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:
- Operating Activities
- Investing Activities
- 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.
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.
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.
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