It is most important to analyze the cash flow statements of a business before making investment. Cash flow statements of a company show how well the company has planned and managed all their expenditures and collections. Common answers that a company asks while analyzing their cash flow statements are like.
- Should we cut back on payments?
- Form where the most cash is getting collected?
- Which products or projects are draining majority cash?
- Is there enough cash to buy new machinery and over heads?
All listed companies prepare cash flow statements and includes it in their annual report which consists of Balance Sheet and Profit & Loss statements. Cash Flow statements have most vital information’s for investors who are analyzing the financial report of the company with investment objectives.
For a layman investor to understand cash flow statements let us define it in simple terms: “The cash flow statements present the source of cash (collection) and use of cash (expenditure) which forms a basis of cash flow analysis”. In this article we will discuss how to analyze the cash flow statements of a company for investment objectives.
The cash flow statements consist of statements of cash collected and cash paid for the following three business activities:
- Investing Activities
- Financing Activities
- Operating Activities
Investing Activities in Cash Flow Statements
Investing activities includes the activities of purchase and sale of securities.
Cash in-flow form investing activities includes
(1) Cash collected due to sale of securities (equity & debt) of other companies,
(2) Cash collected due to sale of fixed assets
Cash out-flow form investing activities includes
(1) Cash paid due to purchase of securities (equity & debt) of other companies,
(2) Cash paid due to purchase of fixed assets
Financing Activities in Cash Flow Statements
Financing activities includes the activities of issuance and re-acquisition of self stocks. It also includes payments of dividends to stock holders and debt financing (taking loan form banks) and repayment of loans.
Cash in-flow form financing activities includes
(1) Cash collected due to sale of self-stocks.
(2) Cash collected due to sale of self-debt securities (like bonds etc).
(3) Cash collected due to purchase of loans form banks etc.
Cash out-flow form financing activities includes
(1) Cash paid due to payments for paying of debts
(2) Cash paid due to payments for re-acquisition of self-stocks
(3) Cash paid due to payments to stockholders as dividends
Operating Activities in Cash Flow Statements
Operating activities are linked to manufacturing and sale of goods and services. For consulting agencies it may be better defined as “rendering” of services.
Cash in-flow form operating activities includes
(1) Cash collected due to sales in the past
(2) Cash collected due to possession debt securities of other companies (as interest)
(3) Cash collected due to possession equity of other companies (as dividend)
Cash out-flow form operating activities includes
(1) Cash paid due for raw materials
(2) Cash paid due to payments made to the vendors for purchasing goods required for operating the manufacturing unit.
(3) Cash paid due to payments made to employees on account of salaries.
Analysis of Cash Flow Statements for Investment objectives
It is very important for investors to know the answers to the following questions before making their decision on whether to make investment in a company or not:
How the expansion projects were financed by the company?
This information is available in the Financing Activities statement of cash flow chart. Cash-inflow for financing activities includes project financing for expansion plans.
What use was made of net income?
Net cash flow (Cash-in minus cash-out) from operating activity is the net income. If the value is positive it means operation is generating enough cash to pay for itself.
Conclusion
Investing section
Any substantial increase in investing section of cash flow may hint at possible attempt to take control of other company for diversification of business. Increase in fixed assets indicates capital expansion and future growth.
Financing section
Issuance of common stocks at attractive prices (high stock price above book value) may indicate that the brand image and product of company is good. Issuance of preferred stock is not a good sign as it hints that the company is having problems in selling common stock. If company is resorting to debt financial then it is important for investors to analyze the debt equity ratio of company. Reduction of long term debts is desirable.
Operating Activities
If operation is generating enough cash to pay for itself, this is an ideal condition. Cash outflows towards customers for refunds for deficient goods indicate product quality problems.
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