Analysing cash flow statements

In this lesson we’ll take a look at another key area of the financial statements to consider in your fundamental analysis, the cash flow statement.

This is a record of the cash generated and used by a company. Unlike the balance sheet, which is a snapshot of a particular point in time, the cash flow statement covers a certain period specified by the company.

You’ll usually see data listed under the following categories:

• Cash from operationsThe money generated by the company’s normal business operations is shown here. Sometimes it may be further broken down into:
  1. Earnings
  2. Additional to cash
  3. Subtractions to cash

The figure is significant because it can indicate whether the company is able to make enough money to maintain and develop its operations, or if it has to rely on external financing.

• Cash from investingThis reports the company’s sales or purchases of long-term investments, property and equipment.
• Cash from financingHere you’ll see details of the company’s corporate bonds and shares that have been issued or repurchased. Dividend payments to shareholders will also be listed.

So what can we learn from these figures? Well, as the saying goes, ‘cash is king’. Many analysts feel that cash in the bank is an important asset, particularly because it’s something that can’t be faked by clever accounting.

The bottom line is that if a company is consistently generating more money than it’s using, it will potentially be able to do a number of useful things with the surplus, such as:

• Increase its dividend payments, benefiting shareholders
• Pay off existing debts, reducing its expenditure on interest payments
• Repurchase shares, which can have multiple benefits

Did you know?

A company might choose to repurchase shares for a variety of reasons:

• Reducing the number of shares owned by private investors lowers the amount that must be paid out in dividends. The money saved can then be used to strengthen the business.
• If the company feels the market has undervalued its business, it might buy back the shares to take advantage of this – possibly reissuing them once the price has corrected
• Reducing the number of shares in circulation helps boost certain ratios that are commonly scrutinised by the markets, such as the earnings per share. The announcement of an upcoming buyback sometimes causes short-term investors to flock to the stock concerned, in the hope that the improved ratios will trigger a rise in the share price

You might want to compare cash from operations with net income (discussed in the next lesson). If the cash figure is higher, the company can be said to have high quality earnings. In other words, a substantial proportion of the earnings from the business is being turned into cash.

On the other hand, if cash from operations is dwarfed by net income, you might compare the company to a friend who takes home a generous salary each month yet never seems to have the cash to buy a pint. Where is all that money going to, and why? Unless there’s a valid reason for the difference, it may imply that the company is operating inefficiently.