT and CFO of VOL over time. Figures are in INR Cr. (10 million). Some calculations might show some mismatch because of rounding off.

We can see that VOL registered profits of INR 351 cr. (3.51 billion) during 2015-2014 and collected INR 353 cr. (3.53 billion) net cash flow from operations. This is a very healthy sign for any company.

• Cash is used to make inventory.

Inventory is sold and converted into accounts receivables (because customers are given 30 days to pay).

Cash is received when the customer pays (which also reduces receivables).There are many ways that cash from legitimate sales can get trapped on the balance sheet. The two most common are for customers to delay payment (resulting in a build up of receivables) and for inventory levels to rise because the product is not selling or is being returned.

For example, a company may legitimately record a $1 million sale but, because that sale allowed the customer to pay within 30 days, the $1 million in sales does not mean the company made $1 million cash. If the payment date occurs after the close of the end of the quarter, accrued earnings will be greater than operating cash flow because the $1 million is still in accounts receivable.

• Harder to Fudge Operating Cash Flows

Not only can accrual accounting give a rather provisional report of a company's profitability, but under GAAP it allows management a range of choices to record transactions. While this flexibility is necessary, it also allows for earnings manipulation. Because managers will generally book business in a way that will help them earn their bonus, it is usually safe to assume that the income statement will overstate profits.

An example of income manipulation is called "stuffing the channel" To increase their sales, a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Inventories will then move into the distribution channel and sales will be booked. Accrued earnings will increase, but cash may actually never be received, because the inventory may be returned by the customer. While this may increase sales in one quarter, it is a short-term exaggeration and ultimately "steals" sales from the following periods (as inventories are sent back). (Note: While liberal return policies, such as consignment sales, are not allowed to be recorded as sales, companies have been known to do so quite frequently during a market bubble.)

The operating cash flow statement will catch these gimmicks. When operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive EPS. In this situation, investors should determine the source of the cash hemorrhage (inventories, receivables, etc.) and whether this situation is a short-term issue or long-term problem.

• Cash Exaggerations

While the operating cash flow statement is more difficult to manipulate, there are ways for companies to temporarily boost cash flows. Some of the more common techniques include: delaying payment to suppliers (extending payables); selling securities; and reversing charges made in prior quarters (such as restructuring reserves).

Some view the selling of receivables for cash - usually at a discount - as a way for companies to manipulate cash flows. In some cases, this action may be a cash flow manipulation; but I think it is also a legitimate financing strategy. The challenge is being able to determine management's intent.

• Cash Is King

A company can only live by EPS alone for a limited time. Eventually, it will need cash to pay the piper, suppliers and, most importantly, the bankers. There are many examples of once-respected companies who went bankrupt because they could not generate enough cash. Strangely, despite all this evidence, investors are consistently hypnotized by EPS and market momentum and ignore the warning signs.

The Bottom Line

Investors can avoid a lot of bad investments if they analyze a company's operating cash flow. It's not hard to do, but you'll need to do it, because the talking heads and analysts are all too often focused on EPS.

Cash Flow can be manipulated