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Thursday, November 12, 2015

What do My Financial Statements Mean? - The Cash Flow Statement

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The cash flow statement is probably the most important of your three primary financial statements. However, despite this it is probably the least understood of the three. Understanding what the line items on this statement mean and the overall significance of the numeric totals will enable you to spot many situations where a business is either in trouble, or could find itself in trouble in the future.

So What is the Purpose of the Statement? What Does it Mean?

The cash flow statement tells you whether the business is capable of generating enough cash from its operations to sustain the business. This is not the same thing as profit. Many times you will hear about profitable businesses that expand quickly and go bankrupt. The reason is insufficient cash flow to meet their obligations as they come due.

Actually, the statement tells you much more than that. It tells you what the net change was in the cash balance of the business - an increase or decrease. More importantly, it tells how how that increase or decrease came about, by disclosing information about the cash flows in three sections:

1. The operating section
2. The investing section
3. The financing section

The operating section is all about the day to day operations of the business. The cash flow statement will always contain a subtotal showing you how much cash was either generated by or used in operations. Except for a startup business, a healthy mature business should always have positive cash from operations. This means that the day to day operations are generating enough cash to pay the obligations of the business as they come due without having to resort to drastic measures like selling off assets or borrowing money.

The investing section contains transactions of a long-term capital nature that are outside the normal operations of the business and that occur infrequently such as buying new equipment or selling off old equipment. Buying or selling of marketable securities held over the long-term would also be disclosed in this section.

The financing section contains information about long-term capital transactions involving either shareholders or long-term creditors.

Understanding The Operating Section

The operating section is prepared in one of two ways by your accountant. Each way will result in different information being shown:

1. The Direct Method.

The direct method will look almost like a repeat of your income statement, except that it will not include any non-cash items. The amounts shown will also reflect the cash impact of increasesor decreases in your current assets and liabilities as explained below.

2. The Indirect Method

This the most common method used now. It starts with your net income or loss figure from your income statement and then adjusts this number for two major classes of items:

  • It removes any items that are non-cash in nature, such as gains and losses as well as amortization (depreciation) of capital assets. 
  • It adds or subtracts the cash flow impact of increases or decreases in current assets and liabilities. 
It is this second group of adjustments that most people struggle with. Have you ever heard someone say "I made a lot of money, but it's all tied up in inventory.". If you have, then this is what that refers to. Whenever you acquire additional assets or pay off additional obligations, you are using cash. Conversely, when you use up assets or take on additional obligations you acquire cash. The reason why this confuses people is because often an acquisition of cash or a use of cash is not accompanied by an actual cash payment. Often it is accompanied by a forgone opportunity to collect cash or an acquired opportunity to defer a payment that otherwise would have been made. For the purposes of the cash flow statement those forgone opportunities or acquired opportunities are treated as uses of and sources of cash. 

So in this second section, adjustments are made to add or subtract the cash flow effect of changes in the ending balances of all your current assets or liabilities, as listed on your balance sheet with those same balances in the prior year. 

After all these adjustments have been made, you will have a figure for total cash flow from operations. As I said above, this amount should be positive for mature businesses and as long as there has not been significant financing or investing activity taking place, it should be relatively stable from one period to the next. 

So a lender or prospective investor will be paying very close attention to this number, and it it is too low, they will probably turn down your requests for financing. 

How Do I Increase This Number?

If your cash flow from operations is low, there are steps you can consider taking that will improve it. These steps include:

1. Reducing your accounts receivable, either by being more aggressive in your collection practices or by reducing your payment terms. 

2. Reducing the amount of inventory carried by using a just-in-time ordering system and or drop-shipping. 

3. Taking as long as possible to pay suppliers without damaging your relationship with them. 

Those three things, done consistently over a period of a year can have a huge impact on the cash flow position of a business over than same period. 

Understanding the Investing Section

The investing section for most expanding businesses will show a negative overall position because the business is spending cash on investing in its expansion. A positive cash flow number in this section usually means that assets or investments are being sold off. This will usually trigger the curiosity of an astute reader, who will want to know why the business is doing this so that they can understand how this is likely to affect the future cash flow from operations. 

For example if there are large negative balances in this section then it means that the business is expanding, which in turn should lead to growth in cash from operations, although it may take 2 or three fiscal years for most of this growth to show up. A business that is able to do this without borrowing money will be able to hang on to most of this growth. Although an astute reader is going to look carefully at the next section to see how this expansion was funded. 

Understanding the Financing Section

The financing section for most mature, stable businesses will show moderate to low outflows as the business makes dividend payments to its owners. A business that has debt will show its annual repayments here. So most existing and lenders will immediately compare the sum of the repayments made with the cash from operations to see if the business is at least generating enough cash to make these repayments. 

Large positive inflows in this section mean that the business has either borrowed more money or has obtained additional investment from its owners. 

Like the investing section, this section can give you some clues as to what to expect in the future. If you see large inflows that have come from debt, then you know that greater repayments will be required in the future periods which will mean more negative outflows in this section in future periods. This in turn means that the cash flow from operations will have to be higher than it is now if the business is to stay afloat. Knowing this will allow you to focus your line of inquiry if you are looking at a company to invest in. On the other hand if you see a significant amount of debt repayment, then that is an indication that less repayment will be required in the future, and thus cash flow from operations can decrease a bit without threatening the future viability of the business.

Red Flags to Watch For

As I have stated in this post there is a way that the cash flow statement should look for certain businesses  depending on where they are in their life cycle. However, the following should alert you that potential problems could be looming on the horizon and that more investigation is necessary:

1. Large negative cash from operations in the current period, or smaller negative cash from operations over 2 or more reporting periods.

2. Large positive cash inflow from sale of assets or investments without a compelling reason as to why, especially if it appears that the sale was undertaken to cover a large operating shortfall. 

3. Large positive cash inflow from the acquisition of new financing that is either not currently sitting in cash on hand, or is not accompanied by an equivalent negative outflow in the investing section. In this case this means that the money has either been paid out to owners or it is being used to pay off existing debt. This isn't necessarily bad, but it could be if the income statement indicates that the business is losing money.

This concludes my post about the three primary financial statements. Tomorrow's post will look at the notes that often accompany the financial statements that your accountant prepares for you. 

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