Diversity Investment Group Cash Flow for Beginners

BetterInvesting Magazine, July, 2006

by Bart Womack

Editor's note: Many investors believe cash flow is an important measure of a company's financial health. The following article by Bart Womack, a college instructor for 14 years in finance and economics, summarizes comments he'll make as part of a seminar on this topic at CompuFest 2006. An assistant director of the BetterInvesting Computer Group, Bart is the treasurer of an investment club and has been the president of two clubs. Chris Collins, a former Computer Group director, helped Bart develop the ideas behind the cash flow seminar.

Cash flow describes the movement of money into and out of a business. The statement of cash flow shows the liquidity of the company -- in other words, the ability of the company to pay its bills for a particular period. Many analysts consider cash flow as or more important than earnings in determining a company's health. Investors use the cash flow statement to test a company's suitability for investment.

We'll use the income statement and balance sheet to construct the cash flow statement, so we need to look at them first. Then we'll discuss the cash flow statement and possible red flags on it.

This article uses the financial information for a hypothetical company during its first week of operation. A table below shows all the transactions generated by the company during that week. It also identifies where those transactions appear on the various reports.

Activity in the First Week of Operation.

Income Statement

The income statement is a record of a company's earnings or losses during a given period. It includes any expenses or revenues generated by the company, covers a specific period (such as a quarter or a year) and shows the company's net income. The income statement has two key numbers:

• net income: revenues minus all expenses including income taxes
• earnings (or net income) per share: net income divided by the number of shares outstanding

For a more detailed introduction to the income statement, see Ann Cuneaz's article in the May issue of BetterInvesting.

The income statement for our hypothetical company on page 36 shows details for each day of the first week of operation. As of the end of the second Monday, the company has earned a profit of $700.

Balance Sheet

The balance sheet contains information about what the company owns (the company's assets), what it owes (its liabilities) and what the company is worth (stockholders' or shareholders' equity). It doesn't include information about expenses or revenues.

On a balance sheet, assets must equal the sum of liabilities plus shareholders' equity. The key numbers on the balance sheet are:

• assets: anything of value the company owns
• liabilities: the company's debts
• shareholders' equity: the company's ownership value

At the end of the second Monday, the company has assets of $6,200 consisting of cash, accounts receivable and long-term assets. The owners' equity has increased from $5,000 (the initial investment in the company) to $5,700 (see table, above).

Cash Flow Statement

The cash flow statement details the flow of money (cash) into and out of the company. It shows how the company generated cash and how the company used it during a specified period.

The cash flow statement has become important in recent years because it directly shows the company's liquidity. In other words, it focuses attention on the ability of the company to pay its bills. In recent years a number of profitable companies have failed because of their inability to pay bills.

Many analysts now consider cash flow as or even more important than earnings in determining a company's health. For example, Value Line reports include a "cash flow" line in the price chart. Value Line also highlights cash flow in two other areas of its reports. It shows cash flow per share in the main data table and provides the actual and projected growth rates of cash flow. To understand how the cash flow statement works, we need to look at how it's different from the income statement.

The income statement often makes use of "accrual" accounting. Accrual accounting can often make a company look healthier than it actually is. Accrual accounting recognizes revenues when earned and not necessarily when received (called the matching principle). This can occur for sales made on credit (shown as accounts receivable).

In accrual accounting, revenues increase on the income statement when the sale is made, whether or not cash is actually received; the idea is to record revenue earned during that period. Since the earned revenues aren't received as cash, however, the company may not have the ability to pay its bills. The cash flow statement makes this explicit.

Accrual accounting also recognizes expenses when they're incurred and not necessarily when they're paid (the matching principle again). This can occur when a company pays for an expense over time.

As a result, when an expense occurs, expenses increase on the income statement whether or not the company actually paid out cash. This can mask the future need for cash. Again, the cash flow statement identifies this.

The cash flow statement really becomes a "cash accounting" statement. Cash accounting adjusts accounts only when cash comes into or goes out of the company.

Construction of the cash flow statement from the income statement and the balance sheet isn't always simple. In many cases making the adjustments requires solid knowledge of accounting. The adjustments aren't always intuitive.

The good news is that investors don't need to know exactly how to construct the cash flow statement, or how to make the adjustments, to use it effectively. But investors do need to understand the three major components of the cash flow statement and how to interpret increases or decreases of cash in each area.

The three major areas of the cash flow statement are:

• operating activities
• investing activities
• financing activities

In this example, the company completely expended the initial investment of $5,000 at the end of the second Monday (see table, above). It generated $300 in additional cash as part of its first sale.

(Note that the company stands to generate an additional $2,900 in the future. Collecting that debt and converting it into cash is critical to the company's success.)

Operating Activities

This section is generally the most important part of the cash flow statement for investors. The operating section shows cash generated from the business's focus: its operations. After all, this is why the company exists. Operating activities lead to the determination of net income, and it's the operating activities that generate cash on a continuing basis.

The operating section of the cash flow statement reconciles net income to a cash basis; this is the most complicated part of developing the statement. This is done by comparing certain of the balance sheet accounts and adjusting the net income by the differences.

If a company is doing well, the operating section of the cash flow statement should show positive changes. A substantial decrease in cash flow from operations is often a sign of fundamental problems.

Investing Activities

The investing section deals with acquiring or disposing of long-term assets. This usually includes acquiring or selling property, plants and equipment. It can also include securities held for long-term investment, such as the stocks and bonds of other companies.

A company typically must use its cash to purchase property, plants and equipment if it's to grow. As a result, a decrease in cash flow from investing activity is often expected.

Financing Activities

This refers to activities the company undertakes to borrow and repay money, as well as to transactions with the company's owners (stockholders). Selling and repurchasing company stock, as well as issuing or re-paying bonds, falls into this category.

Generally, we prefer that a company not increase its cash largely from this source. Financing should certainly not be the major source of cash for any company except during the start-up period.

Red Flags

As you examine financial statements, you should be looking for red flags -- conditions that indicate the company might not be healthy.

• Accounts receivable, inventory and cost of goods sold should increase at roughly the same rate as sales. Look for significant differences. Cash flow analysis can often reveal these kinds of problems.
• Look for cash flow growth from operations that doesn't jibe with growth in earnings per share.
• Check whether the company needs to increase long-term debt significantly to meet cash obligations.

If you have questions or comments, write to: DIGnet@mindspring.com.

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07/01/2006