Cash flow is like the lifeblood of a company. Without it, a business can’t function properly. Therefore, analyzing a company's cash flow is an essential skill for every investor.
This is when the cash flow statement is needed.
The cash flow statement is one of the three major financial statements. It shows a company's cash inflows and outflows for a certain period of time. For example, when a coffee shop sells a cup of coffee, cash flows into the business from the consumer. When the coffee shop pays its employees, cash flows out of the business.
Simply put, you can think of the cash flow statement as a swimming pool.
When you pour water into the pool, the water is like a company’s cash inflow. When you drain water from the pool, you can think of it as the cash outflow. If cash inflows exceed cash outflows, the water level in the pool will rise, indicating a positive cash flow. Conversely, if more cash goes out than comes in, the water level will fall, indicating a negative cash flow.
A company's cash flow statement can be divided into three sections: operating activities, investing activities, and financing activities.
The first section is cash flow from operating activities. It refers to the cash flow generated from a company's regular business activities, including selling products, purchasing raw materials, and paying salaries. Operating cash flow is perhaps one of the most important indicators on the cash flow statement. It tells investors the amount of money a company can earn by selling products or providing services.
If a company's operating cash flow is positive, it means that its regular business activities are making money. Vice versa, a negative cash flow indicates that the company can’t earn money from its main businesses.
The next section is cash flow from investing activities.
It refers to the cash flow generated from a company’s investment-related activities, including purchases or sales of assets, acquisitions of companies, and stock investments.
Generally speaking, if a company is expanding, it probably has a negative cash flow from investing activities. Because it is purchasing new equipment or acquiring other companies.
The last section in the statement is cash flow from financing activities.
It’s the cash flow generated from a company’s financing activities, including debt financing, equity financing, and dividend payments.
The money raised from issuing stocks and borrowed from banks will be recorded as cash inflow from financing. The money used to pay dividends or buy back stocks will be recorded as cash outflow from financing.
Learning how to read the cash flow statement can help investors better understand how well a company is operating and make smarter investment decisions.
On the one hand, a company is unlikely to survive if it can't maintain a positive cash flow in the long run.
From an investor’s perspective, a company has a stronger performance if it generates more positive cash flows from operating activities. This means the company has enough cash to pay its day-to-day operational expenses.
On the other hand, cash flow is harder to manipulate than profit because it doesn't include non-cash items. One example is accounts receivable, which is the money a company hasn't received because of goods or services bought on credit.
If a company sells $100 worth of goods on credit and hasn't received the money yet, the $100 will still be counted as revenue on the income statement and make it look better. However, it doesn't add a cash inflow to the cash flow statement. In other words, even a profitable company can run out of cash, causing liquidity issues.
For a more comprehensive analysis, investors also need to refer to the income statement when analyzing a company’s cash flow statement.
Investors need to be aware when a company’s net profit is much higher or consistently higher than its operating cash flow.
A quick recap: The cash flow statement reports a company's cash inflows and outflows during a given period.
Cash flow from operating activities is a better indication of a company’s financial position.
This is the end of the video. See you next time!