Companies have been reporting statements of cashflows for three decades helping investors understand events that affect cash during an accounting period by examining changes in levels of cash.
The statement of cashflows displays company uses and sources of cash into three business areas of operations, investments and financing.
Operating cash flow – How a company manages its cashflow day-to-day is reported in its operating cash flow statement. It captures items such as cash collected from accounts receivable as well as cash used when producing goods or services, payments to its suppliers and salaries paid to employees. Operating cash flow also includes tax and interest payments. At the end of the period, a surplus of cash implies that the company generated enough cash from its continuing operations. However, a negative cash flow would imply that additional cash flows were required for day-to-day operations of the firm.
Cashflows can be measured in one of two ways. The direct method uses operating cashflows for each operating segment including collections from customers and payments made to employees. The indirect method always starts with net income and looks at adjustments for non-cash expenses, non-operating income and expenses and changes in the balance sheet attributed to operating activities. Investing cash flow – The investing cash flow is captured by measuring changes in a company’s investment in the firm. In order to achieve growth or future profits, a firm may find it necessary to grow both tangible and financial assets. This statement then captures purchases of plant or property and changes to investments or marketable securities.
Negative cash flows are associated with purchases or investments, for example. Positive cash flows are associated with cash receipts from the sale of assets.
Financing cash flow – What financing is needed, how it is performed and how the firm reflects dividend payments to shareholders are all recorded in the financing cash flow statements. Inflows are represented by issuance of new shares or debt and outflows might be represented by events such as retired debt or stock repurchases.
While investors might think that interest payments are reflected in financing cash flows, that is not the case. Interest expense is reflected in the routine operations of the business.
Dividend payments are considered a return of capital to shareholders and DO appear on financing cash flows statements.
Net cash flow – when the impact of cash flows is summed across operations, investing and financing, a net cash flow value can be shown as either positive or negative. This indicates whether, for the period under inspection, the company generated or used cash. This net cash flow metric is added to or subtracted from the ending value for cash and cash equivalents at the end of the prior period, and will match what is reported at the end of the current period on the cash line of the balance sheet.
Accountants will tell you that it is important to review both cash flow operations and income statements together. While it is reasonable to believe that production and sales might occur in one period and that collection of receivables for those sales could conceivably happen in the next period, ordinarily, the two should grow in tandem.
If a company is producing and apparently selling increasing volumes of product, yet bleeding cash in order to do so, that situation should raise a red flag and certainly cannot continue indefinitely.
Growing cash flow – Companies with more cash at the end of a period than they started with are doing better than those who require additional borrowing to fund daily operations. But a company is unlikely to grow unless it continuously generates excess cash flow.
Free cash flow subtracts from operating cash flow any capital expenditures and dividend payments. It is the growth in free cash flow that investors are seeking to find reassurance that the firm can use to streamline or retire debt, create new products and increase dividend payments.
Conclusion – Cash flows are closely monitored by investors and reflect sales growth and the ability of management to control expenses. Analysts must remember, however, that cash flow norms will vary across industries and that many are more capital intensive than others. But make no mistake about one single fact: Without cash flow growth, a firm cannot ultimately grow.
Disclosure: Interactive Brokers
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