Last week, I wrote an article explaining the importance of cash flow, and what it means when there are significant discrepancies between the amount of money coming into a business and its reported earnings.
In this piece, we will look at some other information that investors can learn by scrutinising the cash flow statement.
Cash is king
If there is a big difference between the income statement and reported cash flows, analysts should dig into the data and see what might be causing this. To do this, it is helpful to look at the three sections that the cash flow statement is broken down into: operating cash flows, investing cash flows and financing cash flows.
Operating cash flow is the money generated by a company in the course of its regular day to day activities, i.e. not from buying or selling capital assets or taking on loans. If operating cash flow is negative, that is a sign that the business is not capable of sustaining itself, which should immediately raise a red flag. If a business with negative operating cash flows has reported a profit, it is worth investigating why that is - do they have large amounts of outstanding debts that they are unable to collect? Have profits been overstated? These are all pertinent questions that a diligent analyst should be asking in this situation.
When it comes to investing cash flows, it’s useful to look at what assets are being purchased. Is the company losing cash because it is expanding and buying new property and machinery, or is it trying to tread water and replace old equipment? A good measure of this is the ratio between the depreciation and capital expenditures - if depreciation is high relative to capex, this could be a sign that the company is trying to simply stay alive, rather than expanding.
What about financing cash flows? Information in this section of the cash flow statement can tell you whether the business is issuing more shares or repurchasing them, how much cash it is distributing to shareholders in the form of dividends, how it is managing its debt load and more. Our above example of the business with negative operating cash flow might have a lot of money coming in from debt issuance, but obviously this is not a particularly good or sustainable way to run a corporation.
In short, all three sections of the cash flow statement can give you valuable information about the state of the business that helps you cut through the ambiguity of the earnings statement.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Warren Buffett on Dividends
- Howard Marks: Will Algorithmic Investing Beat Out Humans?
- The Value Investor’s Handbook: Understanding Return on Capital Employed
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