As we embrace the full influx of financial reports for the earnings season of 1st quarter, it is pertinent to note that besides paying close attention to profit margins and management’s view of the company that you’re looking at, an important piece of the financial report called the “cash flow statement” should be given a closer look as well.
The importance of cash flow statement lies in the fact that it explains the changes in cash and gives insight to the company’s operating, investing and financial activities. Also, cash flow statement will unveil the company’s ability to generate cash to meet its short-term obligations, thereby assessing if company’s liquidity and solvency position is sound.
In this article, I will show you a brief example on assessing the health of the company using Cash Flow Analysis. Before I go forth with my explanation, a stark contrast has to be established whereby “High Profits Do Not Equate To Healthy Cash Flows.” Many quickly assume that having high profits generally mean that the company is doing well. Ironically, profit figures could be easily manipulated via unconventional ways such as “off balance sheet financing” or “window dressing”, thereby making profits look “good”.
In a nutshell, the cash flow statement is made up of 3 categories, namely operating activities, investing activities and financing activities.
Operating activities – These are revenue generating activities of the company, which normally includes cash receipts from sale of goods and services, cash payments to suppliers for goods and services and disposal gains and losses of fixed assets.
Investing activities – These are activities that involve the acquisition and selling of fixed assets (long termed assets like land, building or plant), cash receipts from the disposal of fixed assets and cash payments to acquire fixed assets.
Financing activities – These are activities, which change or impact the size and the composition of owners’ capital. They include cash proceeds from issuing shares, or debt and payment of dividends.
The cash flow statement presented below will entail explanations on the analysis on the health of company A.
From the above cash flow statement, even if Company A’s income statement reflects a profitable figure, Company A is not earning real profits but instead “creating” profits. This can be seen by its significant disposal of fixed assets and lowering of provision, thereby reflecting “poor quality” of profits.
Breaking it down further, red flags should strike you upon noticing the fact that net cash from operating activities is negative, indicating unsuccessful business operations in terms of cash earned. Despite improvement in cash flow where closing cash and cash equivalent albeit being negative narrowed, closer attention will enable you to see that said improvement was actually attributable to the huge sell off of its fixed assets (plant and freehold land and building).
Because purchasing and owning fixed assets such as plant and machinery will subject Company A to depreciation charges, thereby weighing down profits, Company A has replaced the disposed fixed assets with long term leases. Long-term leases are akin to “renting”, in which things like depreciation or maintenance of the asset are absorbed by the owner and not the lessee. However, long-term leases will subject Company A to future cash flow commitments, which could create further liquidity problems.
Insufficient cash flow also led to the company raising funds through the share issue, which was done to cover the deficit but Company A’s business still reflected an overdraft figure of $60 million due to its poor operations. This is in addition to the fact that it chose to pay out dividends of $125 million despite such performance.
Summing this piece up, it is pertinent to remember that high profits do not equate to healthy cash flows. It is often easy to manipulate profit or balance sheet figures by adopting policies which capitalize on the grey areas of accounting standards, but it is not as easy to do that on a cash flow statement. To further enhance the analysis, financial ratios could also be used hand in hand with the cash flow statement to better understand the story told by the numbers.
Source: www.sharesinv.com
The importance of cash flow statement lies in the fact that it explains the changes in cash and gives insight to the company’s operating, investing and financial activities. Also, cash flow statement will unveil the company’s ability to generate cash to meet its short-term obligations, thereby assessing if company’s liquidity and solvency position is sound.
In this article, I will show you a brief example on assessing the health of the company using Cash Flow Analysis. Before I go forth with my explanation, a stark contrast has to be established whereby “High Profits Do Not Equate To Healthy Cash Flows.” Many quickly assume that having high profits generally mean that the company is doing well. Ironically, profit figures could be easily manipulated via unconventional ways such as “off balance sheet financing” or “window dressing”, thereby making profits look “good”.
In a nutshell, the cash flow statement is made up of 3 categories, namely operating activities, investing activities and financing activities.
Operating activities – These are revenue generating activities of the company, which normally includes cash receipts from sale of goods and services, cash payments to suppliers for goods and services and disposal gains and losses of fixed assets.
Investing activities – These are activities that involve the acquisition and selling of fixed assets (long termed assets like land, building or plant), cash receipts from the disposal of fixed assets and cash payments to acquire fixed assets.
Financing activities – These are activities, which change or impact the size and the composition of owners’ capital. They include cash proceeds from issuing shares, or debt and payment of dividends.
The cash flow statement presented below will entail explanations on the analysis on the health of company A.
From the above cash flow statement, even if Company A’s income statement reflects a profitable figure, Company A is not earning real profits but instead “creating” profits. This can be seen by its significant disposal of fixed assets and lowering of provision, thereby reflecting “poor quality” of profits.
Breaking it down further, red flags should strike you upon noticing the fact that net cash from operating activities is negative, indicating unsuccessful business operations in terms of cash earned. Despite improvement in cash flow where closing cash and cash equivalent albeit being negative narrowed, closer attention will enable you to see that said improvement was actually attributable to the huge sell off of its fixed assets (plant and freehold land and building).
Because purchasing and owning fixed assets such as plant and machinery will subject Company A to depreciation charges, thereby weighing down profits, Company A has replaced the disposed fixed assets with long term leases. Long-term leases are akin to “renting”, in which things like depreciation or maintenance of the asset are absorbed by the owner and not the lessee. However, long-term leases will subject Company A to future cash flow commitments, which could create further liquidity problems.
Insufficient cash flow also led to the company raising funds through the share issue, which was done to cover the deficit but Company A’s business still reflected an overdraft figure of $60 million due to its poor operations. This is in addition to the fact that it chose to pay out dividends of $125 million despite such performance.
Summing this piece up, it is pertinent to remember that high profits do not equate to healthy cash flows. It is often easy to manipulate profit or balance sheet figures by adopting policies which capitalize on the grey areas of accounting standards, but it is not as easy to do that on a cash flow statement. To further enhance the analysis, financial ratios could also be used hand in hand with the cash flow statement to better understand the story told by the numbers.
Source: www.sharesinv.com
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