Understanding a company’s cash flow statement is a key element to understanding the potential risk the company poses as an investment. When analyzing the cash flow statement, look beyond simple positive and negative figures. Take the time to understand where the money is going and why it is going there. Do this and you will gain a greater understanding of the cash flow statement as a whole.
Know What You’re Looking At
The first thing you must know when looking at a cash flow statement is the reason behind it. Cash and cash equivalents are the first items listed under a company’s assets on its balance sheet. While the balance sheet tells the analyst how much cash the company has on hand, the cash flow statement shows how that money flows in and out of the company. It also serves as a tool for the company’s accountant to reconcile the balance sheet activity from the last reporting period.
Know the Breakdown
The cash flow statement is broken down into three sections. The first is cash flow from operating activities. Operating activities describe the money a business uses in its day-to-day operations. Investing activities detail the cash disbursed and received from various investments the company makes, both internal and external. Financing activities show the cash flow related to the purchase and payment of assets.
Know Your Ratios
While the numbers on the cash flow statement are apparent, knowing how these figures interrelate is crucial to understanding the cash flow statement. Net cash flow is the end result of each of the activities. For example, net cash flow from operating activities is the cash the company has at the end of the period. Free cash flow, the cash the company has available to invest or repay financing, is derived by adding net cash from operations to depreciation less capital expenditures. Calculate your dividend payout ratio, the amount of free cash flow distributed to shareholders, by dividing free cash flow by dividends paid. Calculate your free cash flow margin, the amount per dollar that is converted to free cash, by dividing free cash flow by revenues. Determine the free cash to earnings ratio by dividing free cash flow by net income. This represents the percentage of free cash derived from net income.
Know How to Interpret the Data
Knowing the ratios is only part of the equation. You must know what numbers indicate a strong company and what numbers portray a risky one. If the free cash flow is less than half of the net cash from operations, the company may be in financial trouble. If the dividend payout ratio is over 70 percent, the payouts are too high. The free cash flow margin, on the other hand, should be high. Over 20 percent is considered excellent. Another key to understanding cash flow statements is that you can’t just look at one year and get a picture. If a company utilizes its cash position to increase investments one year, it may show low cash flow, even though its assets are increasing. Two to three years' worth of statements will be necessary to look for trends and red flags.
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