Analytical Review 101 – Part V
THE IMPORTANCE OF CASH FLOW STATEMENTSToday, 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.
Overview
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.
Analytical Review
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Conclusion:
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).
7 comments:
Wisdom, you manage to explain a lot of accounting in simple terms which has deepen my understanding. Thanks a lot!
It's my aim to teach things step by step, so I'm glad its' working!
Financial statements are easy to understand. It's those pesky accountants that likes to make things difficult :)
Dear Avatar,
Aren't you an accountant? What makes you less pesky compared to other accountants?
Haha,
Looks like I have placed myself in a conundrum.
Let me explain: Accountants are largely divided into two categories:
1. Theoretical (or pesky accountants)
These are professors and theorists who come out with fantastic concepts and theories which are by and large goobledegook to most.
2. Practical accountants
I fall into this category. We are the ones on the ground doing the grunt work and scratching our head reading the accounting standards.
So, I'm not a pesky accountant (or at least I try not to be one!)
:)
Dear Avatar,
Now I am very confused and very worried.
Are you saying that these "professors and theorists", these policy makers of the accounting profession, sitting in their Ivory Tower, have no idea what they are doing?
Or are you saying that they know exactly what they are doing, but failed to make their intentions clear, resulting in various equally valid but possibly contradicting interpretations?
Surely you jest! How can there not be any check and balance prior to these "fantastic concepts and theories" becoming accounting standards? No peer reviews? No interpretation/application guidelines? No feedback from members of professional accounting bodies?
If presumably highly trained accountants have problems understanding, interpreting and applying the standards that govern their profession, how could I, an ordinary man in the street, place any comfort, reliance and assurance in their work?
I think I’m beginning to understand now, why you feel there is a need to include a caveat right at the top of your blog!
Dear Annonymous,
I would like to concede to some your well argued points. However, I believe we can discuss about this with a measure of civility, yes?
My earlier post is a light hearted reply as I am unaware as to your depth of understanding (or otherwise) as to accounting standards.
However, I do stand by my (in principle) as to what I have reiterated earlier.
My major points of arguments:
1. The accounting profession has always attempted to reflect the basis of reality in the financial statements. However, when someone tries to value something that is inherently subjective such as the value of a brand, there is bound to be differing opinions just like you and mine. How do you measure the value of person like you and me? Impossible, you might say? Yet, this is exactly where the profession is heading towards with the attempts are valuing brands, goodwills and other similar items.
2. I remember that a decade a ago, the accounting profession was adamant in not expensing of stock options, despite many prominent investors arguing otherwise. Despite all the peer review, that did not change until recently. Times change, so do people. This world is not black and white and you should also exercise some skepticsm when reviewing financial statements.
3. I would like to reiterate that you can have some measure of comfort in a professional's work. However, as with all things, you must exercise due care and diligence on your part. I believe you are aware of the plethora of financial fraud cases ranging from Enron, Worldcom, Transmile and Parmalat. There have been loopholes in accounting and auditing standards and always will be. What Enron did in 2002 was perfectly legal via the use of Special Purpose Entities (SPEs). Did the peer review, feedback and highly trained accountants and Arthur Andersen managed to spot this early enough? Why do you think the Sarbanes-Oxley act was enacted?
I trust my answer are satisfactory to you. However, you feel free to disagree.
Take note that I do not intend to comment further on this issue. If I have offended any one on the *pesky* and *theoretical* accountants comments issue, I apologize. It was a comment in jest and I did not expect such a strong reaction to an offhand comment.
Dear Annonymous,
In case my explanations are not convincing enough, I would like to refer you to BW3 in the 31 May 2008 edition of the Star's BizWeek.
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