How to Read a Cash Flow Statement? [Beginners Guide]

 Great post by The Babylonians

If cash is king and cash is the bloodline of a company, then one ought to know how to read a cash flow statement. There is a saying that goes “Revenue is vanity, Profit is sanity and Cash is reality.”

This is the last series of the Beginners’ guide to getting started in investing. We have thus far talked about the income statement and the balance sheet. The final set is none other than the cash flow statement.

1. What is Cash Flow Statement?

A cash flow statement measures how much cash is coming in and how much cash is going out. It is directly connected to the income statement and balance sheet.

Then you might ask, doesn’t the income statement tells us how much cash is coming in and going out? Nope, it doesn’t. Only the cash flow statement does.

That means the net income you see every year doesn’t mean it is cash. It does not mean that in 2019, company XYZ collected $5,021 in cash profits. Now, why is that so?

This is because of accrual accounting, a concept that has been discussed in the previous post. Accrual accounting records revenue and expenses as and when it is incurred, regardless of whether there is any cash inflow or outflow.

For example, revenue is typically recorded when the company has transferred the risk and delivered the goods over to the customers. At this point of time, no cash has been collected as they might have given the customer up to 45 days for payment. BUT, the income statement would show that the company has earned say $20,000 even though cash has not been collected.

This is why the cash flow statement is important. Because it shows the actual cash that is coming in and going out. It removes the veil of accounting gimmicks and reveals the reality of the business.

2. Cash Flow Statement Example

A cash flow statement has 3 main categories:

1. Operating Activities
2. Investing Activities
3. Financing Activities

Operating activities are things that concern the daily business operations of a company. For example, paying suppliers, buying inventories, selling goods and etc.

Investing activities is as the term implies, investing. These are activities that deal with long-term assets such as purchasing land, buying some machinery or selling assets.

Lastly, financing activities are activities like borrowing money from the bank, paying off loans, refinancing and etc.

This is an example of how a cash flow statement would look like. I have decided to recreate a new set of financial statements to illustrate how everything connects.

The first line item of a cash flow statement will always start with the net income figure. This net income is the bottom-line figure that is taken from our income statement.

However, if net income does not mean cash, then how much cash did we collect in 2019? The answer is in the highlighted yellow text under the “net change in cash inflow/(outflow)”.

We collected $22k in 2019. So even though net income in 2019 is $35,550, cash collected in 2019 is $22,000.

How did that happen and why?

3. How to Prepare a Cash Flow Statement

A cash flow statement can be created from scratch just by looking at the income statement and balance sheet. You will see later how all the figures are connected and interlinked. I will use the above company ABC to illustrate a step-by-step process of preparing a simple cash flow statement.

This will get a little complicated. Hence, it is important that you have a fundamental understanding of the income statement and balance sheet before proceeding.

Cash Flow from Operating Activities

We will start with the “Cash Flow from Operating Activities” first.

First thing first, it always starts with the net income. So our top-line figure is $35,550 which is taken from the income statement. Just follow the arrows and observe where the figures in the cash flow statement come from.

Next, we will add back all the non-cash items in the income statement. In this case, only depreciation is a non-cash item. This is because it does not represent a cash outflow. It is just an accounting or accrual concept.

Finally, we will add or deduct all the changes in working capital. For this, we have to calculate the change in the balance sheet figures. Hence, we will need the 2018 and 2019 balance sheet figures. Then calculate what is the difference between both years.

For example, if accounts receivables decrease from 2018 to 2019, what does that tell you? It simply means the customers have paid up and you have collected cash. So that represents a cash inflow. Remember the journal entry transaction that shows how $10k moves from receivables to cash?

If inventories increase, what does that tell you? Well, the company has purchased inventories and that represents cash outflow.

If accounts payable increases, what does it mean? It means that the company has delayed cash payment. It has not paid anything and that should represent an increase in cash.

Hence, you see that the changes in the balance sheet figures flow directly to the cash flow statement. Just think about each line item logically and ask yourself whether it represents a cash inflow or cash outflow.

After which, just sum up all the line items and you will get the net cash generated from operations. Some investors prefer to use this figure rather than the net income as it represents the amount of cash that the company made.

Cash Flow from Investing Activities

In this category, we are trying to find out the cash inflow and outflow from investing activities. In the above example, you see a cash outflow of minus $10k. Why is that so?

Well, because we bought a machine that costs us $10k. That is also the reason why you see PPE has increased from $90k to $100k in 2019’s balance sheet.

On the other hand, if PPE decreases from 2018 to 2019, then what does it mean? It would probably be the reverse. That means we have sold some machines and that should represent a positive cash inflow. Under the cash flow statement, it would probably be “Sale of PPE” instead of “Purchase PPE”.

In the real world, there is probably a mix of sales and purchase. The next step is to sum up all the cash inflows and outflows from investing activities. That would give us the net cash generated from investing activities.

Cash Flow from Financing Activities

Finally, cash flow from financing activities is all the loans, debts, capital raising and dividends.

Again, if short-term debt increases from 2018 to 2019 in the balance sheet, what does that tell us? The company has borrowed some money so that should be a positive cash inflow.

In the above example, short-term debt has decreased from 20k to 15k. It means the company has paid down $5k and that is the same reason why you see a red negative -$5,000 in the cash flow statement. Because it is a cash outflow.

The same logic applies to long-term debt. Since long-term debt has increased $5k from 2018 to 2019, the company would record an increase in cash of $5k in the cash flow statement.

Retained Earnings in Balance Sheet

Lastly, what if the company pays out dividends to shareholders? Then that obviously represents a cash outflow since cash is given out to shareholders. Company ABC paid $5,550 of dividends in 2019, so we have another line item that records this cash outflow under financing activities.

If you have read the previous post on “How to read a balance sheet?“, you will be familiar with the term “Retained Earnings”. If not, here is a quick recap.

If you look at the retained earnings in 2019, it is showing a balance of $33k. How did we get that?

2019’s net income figure is $35,550. The dividends paid to shareholders is $5,550. So the retained earnings are $30,000. That is the money the company keep for itself in 2019. Since the balance sheet is a cumulative measure of what we have, we need to add in the previous year’s retained earnings. That is how I got $33k.

Matching the Cash Flow Statement & Balance Sheet

The final step in the preparation of a cash flow statement is to add up all the net cash generated from the 3 categories (Operating, Investing & Financing). This would give us the net change in cash for the year which is $22k.

You would realise that if you add the net change in cash with the cash balance in 2018, it should give us the cash balance in 2019. That is how everything links up.

4. How to Read & Analyse a Cash Flow Statement?

The last section is to see what ratios or metrics can be used to analyse the cash position of a company. There are quite a few variations but I realised I have not introduced the concept of Free Cash Flow (FCF). How could I? This is probably the most popular figure that everyone uses, including myself.

Free cash flow is calculated by taking cash flow from operations minus capital expenditures. Warren Buffet referred to it as “Owner Earnings“. The reason why FCF is important because it is the amount of disposable cash earnings they have after spending on all the business needs.

Net income isn’t really a cash figure, there are accounting concepts in it. So people use cash flow from operations. For example, Adam Khoo uses operational cash flow to do his DCF analysis and determine the fair value of companies.

However, cash flow from operations excludes the thought that business needs to invest in CAPEX every year to grow and expand. That is the reason why FCF is a more appropriate measure in my opinion.

Apart from FCF or Operation cash flow, there are other measures such as Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE). Now you start to see how those DCF models are highly subjective? Depending on which cash flow figure you choose, the valuation results would return an entirely different ballpark figure.

4.1 Sustainability of Dividend Payouts

This is perhaps the easiest and common way people measure whether a company’s dividend policy is sustainable. How do we do it?

Simply compare the FCF against the total dividends paid. The wider the gap, the higher the buffer or margin the company has. Let’s use one example.

Source: Retrieved from S&P Capital IQ

This is a real cash flow statement. The company is Singtel. At least now you are more familiar with the line items in the cash flow statement after reading this post. We only need 3 things. The cash flow from operations, CAPEX and total dividends paid. From there, we can calculate the FCF and plot the graph.

There you have it. Free cash flow is above total dividends paid, except for 2016. The gap between FCF and dividends is also fairly wide. There is an approximate $1 billion buffer in between. From this chart, we can tell that the dividends payout are sustainable and healthy.

4.2 Operating Cash Flow Ratio

Doesn’t this formula look familiar? Yeap, it is found under our balance sheet ratios. Current Ratio, quick ratio and cash ratio. That’s why I brought up the point that there are no hard rules in finance. Understanding the concepts and logic behind is more important.

In this case, we are trying to test the liquidity of the company. Since the payment is made in cash, comparing operating cash flow would be a better measure of liquidity rather than the current asset items. That is one way of looking at it. What else can you think of that can be replaced with operating cash flow?

Another popular metric is to modify the interest coverage ratio. This was covered in the first series of “How to read an income statement?” Well, simply replace the numerator from EBIT to Operating cash flow. That’s all. It would be a better measure because operating cash flow is a more accurate representation of the cash earnings rather than EBIT.

4.3 Operating Cash Flow to Net Income Ratio

A more interesting ratio would be the operating cash flow to net income ratio. Remember I started out emphasising that net income is not cash flow?

The net income is just an accounting concept for reporting purpose. That also means that it can be easily manipulated through creative accounting methods.

For example, management can overestimate an asset’s useful life. This would decrease depreciation expenses thereby increasing net profits. Secondly, underestimating bad debts to reduce expenses. Thirdly, accelerating the recognition of revenue. Fourthly, capitalising costs under the balance sheet rather than an expense in the income statement.

All these are accounting manipulations and management assumptions. These are just some of the many examples to “cook the books.” That’s why you need auditors to validate the reasonableness & judgement of management.

So how do we determine the “quality” of the net income that was reported? Quality is meant by how much of the net income is actually real cash earnings.

There is one way and that is to compare the operating cash flow against the net income. The operating cash flow to net income ratio is calculated by taking operating cash flow divided by net income.

Cash Flow to Net Income Ratio Interpretation

A ratio of 1 means whatever net income the company earned is exactly the same as the amount of cash collected. In normal situations, the operating cash flow should be higher than net income as you have to add back depreciation expenses.

The higher the ratio the better the “quality” of net income that is being reported. This is because the company is generating real cash profits from its operating activities. A low ratio means the “quality” of the net income is poor. Most of it could be accounting profits rather than cash earnings.

Let’s try it out on Singtel. We just need 2 things: Net income & Cash flow from operations.

Source: Retrieved from S&P Capital IQ

There you have it. Simple & easy. It is above 1 throughout the years. That is one quick and simple way to check a company’s earnings quality.

5. Summary on How to Read a Cash Flow Statement

These are the basic building blocks of a cash flow statement. It always starts with the net income that is taken from the income statement.

The cash flow statement is categorised into 3 parts: Operations, Investing and Financing. Summing all of them up would give us the net change in cash flow for the year.

The net change in cash flow for the year, when added with the previous year cash balance, should always be equal to the current year cash balance in the balance sheet.

Most people use the cash flow statement to evaluate the sustainability of dividend payouts. This can be done by comparing the free cash flow against the total dividends paid.

Other cash flow metrics are often a variant of the common financial ratios. Simply replace the numerator with cash flow from operations. Some examples of it include current ratio and interest coverage ratio.

Lastly, and this is less commonly discussed, is to evaluate the “quality” of a company’s net profits. This can be done by comparing the ratio of the operating cash flow to the net income.

The cash flow statement is the final set of financial statements. This Beginners’ guide to getting started in investing covers only the basics. But it should help you move towards intermediate as you read more financial statements along the way. It is my earnest hope that you have gained a better understanding of how to read a company’s financial statement after reading these articles.

Be happy with what you have

 “Imagine you were born in 1900.

When you are 14

World War I begins

and ends at 18

with 22 million deaths.

Soon after, a global pandemic

The Spanish Flu

kills 50 million people.

You come out alive and free

You are 20 years old.

Then, at age 29, you survive the global economic crisis that began with the collapse of the New York Stock Exchange, causing inflation, unemployment and hunger.

At 33, the Nazis came to power.

You are 39 when WWII begins and ends at 45. During the Holocaust (Shoah), 6 million Jews died. There will be more than 60 million deaths in total.

When you are 52, the Korean War begins.

At 64, the Vietnam War begins and ends at 75.

A boy born in 1985 thinks his grandparents have no idea how difficult life is, but they have survived several wars and disasters.

Boy born in 1995 and now 25 thinks it's the end of the world when his Amazon package takes more than three days to arrive or when he doesn't get more than 15 likes for his photo posted on Facebook or Instagram.

In 2020, many of us are living comfortably, we have access to different sources of home entertainment, and we often have more than we need.

But people are complaining about everything.

However, they have electricity, telephones, food, hot water and a roof over their heads.

None of this existed before.

But humanity has survived much more dire circumstances and has never lost the joy of living.

Maybe it's time to be less selfish, to stop complaining and crying.”

(Credit: Unknown Author)

Maybe it’s time for some gratitude and love

Warren Buffett talks about Great Depression - Nobody knows what the market is going to do tomorrow

 Another great article from Rolf Suey

The ever positive and optimistic Warren Buffett investment guru sounds cautious during  Berkshire Hathaway (BH) Annual shareholder meeting recently.

NOBODY KNOWS WHAT THE MARKET IS GOING TO DO TOMORROW.

QUOTED WB

“I don’t know, and perhaps with a bias, I don’t believe anybody knows what the market is going to do tomorrow, next week, next month, next year. I know America is going to move forward over time, but I don’t know for sure, and we learned this on September 10th, 2001, and we learned it a few months ago in terms of the virus. Anything can happen in terms of markets, and you can bet on America, but you got to have to be careful about how you bet, simply because markets can do anything.”

UNQUOTE

Comments Rolf:

I agree entirely that nobody knows what the market is going to do tomorrow or next year or the year after next. If you are having the mindset that wow… stock market is cheap and I am going to throw everything in, think again! Or if you think stock market is expensive now because it has risen 20% since late March low and you miss the boat, and are waiting for stock to retest March low, before you throw every cash you have in, also please think again. If you are trading, and in the last few months whether long or short and you managed to win $ and think highly about yourself, that you are going to win loads and loads of $ during this downturn, think again too! Your pride can just be your biggest misery, because nobody knows what the market is going to do going forward.

WB RECOUNTING GREAT DEPRESSION

It is almost first time I recall (correct me if I am wrong) that WB talks a great length about Great Depression during his annual meeting. An event that he himself having almost 80 years of investing experience did not experience the greatest collapse of the stock market in the last centure. Perhaps that is why he rarely talks about the Great Depression because WB loves to relate his experiences when he is giving a speech or answering during interviews. But this time, he sounds different and cautious!

To recap,

WB highlighted on September 3rd, 1929, the Dow average closed at 381.17, and people were very happy and buying stocks on margin that worked wonderfully. His dad, who was 26 years of age back then, was an employee in the bank who sold stocks to people.

Few months later 13 Nov 1929, Dow drop 48% to 198.69. His dad was too ashamed to face those people he sold stocks to, and stay at home and 9 months later WB was born.

The last trading day before WB was born on 30 Aug 1930, Dow was up 20% to 240.42 from 1929 low.

QUOTE WB:

People did not think in the fall of 1930, they did not think they were in a great depression, they thought it was a recession very much like had occurred at least a dozen times, although not always when stock markets were important, but we’d have many recessions in the United States over that time, and this did not look like it was something dramatically out of the ordinary. For a while, actually for about 10 days after my birth, that’d be …and the stock market actually managed to go up all of 1-2% there in those 10 days, but that’s the last day. UNQUOTE.

Almost 2 years later 7 Aug 1932, Dow was at low point of 41.22.

QUOTE WB:

if somebody had given me $1,000 on the day I was born, and I’d bought stocks with it, and bought the Dow Average, my $1,000 would have become $170 in less than two years, and that is something that none of us here have ever experienced that we may have had it with one stock occasionally, but in terms of having a broad range of America mark down 83% in two years, and mark down 89% of the peak, that was in September 3rd, 1929, was extraordinary.

UNQUOTE

1 Apr 1951 Dow 240.85, after more than 20 years, a buyer on WB’s day of birth finally gets even (though dividends had been received).

Comments Rolf:

Rolf: If you buy a stock in 1930 believing the crash in late 1929 is the worst and has bottom, it will take you 20 years in 1951 for your stock to recover to breakeven price. Likewise if you are buying a stock in late March 2020 and think that in the next 2-3, or even 3-5 years the recession will be over and you will earn a lot of money, think again. There can be a chance that you may end up in the mindset or situation with those who invested in 1930 and have to wait for over 20 years to breakeven your stock price.

I never say for sure it will happen, but what I am saying is there is a chance it can happened because nobody knows. Of course, I also think there is an equal chance the market will recover and hit high again.

Therefore when it comes to investment, when it is uncertain, you have to weigh RISK and REWARD carefully and cannot just bet for sure that market will improve within next few years. And if you do not throw all your eggs into the market and only thinking about recovery, then you are betting and not investing. Better to be safe than sorry! It is better to win less money with backup for worst of the worst, than having to wait for 20 years like what happened during 1930-1950s.

CONCLUSION

If you think that you know what is going to happen in the market next month, or next year, or next few years, YOU DON’T!

If you think that you are very smart because you utilize significantly large percentage of net cash buying into the market at its lows in March, YOU ARE NOT!

If you think that you are smarter than the rest because currently you are making money now in the market, YOU ARE NOT!

You are just fooled by randomness, and using betting mentality rather than weighing risk and rewards.

Always be humble and have the prepare for the worst mindset, while staying cautiously optimistic about the future.

Always seek the truth and be realistic and use data, risk and reward metrics to justify your actions.

Last but not least, do not overspend time looking at the market or news, as life encompass more things other than your desire to make money from the market.

Aside from work (if you still have it now),

Spend time enjoying with your family.

Spend time calling your good friends.

Spend time doing some exercise.

Spend time in your hobbies.

Spend time helping others if you are called to.

And of course spend time to relax enjoying nature.... 

The Great Depression (Part 1) – Contraction of Money Supply & Tax Increase Explained

 Great article from this blogger, Rolf Suey

When I was in secondary school, the Great Depression (GD) use to be a major topic together with World War 1 and 2 in our history lessons. Many years ago, I also watched several documentaries on GD and Great Financial Crisis which kickstart my interest in financial blogging and research.

For those who are unaware, the GD was the worst economic downturn in the history of the industrialized world, lasting from 1929 to 1939. It began after the stock market crash of October 1929, which sent Wall Street into a panic and wiped out millions of investors.

If you “wiki or google” Great Depression” and try to find the cause of it, you will find two main causes take precedence. Monetary and Keynesian reasonings. In this article, I will focus on what is the Monetary and Keynesian theories, and why did the US government back then push policies that contracted the money supply, or even raise interest rate during the worst crisis.

MONETARY THEORY

Monetarists believe that the GD started as an ordinary recession, but the contraction of the money supply by Federal Reserve greatly exacerbated the economic situation, causing a recession to descend into the GD. There is a general consensus that the Federal Reserve back then should inject money (e.g. literal printing like what is happening now) to save the economy and not just allow liquidations of companies, which monetarists believe is the main cause of GD. In a speech honouring monetarists Milton Friedman and Anna Schwartz, Ben Bernanke (former Fed Chair 2006-14 ) stated:

"Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you're right. We did it. We're very sorry. But thanks to you, we won't do it again." — Ben S. Bernanke

KEYNESIAN THEORY

Another school of thought is from British economist John Maynard Keynes. Those who studied economy in JC or University like myself, will know Keynesian theory is the basis of our modern economic studies. Keynesians explained that if there is a fall in consumer spending due to recession, savings will increase. This cause interest rate to decline, which will then lead to increase borrowings and spending. But investments will not necessary increase due to drop in interest rate. This is because business make investments based on expectation of future profits. Therefore, if the consumption crunch is anticipated to be long-term, business investments which requires a great degree of optimism will fall, leading to rising unemployment and worsening of the economy. Henceforth, Keynes argued that the GD is caused by the lack of government spending to increase employment and to help the economy recover the money that normally will have spent by consumers and business firms.  

PRESIDENT HOOVER'S DEFLATIONARY POLICY 

Republican Herbert Clark Hoover became US President in Mar 1929. Shortly after he took office, the stock market crash. The next four year of his presidency spells the worst nightmare for the nation. In dealing with the crisis, Hoover administration underestimate the gravity of the crisis, and opted for non-intervention policy. They contracted money supply and allowed companies to go bankrupt, and even raise tax to reduce budget deficit, which led the worst crisis in the history of US. Monetarists and Keynesians put almost all blame of the GD on the incompetence of Hoover administration.

So why did Hoover implemented deflationary policy? Is he really that stupid with so many so-called experts in his administration.

Hoover administration believed that companies who is badly run with high debts should be allowed to go bankrupt.  The free market economy will then self-adjust to absorb the bankruptcy. Injecting excessive liquidity from taxpayers’ monies by the Federal Reserve will only postpone the bad debts and magnify the social costs in the long term.

The argument was not without basis! When dealing with the economic crisis of 1920-21, US implemented deflationary policies and allowed liquidation of companies, which subsequently created the economic growth later in the decade. Nevertheless, the magnitude of the 1929-1930s crisis is too big. Not only that deflationary policy did not work, it worsened the crisis.

Why not print money? – The Gold standard

US had almost always adhere to the gold standard until 1971 when President Nixon introduced fiat currency. For non-fiat, currency has to be backed by gold. For e.g. in 1905, US$20 bill is called demand note, backed by 1 oz of gold. This mean the US$20 bill is a note that can demand for 1 oz of gold or equivalent silver. The Federal Reserve Act in 1913 requires the central bank to have gold backing 40% of its demand notes. The adherence to the gold standard prevented the Federal Reserve from expanding the money supply (i.e. money creation) to stimulate the economy, or to fund insolvent banks and fund government deficits that could possibly pump up an expansion, although long term structural problems will worsen.   

Real interest rate increase

From 1929 to 1933, unemployment was as high as 20-25% in 1932-33 and inflation was more than negative 10% in 1931-32. While the nominal interest rate decrease, the real interest rate actually increases due to the negative inflation. This is because bad debts and bank runs driving huge number of banks into insolvency. And banks that survive makes business borrowing criteria more stringent as repayment ability drop. Hence while nominal interest rate decrease, borrowing levels drop.

Why increase Interest rate?

In the midst of the crisis, the US dollars loss its value as no international investors will want to invest into America. Hence demand for dollars plummeted. In the early 1930s, in order to attract foreign investors, Federal Reserve defended the dollar by contracting the Money Supply and raising interest rates, aiming to increase the demand for US dollars. Target is to have net inflow of investments or money (gold and silver) into USA to improve the budget deficit.

WHY MONEY SUPPLY FURTHER SHRUNK

Bank Runs

When the crisis worsened, bad debts resulted in bank collapse. Years of savings were just wiped out like that. The fear of more banks’ collapses led to bank runs. A bank run occurs when large number of depositors lost confidence in the security of the bank, and started to withdraw their funds all at once. Banks typically hold only a fraction of cash reserve, lending out the rest to borrowers or purchase interest-bearing assets like bonds. During a bank run, a bank must quickly liquidate loans and sell its assets often cheaply to meet cash withdrawals. In extreme cases like in 1930s, bank’s reserves are insufficient to cover the withdrawals leading to insolvency. When deposits in banks plummeted, money supply contracted.

Hoarding Precious metals leading to Gold Reserve Act

Since the dollar bill is a demand note for gold or silver, and seeing banks collapsing, people fear that their demand notes can no longer exchange for gold and silver which they deem as a better store of value rather than the dollar bill. People began to hoard precious metals. At the same time, there is farm crisis due to drought, and people also rush to stockpile food supplies. Money supply further contracted.  

On 30 Jan 1934, US congress passed the Gold Reserve Act changing the value of the dollar from $20 to the troy ounce of gold to $35 to the troy ounce, a devaluation of over 40%. This is money creation, not much different to the modern Quantitative Easing (QE) to print money digitally.

CONCLUSION

After reading the above article, most people will take at face value that either Monetary or Keynesian theories or poor decision by President Hoover MUST be the direct root cause of GD.  

IT IS NOT TRUE. I believe that the non-implementation of monetary or Keynesian policies are just indirect consequential reasons for the GD. There are not the root causes of the depressions.

In my opinion, the root cause is really the sinful nature of human of greed and the love of self and pleasure.  It is the over-confidence, over-optimism, over-spending, irrational stock market exuberance during the “roaring twenties” period, that cause the onset of the crash.

Stay tune to Part 2.