Cash Flow Statement Analysis

• It tells you how much cash went into and out of a company (how much cash generated?) during a specific time frame like a quarter or a year. 
• A +ve change in cash is good, what really matter is how the cash was increased and spent.
• Income statement present the income and expeses based on accural accounting concept (when transactions occur - expenses must match the revenues those expenses created whenever possible, not when cash is exchanged). This method of accounting introduces many interpretations and estimates from management that can vary from firm to firm. 
• Higher sales might not translate into higher cash flow if AR rise.
• Cash maybe used to build up inventories - may depreciate in value or even become obsolete (if not sold in timely manner). The expenses of inventory if not recorded until produts are actually sold. Invenory recognization may vary - e,g, FIFO, LIFO
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• Cash Flow Statement strips out all the abstract, non-cash revenues and expenses that are included in the income statement. Some companies have a good profits in the income statement but insufficient cash flows. It is a linkage between the balance sheet and income statement.
• Companies can generate cash in several ways - (1) from operating activities, (2) from investing activities, and (3) from financing activities.
• Cash Flows from Operating Activities
• How much cash company generated from its core business (as opposed to peripheral activies - investing or borrowing). 
• It is vital. -ve OCF lead companies to seek funding from outside source -
1. Increase debt load - increase interest payment, hinders growth, more vulnurable to business downturn.
2. Issuing stock - dilutes ownership.
• A growing company may have -ve OCF (expands its inventory and pays its increasing bills), OCF must eventually turn +ve for the firm to survive
• A contracting company may exhibit po +ve OCF for a period of time, as spending falls at a faster rate than sales and earnings. 
• 2 ways to determine OCF
1. Direct - reconciliation reports major sources of cash receipts and payments
1. Cash receipts from customers
2. Cash payments for inventory purchases and operating expenses
2. Indirect - start with net income and adjust non cash expenditures
• Net Income - the starting point of how much cash a company provides from its operations. But, some items on income statement affect income but don't affect cash flow, so adjustment is required.
• Depreciation and Amortization - record the wear and tear on company asset. This expenses is not a cash charge. Added back to net income.
• Change in Working Capital  - firm may provide a single line item or breakdown
• Increase AR, increase Net Income, but cash not receive -- subtract it
• Increase AP, decrease Net Income, but cash not pay yet -- add back
• Increase Inventory -- subtract it
• Other Non Cash items
• prepaid expenses - not reduce net income, but reduce cash -- subtract it
• unearned revnue (for future service) - not affect net income, but it increase cash - add back
• deferred tax expenses (pay alrge tax bill upfront and slowly deduct the expenses from earnings) - for 1st year, subtract the cash, subsequent year only affect net income but no cash outflow - added back.
• Net Cash provided by Operating Activities - this is the figure we can get after we perform all adjustments to the net income. It provide a great summary of how much cash a company's core business generated.
• For most firm, +ve OCF is crucial.
• Cash Flows from Investing Activities
•  It  shows the amount of cash firms spend on investments. There are 2 types of invesments.
1. Capital expenditures - to upkeep the current busienss operations. 
1. -ve - if company spends money on fixed assets (mainly PPE)
2. +ve - selling more of its assets than it is buying
3. It can be very large & long term in nature. Companies typically expenses a CAPEX over the course of its useful life (via depreciation) in Income Statement. But, the cash is used in the initial purchase year.
4. A -ve CAPEX can be a good sign for company - spending $ to expand business (be sure to ascertain the company is making wise investments and has good growth prospectes).
5. CAPEX figure should growting at a clip relatively similar to revenue. Spending cash on CAPEX while revenue are stalling can be problematic (if sale decline due to competitive threats and poor management decisions, instead of economic and industry cycles).
6. CAPEX vary by industry. Manufacturing firms required large CAPEX (it need large plants); IT firm need IP and Intangible assets. 
2. Monetary investments - e.g. purchase or sale of government bonds, equity funds, commodity hedges, currency hedge, investing in an associates or joint venture etc. 
1. Keep the company's industry in mind when examining investment cash flow - e.g. financial companies make significant investments in marketable securities.
•  We should pay attention on the capex items and the line item of other business acquisitions.
•  Net cash from investing activities for most healthy firms will be -ve  -- drive cash from operations back into the firm for expansion to generate future profits.
• Cash used for Acquisitions - take note on the figure as companies tend to overpay for acquisitions. And, it will show company achive growth? Internal sources vs acquisitions.
• Cash Flows from Financiang Activities
• It includes any activities that involve the company's owners or creditors.
• Owners - issuance or purchase of common stock, dividend pay to investors
• Creditors - issuance or repayment of debt.
• Should take note on how much stock a company is issuing or repurchasing. 
• Newer companies \ rapidly growing companies need issues lots of new stock to fund their growth. However, it will dilutes existing shareholders' ownership. It  is not necessarily a bad sign, as long as the firm is expanding at an acceptable rate.
• Mature companies that have ample free cash will buy back their own stock - it will increase the value of existing shares (SH own a bigger piece of the pie). Share buyback and dividend are typically the only tow ways a company can enrich its SH with cash flows.
• Issuance Debt - interest will be charged. Ineterest not a financing activity but include in operating activities since these expenses are considered part of normal business operations.
• Dividend
• It should increase (become more negative on the cash flow statement) in subsequent periods. 
• A decrease in dividends - a sign that a company is experiencing difficulties 9take note if the decrease > NOSH reduction)
• A firm with no dividends should be experiencing significant growth.
• It is important to study how the firm is raising cash or repaying cash.
• Free Cash Flow = Net cash from operating activies - Capex.  
• It measures how much cash was generated that can be spent at management's discretion. 
• This excess cash can be used to enrich SH or invest in new opportunities for business without hurting the existing operations.  
• It is one of the most important figures to determine the company capability to enrich its shareholders.
• It can be put to several uses: retire debt, repurchase shares, pay additional dividends and create new products or expand current offerings.
• There are companies with extremely long and expensive product cycles, such as Boeing Co. (BA) and Airbus SAS. As new planes are conceptualized, developed, manufactured and delivered, cash flows devoted to those to projects may be negative for years before profits are realized and net cash flows become positive.  
• Currency Translation
•  Multinational firms with operations in several different countries will generate revenues in several different currencies.
•  There are accounting rules written to supervise how currency is translated.
•  “cumulative effect of exchange rate changes” details the effect of the currency exchange rate changes on the company’s cash flow.
• Net Change in Cash
• Net Change in Cash = OCF + ICF + FCF = Cash at begining of reported period - Cash at the period's end. 
• It can be +ve or -ve. What matters is how cash is increased and spent. We want cash generated from business operations
• Increasing +ve OCF is a good sign
• A few periods of decresing total cash is not worrisome if a firms is spending on worthwile projects, paying high dividend, paying down debt, or repurchasing shares.
• Excess cash does not provide a return to shareholdres. Firms run the risk of management making risky decision with a stockpile of cash, e.g. investing in questionable acquisitions or pet projects.
• Analysis of Cash Flows
• Net Income vs OCF - each figure has its strengths and weknesses. 
• Net income is derived using the principles of accrual accounting, ignoring the effect of non-cash items (increasingly tax credit standards and aggresive revenue recognition can all be mised). 
• Non cash items are dependent on management estimates and discretion, and treatment may vary slightly from firm to firm.
• OCF fails to account for unearned revenue or accrued liabilties.
• The figure is difficult to evaluate for young, rapidly growth firm - increasing inventory, increasing current assets and extending credit to new customers to drive revenue growth. 
• This leads to -ve OCF that are supported by debt and issuance of stock.
• Questions to answer based on CF statements
1. With reference to the net profit, What do you think about the net cash flow generated from operations?
• Is the profit converted to cash?
• Has the company generated adequate CFFO to cover all operating expenses?
•  More specifically is the quality of earnings good?
• Explain why the difference, if any.
2. What do you think about the management’s capital allocation in its investing activities?
• How is the growth of capex in relation to revenue and net profit?
• What do you think is the results of the management’s investing in associate and subsidiary companies?
3. What is your though about its financing activities?
•  How do you view the company’s financing in equity and debt?
• Do you see the financing yields positive result for shareholders?
4. Calculate the free cash flow for the equity shareholders and for the firm for all the years.
• Explain what your understanding on free cash flow
• What is FCF used for? Give 4 examples.
• Are FCF of the company  good. And why?
• Can the company use its FCF to do what it suppose to do in 4a above?
• If not, how have the company been doing things in 4a above?

Profit is a matter of opinion. Cash is a matter of fact.

Revenue is vanity, cash flow is sanity, but cash is king.

References:-

• The Statement of Cash Flows, Morningstar
• The Cash Flow Statement: Tracing the Sources and Uses of Cash, By Z. Joe Lan