Every three months, publicly held businesses go in for a financial check-up. As required by the Securities and Exchange Commission (SEC), every company that is traded on the stock market must file a quarterly balance sheet, earnings report and statement of cash flows. For investors, these reports hold critical information for gauging the financial health of a company and deciding whether to buy more stock or sell, sell, sell!
Earnings and cash flow are two very different ways of calculating the profitability of an enterprise. In fact, they're based on two distinct accounting methods: accrual accounting and cash accounting [source: Investopedia].
Earnings are calculated using accrual accounting, which indicates the company's profitability "on paper." In other words, a sale is counted as a sale as soon as the order is made, whether or not the client has actually paid for the order. Same for expenses; if a company owes money to suppliers, it counts as an expense even if the bill hasn't been paid. The danger of accrual accounting is that it leaves room for "creativity." Savvy accountants can inflate earnings that may or may not ever result in real cash.
That's why the statement of cash flows is so important. Cash flow doesn't concern itself with paper earnings and expenses. It relies on cash accounting, which only records revenue or expenses when the money changes hands. A statement of cash flows indicates how and when a company receives money (from sales, investments or financing) and how and when it spends money (operating expenses, capital investments, taxes, interest, etc.). The bottom line of a cash flow statement reveals how much money (as in real cash) a company has on hand to successfully run its operations, cover its liabilities and expand.
Businesses have several different ways to track and report cash flow, and smart investors need to understand the significance of each one. Keep reading as we break down the five ways that businesses measure cash flow.
Cash flow from operations is considered one of the best measurements of a company's overall financial health. The term "operations" refers to the core business activities of a company. The operations of Ben & Jerry's, for example, is making and selling ice cream. The operations of H&R Block is developing and selling its tax preparation services. Cash flow from operations measures the money that comes in and flows out (expenses) from core business activities.
In most large business, there are very few direct and immediate cash transactions. Instead, there is a whole system to handle delayed payments managed by two departments, called accounts receivable and accounts payable. Let's say the Dunder Mifflin paper company orders 50 truckloads of lumber to turn into paper. It doesn't have the cash on hand to pay for the lumber, so the bill is sent to accounts payable. Meanwhile, salesman Dwight gets an order for 50,000 reams of paper, but the client will need 30 days to send over the money, so the invoice goes to accounts receivable.
On the earnings statement, the paper orders count as income and the lumber counts as an expense, even though the bills and invoices are still sitting in accounts payable and accounts receivable -- and no money has actually changed hands. Cash flow from operations, on the other hand, only concerns itself with the moment those accounts are paid in full. For investors, operating cash flow is a valuable indication of how much real cash a company generates from its core business activities.
If a company has good operating cash flow, but negative earnings, it could mean that it's investing heavily in growth. One of the best ways to find out is to look at the cash flow from investments, which we'll tackle next.
When a company issues a statement of cash flows, it divides the statement into three sections: cash flow from operations, cash flow from investments and cash flow from financing. We already discussed cash flow from operations, which focuses on the cash earned and spent through core business activities. Now let's look at cash flow from investments.
What kinds of cash transactions fall under the category of investments?
- Purchase or sale of equipment
- Purchase or sale of real estate
- Purchase or sale of securities (stock, bonds, futures, options, etc.)
- Lending money to other businesses or entities
For cash flow purposes, investing in an asset or bond is a "cash out" transaction. The business spends money in the short-term with the hope of long-term cash gains in the form of increased productivity from new equipment or returns from high-growth securities. If a company has high operational cash flow, but low earnings, check the cash flow from inventory. It could be that the company is investing its cash aggressively for future growth.
If a company sells stock or sells off some of its assets, those are "cash in" transactions. A smart investor will try to reconcile the statement of cash flows and the earnings report. It's quite possible, for example, that a company is reporting high earnings, but negative operational cash flow. In that case, perhaps the company has sold off assets (equipment, property, even parts of the company) to get more cash. The cash flow from inventory statement would make that clear.
Next we'll look at cash flow from financing, the third section of a cash flow statement.
Businesses don't just grow on trees. They're "planted" with seed money and nurtured with continuing financing. Cash flow from financing is the way that businesses track the inflow and outflow of cash from both debt and equity financing.
Taking out a loan is an example of financing through debt. When a company receives the loan, it provides a direct inflow of cash. As the company pays off the debt through principle and interest payments, the cash flows back out.
Equity financing for a public company is acquired through the issuing and selling of stock. When an investor buys stock in a company, that money is used to fund business operations. In return, the shareholder is entitled to a share of the profits, called a dividend. The shareholder can either cash in his dividend or re-invest it in more stock. The money earned through the sale of stock is "cash in" and the payment of dividends represents "cash out."
Cash flow from financing and investment are both examples of non-operating cash flow. As an investor, it's tempting to focus on cash generated through the core business operation. But it's equally important to understand how a company funds its operation and how it manages its debt and equity obligations. Over the long term, stable and prudent management of assets and liabilities often trumps short-term gains in earnings.
Next we'll look at one of the most significant cash flow measurements for investors: free cash flow.
The best way for a public company to keep its shareholders happy is to ensure that the stock price keeps going up, up and up. And the best way to do that is to increase profitability and overall value by developing new products and services, streamlining operations or acquiring new subsidiaries. Since expansion requires lots of available cash, that's what investors are looking for with a measurement called free cash flow (FCF).
To calculate free cash flow, you need two figures, both of which are found on a statement of cash flows: operating cash flow and capital expenditures. Operating cash flow is easy to find; it's the bottom line of the cash flow from operations section, sometimes called net cash from operations. Capital expenditures is found in the cash flow from investments section and is either listed as capital expenditures (CAPEX for short), or "plant, property and equipment." With those two numbers in hand, the equation is simple:
Operating cash flow - capital expenditures = free cash flow
Now, some investors believe that calculating free cash flow by using total capital expenditures paints a distorted picture of the money available for growth because some of those capital expenditures might already be growth assets. In that case, a better figure for calculating free cash flow is called maintenance capital expenditures, which only includes investments in existing plant, property and equipment [source: Basavaraj]. Depending on the detail of the free cash flow statement, however, the two types of expenditures (growth and maintenance) might be difficult to separate.
Lastly, we'll look at some advanced methods for analyzing a company's earnings and cash flow statements.
Financial reports are notoriously difficult to decipher. All of those earnings figures and cash flow statements aren't worth the paper they're printed on if you don't know how to crunch the numbers to identify trends that inform your investment decisions.
For example, efficiency is a highly prized quality for investors. The whole fields of supply chain management and logistics are built around the idea of lean operations where products don't languish in the warehouse and sales are quickly converted to cash. A useful calculation for determining the overall efficiency of a company is called the operating cash flow margin.
Operating cash flow margin compares two numbers: the net cash from operations and net revenue from sales. You'll find net cash from operations on the statement of cash flows and net revenue from sales on the earnings report. Divide net cash from operations from net revenue from sales and you get the operating cash flow margin. The higher the figure, the better the company is at converting sales into cash.
Another good sign for investors is a company's ability to cover its short-term debts and other liabilities with available cash from core business operations. This figure is called operating cash flow ratio, but it isn't listed anywhere on a financial report. It's the investor's job to know how to find it. For this one, you start again with cash flow from operations and divide it by current liabilities. To find current liabilities, go to the company's current balance sheet and look at the top section of the liabilities column. Again, a high ratio is a good sign, since the company has enough cash from operations to stay in the black.
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- Basavaraj, Shruti. The Motley Fool. "Free Sailing With Free Cash Flow." January 11, 2006 (Accessed March 23, 2011.)http://www.fool.com/investing/high-growth/2006/01/11/free-sailing-with-free-cash-flow.aspx
- Investopedia. "The Essentials of Corporate Cash Flow" (Accessed March 23, 2011.)http://www.investopedia.com/articles/01/110701.asp
- Investopedia. "Non-operating Cash Flow" (Accessed March 24, 2011.)http://www.investopedia.com/terms/n/nonoperatingcashflows.asp
- Investopedia. "Operating Cash Flow" (Accessed March 23, 2011.)http://www.investopedia.com/terms/o/operatingcashflow.asp
- Investopedia. "Operating Cash Flow Margin" (Accessed March 23, 2011.)http://www.investopedia.com/terms/o/operating-cash-flow-margin.asp
- Investopedia. "Operating Cash Flow Ratio" (Accessed March 24, 2011.)http://www.investopedia.com/terms/o/ocfratio.asp
- The Motley Fool. "Foolish Fundamentals: The Cash Flow Statement." December 30, 2005 (Accessed March 23, 2011.)http://www.fool.com/investing/dividends-income/2005/12/30/foolish-fundamentals-the-cash-flow-statement.aspx