Today, we will be reviewing one of the most fundamental components of the annual audited financial statements, namely the Cash Flow Statements.
What is Cash Flow Statements (CFS)?
Cash Flow Statements is a summary of the company’s cash inflows (funds coming in) and cash outflows (funds going out) for a period of one year (in the context of the annual audited financial statements). The CFS tracks the movement in the company’s cash and cash equivalents.
What does the Cash Flows from Operating Activities (Operating Cash Flows) tell me?
Simply put, the Operating Cash Flows are cash generated from the company during its’ ordinary course of business such as cash received from its’ customers less all operating cash outflows such as payments to trade creditors, employees, tax and money tied up in working capital (e.g. inventories and trade debtors).
The Operating Cash Flows indicates whether the company’s business is sustainable and is generating sufficient cash flows to fund its’ business. Unless the company is a new start-up or are involved in long term projects (such as construction companies’), operating cash flows should always be positive.
If the company has negative operating cash flows, you need to be very careful if you intend to invest in such companies. Why? Well, if the company cannot generate enough cash to fund its’ operations, how long do you think the company will last? More importantly, is the business sustainable in the long run?
What does the Cash Flows from Investing Activities (Investing Cash Flows) tell me?
For a company, it is not enough to generate a small positive Operating Cash Flows. It must generate sufficient positive Operating Cash Flows to finance its’ investing activities. In other words, the Company must have enough cash generated to finance enhancements to its' manufacturing capabilities & technologies. It must also have cash to purchase new property, plant and equipment to replace its’ existing factories, equipment and other fixed assets. Interest received from investments and proceeds from disposals of property, plant and equipment will also be classified under this category.
Generally, Operating Cash inflows must be sufficient to finance Investing Cash outflows. If it is insufficient over a period of time, the company must finance its’ investing activities through loans and bank borrowings. When this occurs, you must ask yourself, is the company incurring these loans for expansion purposes or merely replacing its’ current ageing assets.
If it is for the former purpose, the additional future revenues and operating cash flows arising from its' expansion should suffice to repay the loan and interest. However, if it is for the latter purpose, then further analysis is required. If a company cannot generate sufficient Operating Cash inflows to finance replacement of its’ property, plant and equipment, is the business really viable?
What does the Cash Flows from Financing Activities (Financing Cash Flows) tell me?
Financing cash inflows consists mainly of cash received by securing additional loans and bank borrowings. Cash outflows from financing activities usually consists of dividend payments to shareholders, repayment of borrowings &loans and payment of finance lease liabilities.
Commonly, Financing Cash Flows are usually cash outflows except when there are huge loans or bank borrowings secured for a particular year. The Financing Cash Flows indicates how much of cash is being utilised to fund the operations of the company. Over the long term, perhaps for a period of three to five years, the Operating Cash inflows must be large enough to cover both the Investing and Financing cash outflows. This will indicate that the company is a viable one and is in a position to repay its’ loans and borrowings over a period of time.
The sum of the Operating Cash Flows, Investing Cash Flows and Financing Cash Flows will indicate the increase or decrease in cash and cash equivalents for the year. This indicates how healthy the company is, in terms of cash flows. Healthy cash reserves are crucial for the stability and strength of a company. It would be desirable to review a company's CFS over a period of five years to analyze whether the company's business is viable.
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A detailed review of the Cash Flow Statements over a five year period is crucial in analyzing the financial health of a company you intend to invest in. Remember, in the long term, the company must have more CASH INFLOWS (cash coming in) than CASH OUTFLOWS (cash going out).