“Profits are nice, but you cannot pay suppliers, employees, creditors, or the owners with profits: You need cold, hard cash.”
With those words, authors Stephen Horan, Robert R. Johnson and Thomas Robinson introduced the topic of cash flow statements in their 2014 book, "Strategic Value Investing: Practical Techniques of Leading Value Investors."
As in their discussion of income statements, the authors provided a mini case study based on Walmart’s (WMT, Financial) cash flow statement for the fiscal year ending on Jan. 31, 2011:
As we can immediately see, the cash flow statement is divided into three sections: operating cash flows, investing cash flows and financing cash flows.
Operating cash flows
This section shows the movement of cash involved in running Walmart. Customers pay the company for merchandise and, in turn, Walmart pays the suppliers and employees, as well as regular operating expenses for rent, utilities and so on.
We’re told we should start with an overview, rather than diving into the details right away: “What are the company’s major sources (and uses) of cash: operating, investing, or financing activities? Ideally, for a mature company, you will see most of the cash flows being generated from operating activities, while the company is using that cash to invest for the future (investing section) and return capital to investors and creditors (financing section).”
In the case of smaller companies or companies that are growing rapidly, the cash flow statement will look different. They will likely use more cash than they generate, so they will be raising capital from investors and creditors to cover the difference. Because of uncertainty about when these companies will become net generators, rather than net users of cash, they tend to get little attention from value investors.
The authors also encouraged readers to look at the relationship between net income and operating cash flow. Operating cash flow is expected to be higher than net income over the long term because of factors such as depreciation on plant and facilities. That need not be the case for any specific year.
If operating cash flow is routinely lower than net income, a closer examination is warranted. This would be acceptable for a company that is growing its business, but not if it's because the company has trouble collecting from its customers.
Investing cash flow
Where is the company investing its surplus cash flow? Walmart is using most of its cash to invest in property and equipment, both of which are turned into new stores; a more modest amount is going into acquisitions.
While the authors will write about it in more detail later, they wanted to introduce the idea of “free cash flow”. This refers to the “excess” cash flow, the amount remaining after capital expenditures are subtracted from operating income, “Value investors love to see companies that generate free cash flow because doing so indicates that the company can fund its own growth through operations with cash left over for the owners. It is good sign that management is avoiding unwise capital investments, choosing instead to (hopefully) return the excess cash to shareholders in the form of dividends or stock repurchases”.
Financing cash flows
The third section of the cash flow statement focuses on a company’s finances, with an emphasis on where it is directing its free cash flow, or, alternatively, where is getting new capital to cover a cash flow deficit.
Walmart, which generated about $11 billion of free cash flow in fiscal 2011 used its excess cash flow to return capital to shareholders, in the form of dividends and by buying back its own stock from them. The authors added, “This is a good sign for value investors: Investors are receiving cash flows through dividends, and the company likely views its own stock as undervalued.”
One last note on the financing cash flow section: Walmart was a net borrower, since it was issuing more debt than it was repaying. That prompts the rhetorical question, “Shouldn’t the company be paying down its debt with its excess cash flow?”
“No” would have been the response of the authors; because of low interest rates, the company likely figured it could earn more on the borrowed capital than the borrowing costs. In the next section, the balance sheet, Walmart’s debt situation will be examined to see if this level of debt is sustainable.
Balance sheet
This section of the financial statements shows the company’s assets and its financial obligations. These obligations are made up of two basic types: Liabilities and equity. Liabilities refers to the claims of suppliers, employees, lenders and other creditors. Equity refers to the claims of owners, which are almost always common shareholders and preferred stockholders (although there may be other equity claimants as well).
All of this adds up to a financial position at a specific point in time, the last day of a quarter or a year. That’s unlike the income statement and cash flow statement that show a quarter or year’s worth of activities.
Balance sheet analysis focuses on two issues: Liquidity, and solvency. Liquidity refers to a company’s ability to pay its short-term liabilities, while solvency refers to its ability to handle its long-term obligations.
We measure liquidity by determining whether a company’s current assets (those that can be converted into cash within a year) are greater than its current liabilities (those that need to be paid with one year). Walmart has fewer current assets than current liabilities, which would be a problem for a cash-strapped firm, but Walmart has what the authors called “extraordinary” operating cash flow. It is in no danger of being unable to pay its short-term debts.
Solvency addresses the use of debt, or financial leverage, and generally the more leverage the greater the danger of going bankrupt, which means becoming insolvent. Referring specifically to Walmart, the authors concluded, “Overall, the company’s financial leverage has increased, but it is not terribly worrisome because it looks to be a purposeful response to the low interest rate environment. In addition, the stability of Walmart’s operations support moderate debt levels well.”
Regarding liabilities and equity, note that when these two line items are added together, they must exactly equal the value of assets and hence the name "balance" sheet.
Conclusion
As with the income statement, the cash flow statement may be made up of numbers, but those numbers tell important stories for those who read them.
The operating cash flow numbers show us how well management is doing at running the company, as we compare the amounts of cash coming into the business and going out again. The investing cash flow data tell us what the company is doing with its excess cash flow, especially if it is being used to create more value for shareholders. The financing cash flow section explain what the company is doing with its excess cash flow (or where it is sourcing new funding to cover negative cash flow).
And, the balance sheet displays a company’s assets, liabilities and equity in one place, so investors might know how well it is positioned to take care of short-term and long-term obligations.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Strategic Value Investing: Company Analysis,
- Strategic Value Investing: Industry Analysis
- Strategic Value Investing: The Big Picture
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