- Cash flow from operating activities: It shows the money that comes in from sales of the company's products or services and the money going out to produce those sales. It also includes interest and tax payments. Under GAAP, it allows revenue to be recognized on the income statement before actual cash or payment is received. But not so on the cash flow statement, which lists only revenues actually collected or received. Thus, you may see negative cash flow from operations. On its face, this may seem like a bad omen, but it isn't always a signal to sell. Fast-growing start-ups will tend to show negative cash flow because it consumes more cash than they can generate in the first few years of the business. They cover the shortfall by borrowing money or issuing stock. However, at other times, negative cash flow may indicate a company is in trouble, especially if the company is disposing of assets or selling pieces of the business, because it cannot persuade investors to buy its stock or credit market to lend it money.
- Cash flow from investing activities: This is where the company reveals the amount of free cash flow and how it's utilizing its excess cash or free cash. Free cash flow is normally defined as cash flow from operations minus the amount of cash consumed to add plants and equipments. Such free cash if available can be used to reinvest in the business by acquiring more business, build more plants, or return to investors through dividend or repurchasing of common stocks. It also shows the amount of cash spent on acquiring businesses, disposal of assets and also acquiring of plants and equipment. If a company lent money to its executives to allow them to buy stock, it is also shown here.
- Cash flow from financing activities: This part shows how much money a company spends to repurchase its stock and also if the company is raising money by selling its stock or issuance or reduction of debt. A start-up business tends to have more financing activities than a mature business because it has little or no sales, so the cash has to come from somewhere to finance the business. Dividend payment is also indicated here. Remember the company can opt to utilize its free cash to return to investors by either repurchasing stock or paying dividend. Repurchasing of common stocks is usually a more cost-efficient method than in the form of dividend simply because dividend gets tax by Uncle Sam while stock repurchases do not. So the amount of tax saved can be used to repurchase more shares rather than to pay to Uncle Sam.
Saturday, August 15, 2009
The Numbers Game: How To Read Financial Statements (The Cash Flow Statement)
The last part making up the financial statements is the cash flow statement. It simply shows the actual cash flowing into and out of the company. You may now know that the balance sheet reveals a company's assets, liabilities and shareholders' equity at the close of a given period or fiscal year. The income statement shows the changes that have occurred in the balance sheet items, including the promises of money that the company has made or received. The cash flow statement differs in that it reveals the changes in actual cash that the company has generated and raised through creditors and investors. It also shows how the company invested the cash between the start of one fiscal year to the end of another. In other words, the cash flow reflects where the money comes from and goes to.
The cash flow statement comprises of three parts, namely, cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.
To sift for clues in the cash flow statement, it may be necessary to examine the cash flow side by side with the income statement, better still over multiple reporting periods. For example, if net earnings on the income statement have surged, but the actual cash received from operations is much lower, that could be a sign that bad debts or obsolete inventories are piling up and the future quarters' earnings could be lower.
A rough way to gauge if a company is playing the numbers game is to compare the rate of growth in net income with the rate growth in operating cash. If net income is growing at 10% but operating cash is growing at 1%, while in previous years, the two numbers grew at a fairly even rate, that could signal that net income isn't as solid as it appears. Or you can, alternatively, divide the net income with the total cash flow from operating activities. The close the ratio is to one, the higher the quality of the earnings.
As you can see, it is far more difficult to manipulate the cash flow statement than the income statement. But it still can be inflated. Again, Enron's cash flow statement is instructive. In its 2000 annual report, Enron showed that cash provided by operating activities came to $4.8 billion. But investors who looked thoroughly at the balance sheet and its footnote would notice that under its liabilities, it held $4.3 billion of customers deposits compared with almost nothing the year before, and hidden under footnote 3 on page 39, it states "At December 31, 2000, Enron held collateral of approximately $5.5 billion....shown as 'Customers' Deposits' on the balance sheet." Without this collateral, Enron's real operating cash flow would be negative $700 million. Furthermore, Enron also reported a onetime asset sales of $1.8 billion on its cash flow statement. With this, Enron's real operating cash flow fell deeper to negative $2.5 billion. Considering that Enron was showing total sales of $101 billion, a negative $2.5 billion cash flow is a sign that something is really fundamentally wrong.