Evaluating a Statement of Cash Flows

When it comes to financial statement analysis, many people tend to focus their attention on a company's income statement when determining whether a firm is profitable or financially healthy. However, it is important to remember that a cash flow statement offers quite a bit of insight into a company's financial health. If you are familiar with the basic structure of a statement of cash flows, then try to use some of these cash flow metrics the next time you find yourself sizing up a company's financial statements.

Key Takeaways

  • A statement of cash flow is divided in operating, investing, and financing sections.
  • You can evaluate each section individually to better understand recurring and non-recurring activity.
  • You can also evaluate the statement using cash flow per share, free cash flow, or cash flow to debt.
  • Be mindful that the statement of cash flows may not be useful for forecasting as historical cashflow may not represent future activity.
  • A statement of cash flow is also limited in that it may not be comparable against other companies and does not paint the entire picture of a single company.

Evaluating by Section

Reviewing the Operating Section

The cash flows from the company's main business operating activities are displayed in this area of the statement of cash flows. This part should be examined to determine whether the business is producing positive cash flows from its operations, as this is typically a favorable sign.

Regardless of how a company is performing in its investing or financing section, the company should be bringing in positive cashflow. It is also helpful to compare a company's operating section to its competitors. Though companies with a higher market capitalization may be able to generate more cash, this may be a suitable comparison to see how one company's operations are compared to another.

Reviewing the Investing Section

The cash flows generated by the company's investing operations, such as the purchase or sale of assets, are displayed in this area of the statement of cash flows. Examine this part to determine whether the company is purchasing assets that are anticipated to produce income in the future or whether it is selling assets to raise money.

It's important to consider that some activity in this section may represent a one-time expenditure. Companies may opt to make periodic capital expenditures or investments. Therefore, do not be alarmed at any one period spike in cashflow; instead, be mindful of how period-over-period changes create trends that demonstrate overall health.

Reviewing the Financing Section

The company's cash flows from financing activities, such as the issuance or repayment of debt or the issuance or purchase of stock, are shown in this section of the statement of cash flows. Check this section to discover if the company is responsibly taking on or repaying debt or if it is manipulating its stock price through stock buybacks. This section may lend itself to more strategic management endeavors that may point to the long-term projection of how the company may do.

A statement of cash flow is a component of Generally Accepted Accounting Principles (GAAP) and must be disclosed for public companies.

Evaluating Using Financial Calculations

There are a number of financial metrics or calculations that can be used to evaluate a statement of cash flow. Below are some of the more common forms of analysis.

Cash Flow Per Share

A close cousin to earnings per share, cash flow per share is calculated as follows:

Cash Flow Per Share = (Cash Flow From Operations - Dividends on Preferred Stock) / Common Shares Outstanding

A company's cash flow per share is useful as it informs an analyst of how well positioned a company is when it comes to funding its future growth through existing operations. Companies that are able to internally fund their own growth do not need to turn to external debt or equity markets. This keeps borrowing costs low and generally tends to be viewed favorably by shareholders.

Cash flow per share also reveals how much cash could potentially be made available for future dividend payments. Of course, one has to consider the firm's growth prospects and financing needs when considering whether a dividend might be paid, but cash flow per share does inform cash flow statement users whether their cash is potentially available for dividend payments.

Like many cash flow metrics, cash flow per share tells a more complete story if it is analyzed over several time periods, so be sure to look at a few years' worth of data before drawing any conclusions.

Free Cash Flow

Among analysts' favorite metrics, free cash flow indicates how much cash is available from operating cash flows after accounting for capital expenditures required to maintain current production capacity. Said differently, free cash flow is calculated as follows:

Free Cash Flow = Cash Flow From Operations - Capital Expenditures Necessary to Maintain Current Growth

Note that many companies may not disclose the capital expenditures required to maintain current growth; therefore, some analysts use total capital expenditures in their free cash flow calculation. An alternative approach is to estimate maintenance capital expenditures as a percentage of total capital expenditures.

Free cash flow represents a company's financial flexibility. The higher a company's free cash flow, the more flexible that company is when investment opportunities such as strategic acquisitions present themselves. While some of the information presented on an income statement, such as operating and net income, can be managed by a company's management team, it is very difficult to alter free cash flow. For this reason, many analysts evaluate free cash flows when sizing up a company's profit and growth potential.

Cash Flow to Debt

Yet another useful group of metrics derived from a statement of cash flows is the cash flow-to-debt family of metrics. The broadest calculation of cash flow to debt is:

Cash Flow to Debt = Cash Flow From Operations / Total Debt

Expressing operating cash flows as a multiple of debt offers information to analysts about whether or not sufficient cash flows are generated by the business to service debt payments. You can calculate cash flows to current maturities of debt, which represents whether enough cash is generated to pay off debt that matures within one year.

Do not rely on cash alone; consider the holistic financial health of a company relating to its cashflow, profitability, and solvency.

Limitations to Evaluating a Statement of Cash Flows

Although the statement of cash flows contains rich information, there are some analytical downsides to using the data. A company's cash flows for a specific time period are summarized in the statement of cash flows, but it does not give a comprehensive view of the company's financial situation. The balance sheet and income statement are just two additional financial statements to take into account.

Though comparisons where discussed earlier, it can be challenging to evaluate cash flows between different organizations because of the many accounting techniques that companies may employ. Because of this, it may be difficult to compare a company's cash flow statement to that of its rivals. In some cases, it may even be difficult to compare one company's statement from one period to the next.

Although the statement of cash flows can shed light on a company's previous cash flows, it might not be as useful for forecasting future cash flows. A company's future cash flows could not conform to the same patterns as its past cash flows because of shifting economic conditions and other variables.

Last, a statement of cash flows is a financial statement that can be modified by businesses to give a better impression of their financial health. To acquire a clear picture of a company's financial situation, it's critical to carefully examine its cash flows and take into account other financial statistics. In addition, non-cash transactions do not appear on a statement of cash flows which may be a material consideration to be mindful of.

What Is a Good Cash Flow Ratio?

Very generally speaking, a ratio greater than 1.0 means that a company can cover its short-term liabilities and still have earnings it can invest back into the company or reward investors with via dividends. A higher ratio is often preferred, though having too much cash flow may signal the risk of future operational inefficacies.

What Are the Major Activities in Creating a Cash Flow?

Companies separate its cash flow activities into three different categories: operating activities, investment activities, and financing activities. The company may also have a separate note to call out material but noncash transactions.

How Do Cashflow Problems Usually Start for a Company?

The obvious answer is that cash outflows begin to exceed cash inflows. This may occur in two different ways. First, the company may find itself not selling as much product as before (or having a difficulty in collecting credit sales). Second, the company may find itself with a ballooning expense budget that exceeds what the company actual needs to operate. In either case, cash leaving the company may begin outpacing the cash that flows into the company.

The Bottom Line

The statement of cash flows is an informative financial statement whose metrics are best viewed over time. Many users of financial statements prefer to use metrics derived from the statement of cash flows because cash flows are much more difficult to manipulate versus operating or net income. Cash flow per share, free cash flow and cash flow to debt are among the measures that can be calculated using information found on the statement of cash flows. Each of these metrics offers a unique insight into a company's financial health.

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  1. Accounting Tools. "Cash Flow per Share Definition."

  2. Accounting Tools. "Free Cash Flow Definition."

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