They say that "cash is king," and indeed, cash forms the lifeblood of any business. For the Intelligent Investor, it is cash that is used to pay dividends, buy back stock, and fund daily operations. When companies experience a cash squeeze, they find themselves at the mercy of lenders and often find it difficult to concentrate on their long-term corporate goals. This can lead to hurried and poor decision making. Healthy levels of cash lead to the flexibility corporation's need for continued success.
So how can the investor examine the cash flows of a potential business opportunity? They should start by referencing the "Statement of Cash Flows" found within a companies financial statements. The Statement of Cash Flows should be publicly issued every three months with the quarterly reports, and can be found in the Investor Relations section of most publicly traded companies' websites.
The 3rd Quarter 2013 Statement of Cash Flows for Tim Horton's (TSE: THI) is found by clicking on this link and scrolling to page four.
Whereas balance sheets present a snapshot in time for a companies overall financial health, the cash flow statement shows activities over a period of time. Because the ever important earnings per share numbers are not found within the cash flow statement, this statement is often overlooked by investors. However, it is crucial for properly understanding the health of any business.
What does the Cash Flow Statement commonly look like and what does the investor need to know? At its most basic level, the cash flow statement is segmented into three parts:
Section # 1) Operating Cash Flows
Section #2) Investing Cash Flows
Section #3) Financing Cash Flows
Net Cash Flows
Each section can have a positive or negative balance, and the sum total of these three sections will result in a number titled "Net Cash Flows." Generally, a negative number is displayed in brackets. Net cash flow helps the investor to identify whether or not the business had a net inflow or outflow of cash during the period of time being measured. It is very important for the Intelligent Investor to remember that a positive or negative net cash flow is not necessarily good or bad, it all depends on HOW the inflow or outflow of cash was realized. This can be understood by examining the three sections highlighted above.
The investor must act like a detective to discover the story behind the net cash flow number. You can begin doing this by asking some basic key questions:
1) Is the Operating Cash Flow positive or negative? Why? 2) Is the Financing Cash Flow positive or negative? Why? 3) Is the Investing Cash Flow positive or negative? Why?
By examining the information listed below for a hypothetical corporation, we can see the following:
1) Operating cash flow is positive, primarily due to large income levels experienced during the period, there is not excess depreciation being added into this equation. This is a good sign.
2) Financing cash flow is positive, and this is primarily from a share issuance. As an existing investor, you generally do not want there to see more shares issued, as this decreases your stake in the company. This could be a warning sign... especially if these funds are needed to pay off debt or to pay dividends.
3) Investing cash flow is negative, and we can see that this is due to the purchase of new fixed assets. If these assets contribute to increased profits in the future, this may be a worthy cash outflow, and not a negative sign. If, however, there are large inflows of cash from asset sales... you should investigate why. Sometimes it is a sign that a company may be experiencing trouble and selling existing assets to raise money to cover other obligations.
Hypothetical Statement of Cash Flows for Acme Corporation
Operating Cash Flows
Income for the period +$64,795
Equity Income -$5,000
Minority Interest +$2,000
Net Operating Cash Flows = + $63,795
Financing Cash Flows
Proceeds from a Share Issue +$10,000
Repayment of Debt -$2,000
Dividends Paid -$1,000
Net Financing Cash Flows = +$7,000
Investing Cash Flows
Acquisition of Fixed Assets -$15,000
Net Investing Cash Flows = -$15,000
Total Increase or Decrease in Cash (Net Cash Flow) = +$55,795
The Intelligent Investor must always look for warning signs within the cash flow statement, such as:
1) a business continuing its operations through the use of debt and equity financing (borrowing money or issuing shares), and using that money to fund losses highlighted at the start of their Operating Cash Flows.
2) a business that is essentially "borrowing from Peter to pay Paul," which may appear as outflows of cash in the form of dividend payments, but inflows of cash in the form of share issuances or the issuance of new debt. This might be evident by seeing new shares being issued and/or new borrowing happening, while at the same time relatively large dividends are being paid.
3) a business that is experiencing higher levels of depreciation than it is investing in new assets. This might result in positive cash flow numbers for a period of time because decaying assets are not being replaced with new ones, but eventually this might cause trouble as technology becomes obsolete or assets need to be replaced to maintain day to day operations or keep attracting customers.
An interesting cash flow statement to examine is the one issued for Exxon Mobil (NYSE: XOM), which generally experiences positive levels of Operating Cash Flows, and negative levels of Investing and Financing Cash Flows. This means that the company is taking large positive influxes of cash from sales to its customers (Operating Cash Flow), and utilizing that cash to heavily invest in new assets (Investing Cash Flow), and return profits to shareholders via share buybacks and dividend payments (Financing Cash Flow).
Below you can see a graphic illustrating this activity from 2008-2012.
As with the Balance Sheet, you can dig deeper into the Cash Flow Statement, and I encourage you to do so. Please ask if you have any questions, and Happy Investing!