In this lesson, we're going to go over cash flows. First we'll examine the structure of the cash flow statement, and then we're going to learn how to interpret it. The cash flow statement can tell us a lot about where a company is in its life cycle and help us understand the company’s priorities.
So the structure, first of all…
Structure
Cash flow statements are organized into three parts. What you see here is a classic format for a cash flow statement, breaking down cash flows into operating activities section, investing activities section, and financing activities. Within each section we can see the organization’s sources and uses of cash.
Operating activities, naturally, have to do with the day-to-day operations of the company. Investing activities have to do with what the company does with respect to its assets. It's not about people investing in this company, it's about this company investing in assets — or de-investing (disinvesting, divesting - lots of synonyms for this), because you would have positive cash flows if the company sold some of its assets. And finally you've got the financing activities, which is everything to do with borrowing money and issuing shares.
The basic format of the cash flow statement is to show cash coming into the company as a positive number, and cash going out as a negative number. That's what you're seeing here.
Note that the opening balance line, “Cash and cash equivalents, beginning of the year,” is sometimes shown down near the bottom, in a subtotal section. If that was the case here, the statement would start with the operating activities, then show the investing activities, then the financing activities, and would have a little section of calculations at the bottom, with a line for the net cash provided by the three main sections, then the cash balance from the beginning of the year, and finally a total of those two lines giving us the cash balance at the end of the year. So that first line, Cash and cash equivalents at the beginning of the year, could be at the top of the report or down towards the bottom.
The cash flow statement is basically rearranging everything that's on the other two statements we’ve talked about, the balance sheet and the income statement. The operating activities section is where you take the income statement and, with some adjustments, convert the accrual numbers from the income statement into cash numbers. This is done by reversing from the net income calculation all the transactions that didn’t involve cash, such as sales on account or amortization expenses. The other thing that's done in the operating activities section is to add or subtract the effect on cash of any changes in current assets or currently liabilities. That’s because those assets and liabilities are generally considered to be operating assets and liabilities. In fact, the current assets and current liabilities are often referred to collectively as “working capital.” They are separate from the long-term investments and long-term financing structures of the company.
The investing section is pretty much a restatement of the fixed assets section of the balance sheet, showing the cash implications of any changes that occurred there between last year and this year. Of course, you'd expect to fixed assets to go down in value from one year to the next just because of amortization and depreciation, but those aren't cash events. They are accruals. The investing activities section of the cash flow statement shows the decrease (or increase) in cash, as the company uses cash to purchase assets (or generates cash by selling assets).
The financing section is where you have all the changes to do with long-term liabilities and equity. We're talking here about borrowing from the bank for long-term debt, repaying the loan, issuing shares, or repurchasing shares. Paying dividends to shareholders also appears in this section, because that's considered a financing cash flow.
Paying interest on a loan could appear here, too, but most companies using IFRS — and all companies using US GAAP — put interest payments in the operating activities section. Presumably this is to show that the company’s operations can service the debt. I’d rather they put interest payments in the financing activities section (unless the company is a financial institution like a bank, where making loans is very clearly part of the company’s day-to-day operations), because in my mind interest payments fit nicely with loan advances and repayments. Sadly, my opinion is ignored by most corporations and accountants.
At any rate, for companies outside the finance industry, the only thing related to debt that is shown in the financing activities section is changes in principal, either from a loan being issued to the company or the loan principal being repaid to the lender.
So, that's how the balance sheet and the income statement relate to the cash flow statement. Let's take a closer look at cash from operations, or the operating activities section, as it's also called.
Operating Activities
There are two kinds of approaches to disclosing operating cash flows, and they're quite distinct, even though they end up with exactly the same number. These approaches are the indirect method and the direct method. The indirect method is the most popular.
Indirect Method
The indirect method is an attempt to help people understand the difference between the accrual income stated on the income statement and the cash transactions that arose from operating activities. As discussed above, the indirect method starts with net income and then adjusts it to cancel out any pure accrual entries that were made onto the income statement.
So, depreciation or amortization of fixed assets, for instance: that was a deduction from net income, but it had to do nothing with cash. If you add those back, then you're basically moving from the net income number closer to the cash flows from operations.
Same thing if the company disposed of any assets and recorded a gain or a loss. The gain or loss is an accrual number, just like amortization expense, so you want to undo it to move from net income towards cash from operations.
The next thing you need to deal with is any change in the non-cash working capital. Non-cash working capital is all the current assets and current liabilities other than the “cash and cash equivalents” asset. You ignore changes in cash in this section, even though it is a current asset, because the change in cash exactly what the cash flow statement is trying to explain.
So all we're trying to do here is show how the changes in accounts receivable, inventory, prepaid expenses, those kinds of assets, and the changes in current liabilities like accounts payable, affected the company’s cash balance
The thing to look at is the changes in these numbers from one year to the next. You can often calculate the effect of these changes on cash yourself. Just keep in mind that if accounts receivable was high last year and has gone down this year, it means the company must have collected money from its customers. That would show up as a positive number on the cash flow statement, labelled as a change in accounts receivable.
Think about inventory. If inventory was low last year and is higher this year, that would indicate that the company must have used money to purchase more inventory. Same with prepaid expenses. If they've gone up, the company has used money.
Conversely, if inventory or prepaid expenses went down, we should think of that as a source of cash, just like accounts receivable going down. The reduction in inventory tells us that part of the cost of goods sold was not a cash expense. A reduction in prepaid insurance tells us that part of the insurance expense (or maybe all of it) was not a cash expense. Net income included all those expenses, overstating the use of cash for operating activities, but adjusting for the change in inventory or prepaid expenses cancels the non-cash portion of the expense out, so that our cash from operations calculation will be correct.
Now consider current liabilities. They are the mirror image of current assets, in terms of their effect on cash. With accounts payable, for instance, if that goes down from one year to the next, it means that the company paid its supplier. That would be a use of cash, and you'd expect to see a negative number on the cash flow statement to indicate that.
Let’s look more closely at the example of the indirect method we saw earlier:
It starts with the net income number up at the top, and you can see that in the previous year, it was a negative number. They lost money. This year, however, it's a positive net income. So last year's net loss of $5,157 — this is in thousands, so $5,157,000 — got turned around this year, into a net income, a positive number, of $894,000. Working from this line, then what you need to do is adjust each column for the non-cash items that went into that net income or loss. So, you see that amortization, interest accrual, gain on sale of property, future income taxes, stock based compensation, lease inducements — all of these things are expenses or gains on the income statement that didn't actually involve cash. Each of those parts of the net income calculation has to be reversed in order to help convert the net income number to cash from operations.
The last line that you see here is summary line, the “net change in non-cash working capital components from operations.” Each item from working capital (that is, current assets and current liabilities), except for the cash itself, is evaluated to see if it changed during the year. Companies often list each element of non-cash working capital, line by line, to show the change in each one, but lots of companies summarize all of that onto a single line on the cash flow statement, while providing the details in the notes to the financial statements. So in this case, you would want to turn to those notes and look to see where the two numbers on the cash flow statement came from.
We’ll skip over that for now and just say that the overall change in non-cash working capital for this company was positive in both years. That means they were drawing money out of their working capital. Whether the numbers were positive or negative, you want to ask why this overall change was happening. If you see that the number is negative, one hypothesis would be that they purchased a lot of inventory during the year. You could confirm that by looking at the notes, and if that was the case, you ask yourself why they needed to build up inventory? Would it be for an expansion into a new geographic area or a new line of products, or might it be because customers stopped buying their goods and they were left with a lot of unsold inventory? These are examples of critical questions you can ask about the cash from operations.
Anyway, what you end up with in this section is the net cash provided by — or if it's negative, the net cash applied to — operating activities.
So this was the indirect method. Let’s look at the direct one.
Direct Method
The direct method is much easier to understand because it simply lists what were all the inflows and outflows by various categories. How much money came in from customers? How much money was paid to the suppliers that year? How much money was paid to the employees in wages and other compensation? Did the company receive interest on its investments, or perhaps pay interest on its bank loan? And what happened with regard to tax payments or refunds?
The taxes line in the direct method is especially interesting because it lets you the overall cash exchanged with the government for taxes. Lots and lots of companies have tax expenses on the income statement that are completely unrelated to the amount of cash paid to or refunded by the government. In some cases, a tax expense might be shown when the company actually got cash back from the government that year. So this is a very helpful number to look at if you're trying to understand the company's tax situation.
Here is an example of the direct method from way back in 2013, for a company called Stantec, which is an engineering and design firm:
You can see that Stantec has broken out its cash receipts and payments into categories based on who it was dealing with. You'll notice that it breaks its interest number into two separate lines, how much it received and how much it paid, rather than netting those out. That's good information.
Same thing with income tax. They've shown how much income tax came in and how much was recovered, and that can easily happen if you're operating in multiple countries. You may end up paying cash for income taxes in one country, but getting a recovery in another. Again, that’s helpful to know, so that's why they are shown on separate lines instead of being netted out.
Finance costs paid is separate from interest, so that might be fees and commissions paid in order to set up new debt financing. These are negative numbers, so that is cash flowing out of the company in order to arrange new financing. Those are listed here in the operating activities section, instead of in the financing activities section, for the same (unhelpful) reason that companies list interest payments here. They want to show that their operations are generating enough cash to cover financing costs. That’s fine, but I think I could figure that out myself if they put these in the financing activities section where I personally believe they belong.
The total at the bottom, of course, is the net cash flow from operating activities. Stantec is generating a lot of cash from its operating activities. Looks quite healthy.
Investing Activities
The investing activities section section is where you will see the purchase and sale of long-term assets. While current assets are considered part of a company’s working capital and therefore part of its operations, long-term (or “fixed”) assets are considered to be strategic investments. Examples would be factories and vehicles that are expected to last for years. If a company buys a new factory or some trucks, for instance, you'll see cash outflows here, represented by negative numbers. If they sold vehicles or other fixed assets, you'd see positive cash flows here.
A critical question that you can begin to ask about this section is one we ran into with Apple, in the first lesson: is the company investing in productive assets related to its own business, or are they just parking their excess cash by investing in financial securities while they decide what to do?
If they are investing in productive assets, another question would be whether they are investing enough? That's a qualitative question that requires some interpretation. You can't simply calculate a direct answer, although you can do calculations that help you arrive at a good interpretation. We’ll get into those in a later lesson.
Another possibility is that a company might be retiring some of its older assets. That could be a healthy strategic move by the company’s managers, part of a renewal of the company’s productive capacity, or it could be a desperation ploy to drum up some cash during a crisis. You cannot know the manager’s intentions directly, but you can sometimes infer their intentions by looking at other factors related to the financial health of the company, such as trends in its profitability. Perhaps they're selling an asset that they really don’t want to, but they have to in order to survive. (You can see this with football teams in England, for instance, when they get relegated to a lower division and have to unload good players who are on expensive contracts.)
So, these are the kinds of questions that you should be asking yourself when you look at the investing activity section of the cash flow statement.
Financing Activities
Finally, there's the financing activities. Here's where we have the borrowing and repayment of debt, the sale and repurchase of shares, and the payment of dividends. Sometimes, as mentioned, we also have interest payments on debt, but this is less common.
The cash flow statement is very helpful in regard to a company’s financing because it spells everything out quite clearly. For dividends, for instance, the information provided here is different than the dividends number stated in the “Changes in Equity” statement. (We won’t discuss that statement in detail yet. Suffice to say, it provides information on why the numbers in the equity section of the balance sheet have changed, and it is an accrual accounting statement similar to the income statement and balance sheet, not a statement of cash flows.) The statement of changes in equity tells you the value of the dividends declared by the company during the year, regardless of when the dividends were actually paid and how they were paid. The dividends number in the financing activities section, in contrast, is the actual cash paid out during the year to shareholders as dividends. A company can, obviously, declare a dividend near the end of the fiscal year but not get around to paying the shareholders until the following year. In addition, as we’ll find out later in the course, they can declare a dividend that is not paid in cash at all, it’s paid in more shares. The financing activities section of the cash flow statement helps you quantify all these matters.
So, what are some critical questions you can ask about this section? One of the things shown here is the cash flowing from and to creditors, such as banks or people who have purchased the company’s bonds. If a company is borrowing money, why do you think it is? Does it make sense for them to be borrowing money, given their strategy and their opportunities? As we saw with Apple, it was weird that they were borrowing money when they had so much cash line around, as well as so much cash coming in from its operations. Why were they borrowing?
And if they are borrowing money, is it from the bank, or is it by issuing bonds in the financial markets? Those are quite different forms of financing. They imply different reasons for borrowing and certainly very different patterns of cash flows for paying interest and repaying principal. A bank might have a lien on the company’s new equipment. The term “bond” is generic, but if you look closely, it might be a true bond secured by a collateral claim on some or all of the company’s assets, or it might be a debenture, which is an unsecured bond. These details would change your understanding of the debt structure of the company.
You'll also see positive and negative cash flows appearing simultaneously in this section because teh company may be refinancing its debt, replacing an old bank loan with a new one at a better interest rate, or paying off one series of bonds by issuing a new series. These details are certainly worth looking at to understand the financial health of the company.
If the company is paying off its debt and this is not clearly connected to new borrowing, you will want to ask where it got the money. So, you would look at the other sections of the cash flow statement. Or it may be that they have paid off their debt by issuing more shares, which would be shown right in this section of the cash flow statement. If the company is issuing new shares in order to pay off debts, you should be able to tell this by looking at the quantity of money raised by the share issue. Is this a substantial amount of capital from new shares issued to the stock market, or is it just a small amount that is more likely related to compensation paid to executives under their employment contracts? These details will not be spelled out in the cash flow statement, but the amounts will be a clue, and you can investigate further by looking at the notes to the financial statements, the MD&A section of the annual report, and the proxy circular.
And if the company is buying back shares rather than issuing new ones, why are they doing that? Who benefits from the fact that they're buying back shares? Is this an effort to consolidate the power of the company’s own managers, who are often major shareholders. And whose money is it that they're using to buy back the shares? What is the impact on the remaining shareholders after the share buyback? Do they own more of the company, and is that something that they're happy with? Is this part of strategy to consolidate senior management’s power? All these questions are interesting.
If the company is paying dividends, you will want to ask if it can afford to. It may be that it's trying to pay dividends that it previously committed to, even though it might be currently be in financial straits. Company’s don’t like to cancel dividend payments because it's politically costly, in terms of shareholder voting at the annual general meeting, and it’s financially costly in terms of the company’s share price. Again, this is another critical question worth asking.
Now let's look at how one goes about interpreting the cash flow statement as a whole.
Interpretation
We've already asked a lot of critical questions about specific elements of the cash flow statement. Now I want to give you a tool for looking at the overall patterns of the cash flow statement, to help you get at some of the implied meanings the cash flow statement can offer.
Critical questions always have to be asked about the cash flow statement. When you're looking at the overall patterns here, you want to think about the business model of the company — in other words, how does it make money and where is it in terms of its life cycle? Is the business is generating enough cash to meet it's operational requirements? If it's got opportunities to expand, does it have enough cash to do so? Is it able to cover short-term debts? Is it paying off its long-term debt on schedule or is it making huge repayments to retire its debt early? And if so, why? Is it paying dividends or conserving cash to reinvest in the company?
One critical question to ask is whether managers have unduly influenced the timing of the cash flows? Because that would be something that they would have significant control over, and you want to ask, not just what the cash flows are, but why those cash flows are happening in this fiscal year rather than some previous or later year? And that will relate to the company’s financing opportunities, to strategic questions, political questions, and so forth. Timing questions are always worth asking.
It is crucial to at least attempt to link all of these questions back to the company’s strategy. And for that, you need to really understand the company. As with all financial statement interpretation, you really have to understand what the company is and what it's trying to do, otherwise your interpretations will be superficial and generic, at best.
All right, so here’s the tool I was talking about:
This little table lists all the possible patterns of interaction amongst the three sections of the cash flow statement, and it comes from a wonderful article by Dugan, Gup & Samson, published in 1991 in the Journal of Accounting Education. (Incredibly, this article has only been cited 17 times, which perhaps explains why accounting academics don’t publish as much as they could on teaching-related topics.) It’s a really interesting article for instructors on how to teach the cash flow statement, and I'm going to use it here pretty much as the authors laid things out in their article.
The basic idea here is that with three different sections of the cash flow statement, you have eight possible combinations of positive and negative cash flows. These patterns are numbered across the top of the table so that we can refer to them. The authors, Dugan et al., quite reasonably ignore all potential combinations where net cash flows in any given section are neutral or miniscule, as those are less interesting.
The key contribution from Dugan et al. is that they suggest possible hypotheses for what might be creating any given pattern of cash flows. This is a crucial thing to keep in mind when interpreting financial statements: you are not looking for definitive answers so much as you are looking for good questions to ask. Financial statement analysis is very much about developing useful hypotheses and then going to look for evidence to prove or disprove each hypothesis. You might find the answers in another financial statement or the notes to the financial statements, or somewhere else in the company’s annual report. You may well need to read news reports on the company’s activities or plans, or look at economic data relevant to the industry the company is in. But here, thanks to Dugan et al., we have a great starting point for our investigations: the broad-brushstroke patterns that you might observe on any given cash flow statement, along with tentative suggestions for what that pattern might tell us about a company.
Pattern 1
Let's look at the first pattern, then. It’s the one where you have positive cash flows in every section. This means that the operating section is generating good cash flows. The company is also producing cash by selling off some of their assets -- and you'd want to ask what kind of assets they're selling -- while also producing cash through financing, either by borrowing or by issuing new shares.
So what might be happening here? Dugan et al. suggest that the company is highly liquid, it's generating lots of cash and is possibly trying to loosen up even more cash, perhaps in order to make an acquisition in the future. Now, this isn't the only possible explanation, but it's a really interesting one, right? Otherwise, why would the company be selling off assets and borrowing money from financing or issuing shares at a time when its operations are already healthy? Could be that it’s got a really great opportunity in the near future that it needs lots of money to pursue.
Pattern 2
The second pattern is where you've got positive cash flows from operations, but negative cash flows in the investing and financing activities.
The company is generating strong cash from operations and it's using that cash to invest in new assets. At the same time, they are either paying off debts, repurchasing shares, or paying large dividends to the owners. So that's a pretty healthy situation for a company to be in, generally speaking.
Pattern 3
If you got positive cash from operating and investing activities, and negative cash flows related to financing, it could be that the owners are deliberately drawing money out of the company. Perhaps they're being paid dividends in order to use the cash for other purposes, unrelated to this company.
It's a curious sort of pattern. The company is generating healthy cash flows from operations. It’s also selling off some assets and either repaying money to the bank or the debt markets, or giving it to the shareholders. You would need to look a little more closely at the financing section to understand which of those was happening, but one possible explanation is that the company is winding down.
Pattern 4
The fourth pattern has positive cash flows from operations, positive cash flows from financing, but negative cash flows in investing. The company is healthy enough, because it is generating operating cash flows, but it's also raising cash through financing, by issuing debt or shares, in order to fund its investment in new assets.
So the question is, is this an expansion for the company, or or are they just replacing some of their obsolete equipment?
Pattern 5
Fifth scenario: negative cash flow from operations, but positive cash flows from investing and financing. The company could be trying to cope with its operating cash flow problems by selling off its assets and borrowing from the bank. That would be a potential warning sign. This does not mean that all companies with this pattern are in trouble. They might be repositioning themselves to move in lucrative new directions but are not yet ready to make the required investments in new assets. A pattern like this is very much something to look into further.
Pattern 6
The sixth pattern is a situation where you've got negative cash flows from operations, negative cash flows for investing, and positive cash flows from financing. A classic example of this pattern would be a company that is just starting up.
A start-up is typically raising capital and investing in new assets, but its operations are not yet generating positive cash flows. The company is probably not yet profitable, either, but expectations must be high if it is successfully raising capital by issuing shares or debt instruments.
Pattern 7
The seventh pattern suggests the opposite situation: you see negative cash flows from operations, but it's not because the company is new, it's because the company is old. It could be winding down their operations. The fact that the positive cash flows come from investing activities rather than financing activities, as we saw in the previous pattern, suggest that the company may be selling off its assets and returning capital to shareholders or creditors. Imagine it's a mining company and its mine has been depleted. The operations are no longer generating cash and the mining equipment is being retired. The company is selling off its assets and going out of business. Other explanations are possible, of course, but this is a standard pattern for companies that have done what they were intended to do and the work is now finished.
Pattern 8
Finally, negative cash flows in every section of the cash flow statement. Not a sustainable situation, obviously. Cash is leaving the company everywhere. The company could be using its cash reserves to cover operational shortfalls, pay off debt, and so forth, but at the same time, it is buying new assets. This is not necessarily a crisis. It could be that a change in strategy is driving this pattern, as the company repositions itself to move in new directions.
At any rate, those are all the patterns. Other explanations for each pattern are possible, but this shows you the potential of the cash flow statement to reveal things about the company, or at least to suggest avenues for further research.
Summary
Let's sum up what we've learned about the cash flow statement. We have covered the structure of the cash flow statement, looking at the direct and indirect methods of the operating cash flow section. We've looked at the investing and financing sections as well. And then we've walked through a series of patterns of cash flows that suggest critical questions about a company and help us interpret its cash flow statement.
I would argue that the cash flow statement is not very helpful on its own because, by excluding amortization and depreciation expenses, it ignores the history of investments that enabled the company to be in a position to generate cash flows. However, I hope you will agree that the cash flow statement explains details about the company than cannot be found anywhere else, and that it is a very good source of critical questions that can help us understand the company better.
Title photo: some serious flow at Niagara Falls