08 Oxygen for a Business: How to Analyze Cash Flow

Cash is indispensable for a company. Stable, positive cash flow helps maintain financial stability.

Once its cash flow is disrupted, the company might face bankruptcy.

Just as Warren Buffet says, "Cash is like oxygen, it’s there all the time but if it disappears for a few minutes, it’s all over."

So how to evaluate a company's cash level? Let's take a close look at the cash flow statement.

It is divided into three sections: operating activities, investing activities, and financing activities.

First, operating activities.

This section shows the cash inflows and outflows from the company's daily operations, such as sales income and cash paid to suppliers.

Subtracting cash outflow from cash inflow, we can get the net cash flow from operating activities.

If the number is positive, it means the company's operating activities generate more cash than it consumes; otherwise, the company has negative cash flow from its core business operations.

For example, as we can see on moomoo app,

Tesla had a net cash outflow from operating activities for most of 2017.

It was not until 2018 that its net operating cash flow turned positive.

But how to assess a company's cash flow from operating activities?

First, we should look at its net cash flow.

If the company consumes more cash than it generates from its operating activities for an extended period, it may suggest the company's core business is not profitable, which might lead to potential bankruptcy.

On the other hand, if a company's net cash flow is positive, we can compare it to its net income.

For a financially healthy company, its net cash flow from operating activities should grow hand in hand with its net income over time.

What's more, if its net cash flow exceeds net income, it means its profits can be retained as cash, suggesting the company is in a sound financial position.

By contrast, if its net cash flow is lower than net income, it may suggest the company has growing accounts receivable, inventories, or advance payments.

In such cases, the company will see lower levels of cash inflow or a large amount of cash occupied, affecting the net cash flow.

The second section of the statement is cash flow from investing activities.

It includes cash inflows and outflows related to acquisitions, sales, and investments, for example, purchasing fixed assets or collecting loans.

It's common to see negative cash flow from investing activities because a company needs to invest in new equipment and production lines to expand its business.

However, if the company spends too much money on the expansion, its net cash outflow from investing activities may surpass its net cash inflow from operating activities for an extended period.

In this case, we must evaluate the prospect of the new projects, calculating their upside and downside potential, respectively.

That's because failure of such high investments can be a major blow to the company.

Again, let's take Tesla as an example.

Since manufacturing electric vehicles requires constant investment, Tesla had negative net cash flow from investing activities every year.

However, its net investing cash outflow has fallen short of net operating cash inflow since 2019.

Some companies may have positive cash flow from investing activities during a certain period.

That's probably because their investments generate exceptional returns, or because they sell their properties.

If the company sells assets with operational issues, we might interpret it as a positive sign as the company may steer towards a lean operation model.

Conversely, if the company is forced to sell its core assets to meet its obligations, we should be aware of its operational risks in the future.

The third part of the cash flow statement is cash flow from financing activities.

It refers to money used or generated through investing activities, such as the issuance of stock or bonds, payment of dividends to shareholders, share buybacks, or repayment of debt.

If a company keeps raising money from the market by issuing shares or bonds, it might suggest its operations cannot generate sufficient cash to meet its needs.

In this case, we must be aware of the relevant operational risks.

Conversely, actions including dividend payments or share buybacks that can raise ROE and EPS might be well received by the company's shareholders.

Still, let's look at Tesla's figures.

The company implemented several rounds of equity or debt offerings before 2020, sustaining a positive inflow of cash from financing activities.

From 2021 to 2022, the EV maker repaid some of its debt, resulting in a net financing cash outflow.

Finally, let's zoom out and take a broader view of the cash flow statement.

Here, two indicators deserve our attention.

The first one is changes in cash balance.

We can compare the current cash balance to the previous periods.

If the cash balance has decreased sharply, we should examine the possible reasons why it happened.

The second is the free cash flow, a closely watched indicator.

Free cash flow (FCF) refers to the amount of cash available for the company to use, calculated by operating cash flow less capital expenditures.

A positive FCF means the company can return value to its shareholders and repay its debt.

Otherwise, it needs extra funding to meet its financial needs.

Moreover, FCF is a commonly used metric for valuing a business.

Many analysts compare the current FCF with the calculated present value of expected future cash flows to inform their investment decisions

If a company has growing free cash flow, it might look attractive to many investors.

To sum it up, net income is a key profitability metric used by investors when making trading decisions.

We can analyze either net income in absolute terms and its growth or net margin and the trend to better understand this indicator.