Thursday, November 7, 2013

Understanding Financial Statements (Part 3) - The Cash Flow Statement

The cash flow statement is the 3rd and the last of financial statements you can find in a company's annual report. The other 2 statements are The Income Statement and The Balance Sheet which we have discussed earlier.

The cash flow statement is one of the most important among the 3 financial statements. It shows the actual cash the company has generated and removes all the non cash items which you see in the income statement such as depreciation.



The Cash Flow Statement

The cash flow statement is divided into 3 parts:

1) Cash Flow from operating activities / Cash from operations
2) Cash Flow from investing activities / Cash from investing
3) Cash Flow from financing activities / Cash from financing

You can access a sample of Singtel's Cash Flow statement here. You can refer to this as we go through the cash flow statement line by line. Let's start.


Cash from Operations
First up is the cash from operations section. This section shows you how much cash the company has generated from its business. This is an area you will focus on more when evaluating a company as it will tell you how effective the company is in terms of generating cash from its business operations

Net Income
Firstly, on the top line of the cash from operations section, we have the net income. This figure is simply taken from the income statement.

Depreciation & Amortization
Next we have the depreciation & amortization. Depreciation is the drop in value of assets of the company over time. However, just because the assets drop in value doesn't mean the company pays for the loses. No cash is being transferred out. Thus, this is added back to net income.

Changes in working capital
The next few items we see are all part of changes to working capital. The first 4 items are quite straight forward which i will not discuss here. The 2 important ones here are changes in accounts receivables and changes in accounts payable. Recall that this 2 items are found in the balance sheet also. Accounts receivables is what the company expects to receive which it hasn't collected yet. Accounts payable is what the company owes to others.

If accounts receivables is lesser this year compared to the previous year, it will be a positive figure in this years cash flow statement. This means that less people are owing the company thus the company receives more cash this year. Remember, only real cash items are recorded in the cash flow statement. This is the actual cash which the company receives.

For accounts payable, it is the other way round. The more you owe to others, the less cash you have to pay up this year. This means that you have more cash stored up for this year and it will be a positive figure in your cash flow statement.

Cash from operations
Adding up and subtracting all the items above, you get your final figure of cash the company has generated from its operations. This is an important figure to note.


Cash from investing
Let's move on to the second portion of the cash flow statement. These are activities which involve the acquiring or disposing of property, plant and equipment (PPE), corporate acquisitions and any sales or purchase of investments.

Capital Expenditure
The first entry is the capital expenditure. This is the expenditure on property, plant and equipment. Basically any expenditure to keep the business running. Cash from operations minus capital expenditure will give you what is known as free cash flow(FCF). FCF is the amount of cash the company generates after investing in its business.

Investments
Other entries inside are some investments the company has made for example cash acquisitions of other companies, investments gains or losses from bonds or equities etc. Adding and subtracting the above items you'll get the final figure of cash from investing.


Cash from financing
This is the final portion in the cash flow statement. This part records any transactions between the company's owners or creditors.

Issuance & repayment of debts
The company can borrow money by issuing debt in the form of bonds. This portion shows you whether the company has borrowed more money or repaid debts it previously borrowed.

Issuance & purchase of common stock
This is an important number to note also. Companies can issue more stocks to raise capital for expansions. However, issuing more stocks/shares can dilute the existing shareholders worth in the company.

On the other hands, companies which has cash and are slower in expansion, can buy back shares and minimize the dilution for existing shareholders.

Dividends paid
This is straight forward. It just shows the amount of dividends the company has paid.


Conclusion
The cash flow statement is one of the most important of all the 3 financial statements. It shows the amount of cash the company has generated for that financial year. Cash that constantly flows into a company, provides life for it to survive. Thus, the phrase: "Cash Flow is the life blood of any business".

We have concluded this series on understanding financial statements. Knowing how to interpret these 3 financial statements is crucial for your investment decisions. If you know how a company generates its cash and where it makes its money, you'll be clearer on whether is it a good company to invest in?

Of course, the evaluation of a company's business doesn't stop here. After knowing whether it is a good or bad company, we have to know whether the price of the stock of the company which we are buying now is under priced, at the right price or over priced. When we buy things, we like to buy at a discount. For stocks, it is the same concept. We also want to buy a company at a discount relative to its actual price. How to evaluate whether the price of a company is fairly valued is another skill to learn.


Like my Facebook page to receive market updates and notifications of new articles. SG Young Investment seeks to educate readers on finance and investment. Join many other readers on this journey towards financial freedom.


Related Posts:

2 comments:

  1. One of the most important of all 3? Honestly I think the 3 of them are all parts of a picture rather than 1 being more important than the other.

    Anyway I would like to point out you have forgotten THE MOST important part of the financial statements. The Notes. The numbers in the financial statements are meaningless without them.

    PPE? What is it made up of?

    E.g. Investment properties 10M. Is is 1 property or 10 properties. Where are the properties. What are their tenures like.

    OR maybe Financial guarantees? Good way to borrow money without it showing on your balance sheet. E.g. 3 companies set up a shell company to raise capital and all provide financial guarantees. Neither one has control so it isnt consolidated and does not show up on any balance sheet.

    Operating Leases - the third form of financing.

    Court case which the company could lose and bankrupt it?

    Interest rate risk, Credit risk

    All these and more are available in the notes. Please dont forget them ya?

    THanks.

    A Crazy Auditor who has spent a lot of time on the NOTES. Hopes his work will be of value to you.

    ReplyDelete
    Replies
    1. Hi Anonymous,

      Thanks for your comment. It is useful information for me as well as readers who're reading this.

      All 3 statements are important but the cash flow statement is even more important from an investor's point of view. We want to see real cash which is generated from the business.

      I agree with you that The Notes is the most important part in the financial report. I do refer to the notes to check on where these numbers in the 3 main statements come from.

      For an average investor, it'll be very hard for us to know exactly when a company will get into trouble. Thus, we choose companies which has relatively good reputation and good track record. Sometimes even that may fail so for an investor, it is always wise not to put all your money in one basket (one stock). I do believe if a company wants to hide something, it is very difficult to find it sometines even for professionally trained accountants. But we still exercise our due diligence to check on the accounts and find any red flags that may be present so as to avoid investing in the company.

      Thanks for your views on this again. Its really useful.

      Delete