Importance of Cash Flow Statements in Stock Picking

“Revenue is vanity, profit is sanity, but cash is king”. This common consensus was used by former Volvo CEO Pehr Gyllenhammar in 1988 while discussing the global stock market crash of 1987. During that time, companies with ample cash reserves weathered the markets better than those who had poor cash management. When evaluating stocks, we can employ a number of relevant metrics. However, one of the most effective measures is also one of the most frequently overlooked. Cash flow statement is an excellent indicator of a company’s financial health. Since it is the ultimate measure of how the business is doing, cash flow statement is an important indicator for investors when determining whether the company is making or losing money.

The cash flow statement summarises a company’s cash receipts and cash payments over an accounting period. The cash-based information provided by the cash flow statement contrasts with the income statement’s accrual-based information. The income statement, for example, reflects revenues when they are earned rather than when they are collected. In contrast, the cash flow statement reflects cash receipts when they are collected rather than when the revenue was earned. A reconciliation of reported income and cash flows from operating activities provides useful information about when, whether and how a company generates cash from its operations. 

Although income is an important indicator of a company’s performance, cash flow is also critical. As an extreme example, a hypothetical company that makes all sales on account, regardless of whether it will ever collect its accounts receivable, would report healthy sales and possibly significant income on its income statement but with no cash inflow, the company would not survive. The cash flow statement also provides a reconciliation of the balance-sheet’s beginning and ending cash. There are three statements that make up the cash flow statement. 

The first is the cash flow from operating activities (CFO) which represents cash flows related to the operating activities of the business. Second is the cash flow from investing activities (CFI) which represents cash flows related to the investing activities of the business. These represent the company’s purchases and sales of assets. And the third is the cash flow from financing activities (CFF) which concentrates on a company’s cash inflows and cash outflows as a result of borrowing and repaying money. These statements allow us to determine whether the company generates enough cash from operating activities to cover the new investments it is making.

They also indicate if the company must issue additional debt to finance them. Further, they allow us to determine whether the company pays its dividends to its shareholders using cash from operations, the sale of assets or the issuance of additional debt. As a result, it tells us whether the company has enough cash to support itself over the long term through its operating activities, independent of the need to sell assets or pay off debt. We can assess the company’s liquidity, solvency and financial flexibility with the use of information regarding the sources and uses of cash. In short, the cash flow of a company indicates its health – whether it has the potential to carry on with its business in the long term.

Cash Flow and Company Quality
A cash flow statement is an important financial reporting document because it tells the reader how much cash the company generates in a given time period. When cash inflows exceed cash outflows, it indicates good financial health. This is referred to as positive cash flow. It is important to note that this statement excludes any income in the form of future receivables as well as any expenses owed by the company. Operating cash flows are the foundation of a company’s cash flow statement because they originate from the company’s main line of activity. Businesses that continuously generate large operating cash flows are strong and self-sufficient. Businesses must continually invest in prospects for strategic growth.

In addition, they must pay back their debt and distribute dividends to shareholders. As a result, their cash flows for investing and financing are often negative. Negative investing cash flows show that the business is growing or upgrading its outdated assets. Examine whether these investments can lead to future revenue development by trying to determine their purpose. Positive financing cash flows frequently follow negative investing cash flows. This is so that businesses can fund their investments by raising more loans or equity financing. However, over the long run, a company’s core operations should generate enough income to pay for its strategic expenditures and fulfil its debts to shareholders and lenders.

In other words, over the long term, investing and financing outflows should be about equivalent to operating cash flows. This is a crucial test of a business’s financial stability. Consistently low or negative operating cash flows and positive investing cash flows indicate that the business is selling assets to support its operations. These can indicate a failing business that’s even close to filing for bankruptcy. Even when operating cash flows are sluggish, firms will occasionally sell off assets to keep dividend amounts the same. Since investors view a dividend drop as an indication of weak financial health, they prefer not to reduce dividends. 

In this case, the company will have low or negative operating cash flows, positive investing cash flows and negative financing cash flows. Look at the items the business is selling. It is okay to sell assets that are not core to the business and are an unnecessary financial burden. However, if the corporation is selling important assets, you should be worried. Low or negative operating cash flows and consistent positive financing cash flows point to an inefficient capital allocation by the organisation. This is an indication of poor management and ineffective operations. The table provides examples of companies with great operating cash flow:

Conclusion
Thus, with this article, we can perceive cash flow statements as one the most important statements for stock picking as we get a valuable measure of strength, profitability and the long-term future outlook of a company. By studying cash flow statements, an investor can gain a clear picture of how much cash a company generates and gain a solid understanding of the financial well-being of the company. There are several methods used to analyse a company’s cash flow, including the debt service coverage ratio, free cash flow and unlevered cash flow.

However, the cash flow does not necessarily show all the company’s expenses. That’s because not all expenses the company accrues are paid right away. Although the company may incur liabilities, any payments toward these liabilities are not recorded as a cash outflow until the transaction occurs.