Fundamental Analysis: The Cash Flow Statement

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?

Fundamental Analysis: Balance Sheet

A company's balance sheet is a record of its assets and liabilities.  

Basically, if we look at how much the assets are worth and deduct the total value of the liabilities, we will arrive at the net worth of the company.  

Net worth or the book value of the company is also known as shareholders' equity.

Under assets, first, we see Current Assets.  

Current Assets are cash and other assets which can be converted into cash within a very short time.  

Usually, they are listed in the balance sheet in order of liquidity with cash being the first item as it is the most liquid.  

Secondly, we have Non-current Assets.  These are assets which cannot be converted into cash within a very short time.

One thing that value investors look out for is how much cash and cash equivalents a company has.  

Having a lot of cash is usually a sign of strength.  

The company will have the ability to seize business opportunities and will be able to go over rough patches in the business cycle relatively intact.

Next on the list is inventory or the goods which are in the company's warehouse which it sells to customers.  

In business, we say that we cannot do business with an empty wagon.  

Our wagon has to be stocked and that's our inventory.  

However, we do not want our wagon to be overstocked as well.  

Goods also run the risk of becoming obsolete in many cases.




Accounts Receivables is next.  

When the company sells goods to its customers, very often, the customers are given credit terms.  

In businesses which have a strong retail bias, this might be a very small amount if it exists at all since they collect cash for all their sales.  

We want to keep an eye on this because if most of a company's Current Assets are in Accounts Receivables, we have to question the financial health of its customers and how long does it usually take before payments are made.

Prepaid Expenses or payment in advance is next.  I like this because it shows that customers are willing to pay in advance before they receive the goods.  

It shows that the company's products are in demand and, probably, cannot be replicated or very difficult to replicate by its competitors.  The company has a competitive advantage.




Next, we move on to Non-current Assets.  Companies might own properties, vehicles and production equipment.  

Vehicles and production equipment will depreciate in time and the value we see in this line is the total value at the time the balance sheet was prepared minus depreciation.

Then, we have goodwill.  This is something which has been discussed in the case of Healthway Medical.  

This number appears when a company buys over another company at a price above the latter's book value.  

The value above the book value ends up as goodwill in the former's balance sheet.




This is followed by other intangible assets which cover copyrights, patents, trademarks and so on.  

Only intangible assets bought from another company can be reflected in a company's balance sheet.

Both goodwill and other intangible assets must be amortised over time if they have a finite life.  

If they are not depreciating in value over time, then, they need not be amortised.

Long Term Investments are next.  This shows any investments a company might have made which have durations of longer than a year.  

We will have to dwell on this a bit more to see what kind of investments have been made here as and when it occurs.  

It will differ from case to case but generally, we want to see that these are investments which generate higher returns for the company.




An important ratio we use in fundamental analysis is Return on Assets (ROA).  

This is a measure of the level of efficiency in which a company utilises its total assets.  

If we take net earnings and divide this by total assets, we get a figure in percentage terms.  The higher the better.

We move on to Liabilities and just like Assets, there are Current and Non-current forms.  

First off under Current Liabilities, we have Accounts Payable which is money owed to suppliers for goods and services provided.

Then, we have Short Term Debt or Debt which is due.  If a company has a lot of Short Term Debt, this could be dangerous in times when credit is suddenly difficult to come by.




To calculate the financial health of a company, analysts employ the Current Ratio which divides the total Current Assets by the total Current Liabilities.  

So, you can imagine that if you have more of the former and less of the latter, it's a good thing.  A more stringent ratio is the Quick Ratio and it measures a company's ability to meet its short term obligations using its Current Assets minus Inventory.  Any ratio value of more than 1 is good.

Under Non-current Liabilities, we have Long Term Debts and so on.  

I guess the important thing to say here is that very strong and long established companies which generate healthy cash flow usually have very little debt.




I think it is common sense that we want to see as little debt as possible in a company's balance sheet but debt is sometimes a necessary evil.  

So, we have to evaluate debt on a case by case basis.

I hope this quick introduction to what is a Balance Sheet and how to use certain ratios to determine the health of a company is useful.  Next post will be about the Cash Flow Statement.

Related posts:
1. Fundamental Analysis: The Income Statement.
2. Recommended books for Fundamental Analysis.

Fundamental Analysis: The Income Statement

Every trading day would see me looking at charts in the evening and looking out for pertinent news which might have an impact on my investments.  

On weekends, I would sometimes blog about my personal experience and some ideas which I might have about investments.  

The Chinese New Year long weekend is giving all of us a much needed break from trading. Take some time to smell the flowers, so to speak.

I have decided that I will blog about different aspects of FA and this will probably spread over a few posts to make it more manageable.  

My formal education in Economics and Business Administration, specifically, Financial Management help to inform my FA.  

Of course, these are textbook material and I try to keep myself up to date by reading weekly periodicals such as Newsweek and The EDGE.  

I also read analysts' reports, not to blindly follow buy or sell calls but more as an idea generating exercise.  

Being in business development also gives me an inside feel of the business climate especially in South East Asia where the company I work for has the greatest exposure.




In an earlier post, I said that FA could be done on many levels but the most basic level would be looking at a company's financial numbers.  

I have learnt much to my own regret that to overlook this for any reason (usually due to complacency) could be a big mistake.

What is an Income Statement?  

This basically tells us how a company's operations performed over a period of time.  




Right at the top is the gross revenue (GR) the company has generated.  In a company that deals with goods, you will have to deduct the cost of goods to arrive at the gross profit or GP.  

For people who are in tune with Warren Buffet's investment philosophy, you would remember that he says we should always look for companies with GPs of no less than 20%.  In fact, he consistently targets companies with GPs of 40% or higher.

So, let us say that a company has a gross revenue of S$100,000 and their cost of goods is S$60,000.  Gross profit is S$40,000.  

As a percentage, the GP is S$40,000(GP)/S$100,000(GR) = 40%.  

Simple enough.




Does this mean that everytime we see businesses which generate a GP of 40% or more, it is a good buy?  

No, we continue by looking at the next part of the Income Statement which shows the operating expenses.  

These are the Selling, General and Administration expenses or what is referred to as SGA, the Research and Development (R&D) expenses and Depreciation.  

Upon taking out all these expenses, we arrive at the Operating Profit or Loss of the company.  




As you can probably tell, a company which incurs massive expenses despite a high GP is not going to have much left for the shareholders.

The next part is the Interest Expense, Gains or Losses from sale of assets and Others.  

Taking all these out give us the Income of the company before tax. 

We want to make sure that the company is not borrowing too much and not paying too much for its borrowings.  This is what is known as leverage.  

There are many companies which are heavily leveraged and as long as they are making more money than the interest they are serving on their loans, they look good but if the tide turns and, in the last financial crisis, we saw how quickly they could turn, things could become very ugly.  

So, imagine if revenue dries up during a recession and the interest expense remains high, not a pretty picture. 




Having said this, leveraging is not all bad.  Credit is said to be the lifeblood of businesses.  Few businesses in this world operate with zero leveraging.  

As long as it is kept at a level that is manageable, a level that will not threaten the viability of the company in the worst case scenario, it is acceptable.  This is what is called stress testing.

The next part of the Income Statement would be the taxes paid.  

Once this is taken out, we have the net earnings of the company.




I hope you have found this post to be informative and I will blog about the Balance Sheet and Cash Flow Statement in upcoming posts.

Related posts:
Identifying trends and value: FA and TA
Determining the impact of news on specific companies.
Monitoring our stocks.

Gong Xi Ni Fa Cai!

With the Chinese New Year just two days away, I would like to extend my heartiest GONG XI FA CAI to all visitors to my blog.  May the new year bring you the best of luck and may all of us HUAT big time.  HUAT AH!!!





For my sister who wants to go see the Sakura flowers in Japan!




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