If you are investing in stocks, you know the importance of evaluating a company. Cash flow evaluation, among income and balance sheet evaluations, is one of the fundamentals every investor should master.
Cash flow statement basically covers stuff like whether is coming in or leaving the registers. As the name implies, it is literally a statement of the cash flowing into and out of the company.
Common accounting terms
Cash flow statements may offer tons of information, but really only 5 lines are important. Those 5 lines are,
- Net income: This is always the first line in the cash flow statement. This is the income of the company, after paying (or setting aside money for) any taxes it may owe.
- Total cash from operations: This is the actual amount of cash, moving into, or out of, the company, due solely to its operations. This number is usually derived backwards from net income by adding back all those line items that aren’t strictly about cash flows due to operations.
- Total cash from investing: This is the actual amount of cash, moving into or out of the company, due solely to investing activities (e.g., buying new factories, new equipment, buying other companies, etc.)
- Total cash from financing: This is the actual amount of cash, moving into, or out of the company, due solely to financing activities. This includes things like taking out a new loan from a bank, paying off an old loan, paying a dividend to shareholders, etc.
- Net change in cash: This is the actual change in the cash balance of the company.
How to interpret the cash flow statements?
From the cash flow statement, we can discern a few very important tidbits:
Is most of the cash coming into the company via actual operations?
Or is the company being propped up by more and increasing debt?
Or by selling off assets?
Ideally, we want “total cash from operations” to be a positive number, and much larger than “total cash from investing” and “total cash from financing.”
Even better if “total cash from financing” is a negative number (this means the company is doing well, and they are paying down debt.) note that a positive “total cash from financing” number isn’t necessarily a bad thing. Maybe the company is raising debt to buy out a competitor and thus expanding its business. Or maybe the company is developing a new product line, etc. One off debt issuance to invest into the business is usually a good thing! The red flag is when “total cash from financing” is always positive (i.e. The company is always issuing debt), and always a substantial amount compared to “total cash from operations.”
“Total cash from investing” should hopefully also be a negative number, indicating the business is likely profitable and the company is investing more money into it. However, this one is more nuanced.
If “total cash from investing” is always negative, and always a large absolute number, that may indicate a business that is heavily dependent on new injections of capital. For example, if a company has $1 million of “total cash from operations” every quarter, but also $(900,000) of “total cash from investing” every quarter, that suggests that perhaps the company is heavily dependent on rolling over its investments every period to generate the profits for the next period.
Companies like this are sometimes at the mercy of their customers – if they also have a large accounts receivable, if their customers fail to pay up on time, these companies may get into temporary liquidity distress.
Free cash flow and unlevered free cash flow
Free cash flow tells us the core efficiency of a company’s business – it is simply the cash generated by the operations of a company, without consideration for reinvestments (aka. Capital expenditure).
- Free cash flow = total cash from operations – capital expenditure
Free cash flow essentially tells us “how much this company can return if we just run it into the ground.” It is a base case of what profits the company is capable of extracting from its businesses.
Another form of free cash flow, unlevered free cash flow, is simply free cash flow assuming the company has no debt. In this case, interest expenses are added back to the value of “free cash flow,” while tax breaks for interest expenses are taken out:
- Unlevered free cash flow = free cash flow + interest expenses – tax deductions due to interest expenses
Note that tax deductions due to interest expenses may not appear in the cash flow statement nor the income statement, and may have to be estimated.
Similar to free cash flow, unlevered free cash flow gives us an idea of what free cash flow would look like, if an acquirer buys out the company and pays off all its debts.
Ideally, we want free cash flow to be increasing over time, and at a pace equal or faster than reinvestment rate – if the company is reinvesting profits equal to 20% of capital assets, then free cash flow should increase by 20% or more in subsequent periods. Otherwise, the company would probably be better off investing that money in other pursuits, or returning the cash to investors.
Sometimes, an unprofitable company may be a good investment, even if free cash flow is currently negative! A company that is heavily investing in its businesses may sometimes have negative free cash flow. Assuming the capital expenditure is a temporary event, when the need to invest in scaling the business stops, free cash flow will likely quickly jump to positive. Note that such businesses are not without the risks! There is a chance that the capital expenditure does not result in future profits, for example, if the research failed to find anything useful, etc.