Cash Flows

So, when I was in school one of the first things we learned was Financial Accounting. I think because it was one of the first things we learned, it was one of the first things I forgot. I have a couple of interesting investment ideas that I am playing with right now and some models which I might explain later but for me to do my due diligence I really do need to understand the Cash Flow statement a little better. Time to pull out my Financial Accounting textbook by Libby, Libby and Short (actually a really well put together book, by the way).

What is a Cash Flow Statement and why do companies produce them?
Well they really provide a picture of how the money at the start of the period (typically the year) turned into the amount of money at the end of the period. Why do we care? Well if we understand where the money is going to or coming from, we know have a better idea on whether the company will be around next year, we know if they are increasing productive capacity (more money made later) and we see how they are managing the accounts receivable (money owed to them) and inventory (stuff they need to make new products).

I think some of what always bothered me is that the Cash Flow statement is broken into three sections 1) Operating Activities, 2) Investing Activities and 4) Financing Activities. I am bothered because I dont understand why they are broken down this way, I am assuming it is just convention but maybe for another post I will do more digging.

Before going into the actual Cash Flow it is important to think about the fundamental equation of business that:

Assets = Liabilities + Stockholders Equity

(If I own a company that has $10 of assets but owes $3, then my Stockholders Equity is $7).

Using this formula we can split Assets into Cash (and equivelants) and Noncash Assets (I have $5 in cash and $5 in lemons for my lemonade business). Simple algebra will give us the following formula which is important to remember when trying to understand why certain lines appear in the Cash Flow:

Cash = Liabilities + Stockholders Equity - Noncash Assets

When looking at any activity of the business any transaction that changes cash must be accompanied by a change in Liabilities, Stockholders Equity or Noncash Assets.

Operating Activities
Really this is the section that looks at the inflows or outflows that relate directly to the revenues and expenses that appear on the Income Statement. There are two ways of presenting this information the first and the one recommended by the FASB is the Direct Method. In this one inflows and outflows are totaled seperately and the difference is the Net Cash Inflow (Outflow). Unfortunately this method isnt widely used in the US and so we do the Indirect Method. In the Indirect Method we start with Net Income (from Income Statement) and add or subtract back out any of the non-cash items:

Net Income
+/- Adjustments for noncash items
= Net Cash Inflow (Outflow)

Generally when you look at a public company they will have the following lines (or something very similar in their Cash Flow Statement):
Net Income
+ Increase in Depreciation and Amortization
On the Income Statment we subtract depreciation as an expense. Really when the item was bought we paid for it but accounting rules allow us to spread the cost of multiple years for tax and reporting purposes. If we did pay for plant or equipment, it really is an investment and captured elsewhere.
+ Decrease in Accounts Receivable
When we sell something but dont get the money straightaway our Accounts Receivable is increased. On the Income Statement this is an assets but really, there is no money yet. If we have an increase during the year of Accounts Receivable our Net Income is higher than it should be (from Cash Flow perspective) and so we need to take the cash out (it should come later).
+ Decrease in Inventory
If we increased inventory by buying something for $10 than we decreased our Cash by $10. This can be a little confusing as when we think about it a decrease in inventory doesnt nessecarily mean that we got more money. But we have to understand that if the inventory in the balance sheet decreases, we have sold more than we bought (for the period) and so our cash position is stronger.
+ Decrease in Prepaid Expenses
Similar to Inventory a prepaid expense, is money that we paid for something before it has been used (or sold in inventory case). If we have lower Prepaid Expense in Balance sheet at the end of the period then we have less cash tied up in the business and so that should be added as part of our cash flow.
+ Increase in Accounts Payable
When we buy somehting but dont pay for it, it goes to our Accounts Payable. If we have a bigger tab with a vendor it might add risk somewhere else but it does free up the cash that would have otherwise been committed and was actually removed from our assets in our Net Income.

From an analysis perspective these items amount to the companies ability to generate (or save) cash from operations and are sometimes referred to as Working Capital. One interesting ratio that can be used when comparing companies in the same industry is to figure out its Quality of Income Ratio where the ratio is calculated by dividing the Cash Flow from Operating Activities by the Net Income number. The higher the number, the better able the company is to earn revenues and profits while managing thier cash situation.

Cash flows from Investing and Financing activities follow a similar pattern and provide an insight into the longer term strategy of the company. If there are big investments in new equipment or properties, it might be a sign that management are very optimistic about some opportunity. Likewise if they are taking on large amounts of debt something interesting may be afoot. In all cases the only way to validate is to actually read their annual reports or look for statements (afterall a number is just a number).