Cash Flow Analysis in Stock Selection

It’s similar for a business. Ultimately, a company needs to be able to generate cash to ensure they are "living within their means". A failure to generate an adequate cash supply can lead to a business failing or having to sell off other assets in order to bring their books into balance. Either way, cash flow is a critical element to understand when considering whether to invest in a business.

This article will help you understand what cash flow is, what the different components of a cash flow statement mean, how to read a cash flow statement, and the limitations of cash flow when conducting a fundamental analysis. 

What is cash flow?

Cash flow is a measurement of how much cash and cash equivalents a company is receiving and how much it is sending out. Cash flow is considered to be an important measurement of a company’s financial health because it really cannot be fudged. A company has the cash it has.

To report their cash flow, companies issue cash flow statements. Unlike a company’s reported earnings, cash flow allows little room for manipulation. Public companies have to file regular reports with the Securities and Exchange Commission (SEC) and a cash flow statement is one of the required documents. For this reason, companies must accurately tell the appropriate cash flow story.

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The cash flow statement, along with the balance sheet and the income statement, is a key financial statement that a company will regularly provide as part of their earnings reports. The cash flow statement differs from these other documents because it seeks to reconcile both the other documents.

Think of analyzing cash flow like taking a peek into a company's checkbook. The cash flow statement tells investors what revenues have been actually realized and what expenses have been paid out. In this way, cash flow is not the same thing as profit. For example, if a business takes out a $5,000 loan they will report that $5,000 on their balance sheet as an asset, but it is also a liability because it represents a debt that must be serviced. In this case, the company may show a positive cash flow, even though the loan proceeds are not a measure of profit.

A business may record income that is promised to them in the future on an income statement or balance sheet. However, if the sale was made to customers via credit, the company may not realize that revenue as cash until a much later date. For that reason, that revenue would not show up on their cash flow statement until it is actually realized.

How to read a cash flow statement

Just like a balance sheet or income statement, a cash flow statement has three broad categories which are broken down into individual sub-items that may be different depending on the realities of a company's industry. For that reason, while a cash flow statement does tell you something about what is going on with a company, it is an incomplete piece without examining the other financial documents.

The three common sections of a company’s cash flow statement are cash flows from operating expenses, cash flows from investing activities, and cash flows from financing activities. Let’s take a closer look at each one.

Cash flows from operating activities– For many investors, this is considered the most important cash flow measurement because it reflects the activity that is taking place in a company's core business. So for McDonald's, this is selling food. This is a measurement of how effectively a company is able to generate positive cash flow from their core business. While this number may go up and down for a variety of reasons (retail, for instance, is a notoriously seasonal business) if a company is not able to show that it can generate consistently positive cash flow from its core business, investors will want to know why.

Cash flows from investing activities– This measures how much cash a company has earned or paid out to buy or sell assets that produce income for the company. So if McDonald’s were to buy another company for a profit (or sell one for a loss), the realized cash amount from those sales would appear in this section.

Cash flows from financing activities – This measures how much cash was paid out to a company’s owners and/or creditors. We use the words and/or because if a company reports a negative number here, it could mean that it is servicing debt. On the other hand, it could mean that it is rewarding shareholders by issuing dividends or participating in a stock buyback.

Analyzing a company’s cash flow statement

It may seem obvious, but one of the first places to look at a cash flow statement is the "bottom line". This will probably be a line item that says something like "net increase/decrease in cash and cash equivalents". This will tell you whether the company increased or decreased their cash position from their last reporting period. Another way to find this number is to look under the "Current Assets" section of the balance sheet and find the line item for "Cash and Cash Equivalents" (CCE). If you compare the current CCE with the prior CCE, it should match the number on the cash flow statement.

Once you know what that number is, you can take a closer look at the total from each individual section of the statement. If a company shows a positive cash flow from operating activities, but negative cash flow in other areas, it is usually a good sign. A negative cash flow in investing or financing activities is not necessarily a negative sign. For example, if a company reports a negative number of cash flows from investing activities, it could be because they made a long-term investment in equipment that will lead to profitability in the future. Likewise, a negative number in financing activities could be explained as the payout of a dividend, which is a good thing for investors. However, a negative cash flow in operating expenses is more concerning because it suggests the company is having difficulty generating cash from its day-to-day business.

Like any metric, the significance of cash flow numbers has to be considered in context with a company’s industry. Retail companies and businesses that rely on tourism are notorious for having “cycles”. For these companies, it may be helpful to look at year-over-year statements to get a more accurate picture.

The limitations of cash flow analysis

Like the balance sheet and income statement, a company’s cash flow statement is a snapshot of how much cash a company has on hand for a particular period of time. This is different than measuring all the revenue a company may report in its earnings statement since some of that revenue may not be realized at a particular moment in time. Likewise, a cash flow statement may not show all of a company's expenses. That's because, at a given moment, a company may have expenses (or liabilities) that they do not have to pay right away. These will be recorded when the company records paying the expense as a cash transaction.

This is the difference between accrual accounting and cash accounting. Accrual accounting lists all a company’s assets and liabilities whether they are realized or not. This method is used for creating the balance sheet and income statement. The cash flow statement, by contrast, uses cash accounting.

So while there’s no question that cash on hand is a major sign of liquidity for a company, it is not an indicator of profit earned or lost because a company’s profitability takes into account things that are not cash based. A cash flow statement reveals only the cash transactions of a business for a given period of time. In addition to how profitable a company is, the cash flow statement does not list items like account receivable and accounts payable. These can represent significant future earnings or expenses for a company that may have an impact on their overall financial position.

The bottom line on cash flow

Understanding how a company generates and spends cash is a key financial metric used in fundamental analysis. As part of their earnings reports, every company will generate a cash flow statement that will support and be a reality check for their balance sheet and income statement. The cash flow statement is similar to both the balance sheet and the income statement in that it is limited to a specific period of time. As such it only provides a limited snapshot that should be compared to prior statements to look for patterns. Also, the significance of a company’s cash flow must be looked at relative to other companies in their industry.

One of the most significant ways cash flow analysis is different from other financial reporting tools is that it uses cost accounting as opposed to accrual accounting. This makes it extremely accurate on the one hand. A company has the cash it has. It can also make it somewhat incomplete because it does not list any pending income from accounts receivable nor liabilities that could be expressed in accounts payable.

The three components of a company’s cash flow analysis are:

• Cash flows from operating activities
• Cash flows from investing activities
• Cash flows from financing activities

For most investors, the most important of these is how much cash a business generates from operating activities because it indicates how much they are generating from their core business. When a company reports a negative number from investing or financing activities it can be both good or bad. It is up to investors and analysts to draw their own conclusions.