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Fundamental Analysis: The Cash Flow Statement

Sunday, February 14, 2010

Cash Flow Statement quite obviously describes whether cash is flowing in or out of a company.  There are three sections.  

Firstly, Cash Flow from Operations.  

Secondly,  Cash Flow from Investments.  

Lastly, Cash Flow from Financing Activities.

Cash Flow from Operations is an aggregate of Net Income and any depreciation or amortisation put back.  

Depreciation and amortisation represent money which was spent years ago and must be added back to give us an accurate picture of the company's Cash Flow from Operations.  

Here, not only do we want to see a positive cash flow, the higher the cash flow, the better.

Next, we examine Cash Flow from Investments.  

Businesses make investments in income producing assets such as production equipment.  

Any money spent making such investments are labelled Capital Expenditures (CAPEX).  

It is also possible for companies to sell such investments and we might therefore get a positive figure under Others.  

However, here, cash flow is usually a negative figure.  

Companies which consistently have very high CAPEX should show that they are able to fund this through internal resources as far as possible and that they should be able to generate higher returns on such expenditures.

Lastly, we look at Cash Flow from Financing Activities.  

Money used in the payment of dividends or in the buy back of shares results in negative cash flow.  

Shareholders like dividend payouts.  They also like to see the value of their shares rising which happens when a company does a share buy back.  

So, negative cash flow here is actually good for shareholders.

Money gained from selling new shares or issuing bonds provides positive cash flow.  Here, again, we get a bit of a twist.  

The company might get positive cash flow through the issuance of new shares or bonds but it is actually bad for the shareholders as their shareholdings are diluted and bonds have to be repaid with interest.  

Unless the company is able to demonstrate that it will be able to use the funds raised to increase value for its shareholders, it has to be looked at most cautiously.

This post ends the quick introduction to Fundamental Analysis which I set out to blog starting with The Income Statement and followed by the Balance Sheet.  

I hope you have found these posts informative and if you are not already doing FA, I hope these have made you interested enough to look into the subject in greater detail.

I will be going away for a short holiday over the next few days with my family and will return mid week.  I wish everyone the very best and I will talk to you again soon.

Related posts:
1. Fundamental Analysis: The Income Statement.
2. Fundamental Analysis: Balance Sheet.
3. Why is Warren Buffet the world's greatest money maker?


justin said...

Thankyou AK71.

AK71 said...

Hi Justin,

You are welcome. Hope you have found the 3 blog posts helpful. :)

Toma said...

Hi AK,

I am currently learning the ropes to better analyse companies' fundamentals and your articles have been more than helpful!

Regarding the cash flow statement, can I ask how do you derive free cash flow? As some companies do not explicitly state their capital expenditure, it was tough figuring out their FCF.

My second question is what is the relationship between cash, retained earnings and FCF? Does the FCF created each year becomes cash or retained earnings? This has been very confusing!

Thanks for taking time out to read this AK. I appreciate it very much :)

AK71 said...

Hi Toma,

Welcome to my blog. :)

Free cash flow (FCF) is just operational cash flow minus capital expenditure (CAPEX). If a company is less transparent about CAPEX, then it would be difficult to be sure about its FCF.

Cash can be from various sources as you can tell from the Cash Flow Statement.

We just have to remember that FCF is about operational cash flow. It affects the level of cash that is in the company.

Retained earnings is about how much of the company's earnings is retained in the company instead of being distributed to shareholders. Revenue minus expenses minus dividends paid to shareholders = retained earnings.

I do not think that there is any direct relation between the two. They exist in two different statements.

Toma said...

Hi AK,

Thanks for the reply!

Does that mean that the free cash flow accumulated over the years are reflected under "Cash and cash equivalents" in the balance sheet?

AK71 said...

Hi Toma,

Well, cash could be from other sources as well. So, not necessarily. :)

Having said this, this is but a technicality. What is more important to know is how should we look at the financial statements as investors.

You might want to get your own copy of the book "Warren Buffett and the interpretation of financial statements". You can see it here:
Recommended books for FA and TA.

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