The analysis of a company’s cash flows can provide useful information for understanding a company’s business earnings and for predicting its future cash flows. There are various tools and techniques for analyzing the statement of cash flows, including the analysis of major sources and uses of cash, cash flow, common size analysis, conversion of the cash flow statement from the indirect method to the direct method and computation of free cash flow and cash flow ratios.
Evaluation of the sources and uses of Cash:
Evaluation of cash flow statement should involve an overall assessment of the sources and uses of cash between the three main categories as well as an assessment of the main drivers of cash flow within each category.
- Evaluate where the major sources and uses of cash flow are between operating, investing and financing activities.
- Evaluate the primary determinants of operating cash flow.
- Evaluate the primary determinants of investing cash flow.
- Evaluate the primary determinants of financing cash flow.
Step 1: The major sources of cash for a company can vary with its stage of growth. For a mature company, it is desirable to have the primary source of cash be operating activities. Over the long term, a company must generate the cash from its operating activities. If operating cash flow were consistently negative, a company would need to borrow money or issue stock (financing activities) to fund the shortfall. Eventually, these providers of capital need to be repaid from operations or they will no longer be willing to provide capital. Cash generated from operating activities can either be used in investing or financing activities. If the company has good opportunities to grow the business or other investment opportunities, it is desirable to use the cash in investing activities.
Step 2: Turning to the operating section, the analysts should examine the most significant determinants of operating cash flow. Some companies need to raise cash for use in operations (to hold receivables, inventory, etc) while occasionally a company’s business model generates cash flow (eg. When cash is received from customers before it needs to be paid out to suppliers). Under the direct method, the increases and decreases in receivables, inventory and payables and so on can be examined to determine whether the company is using or generating cash in operations and why. It is also useful to compare operating cash flow with net income. For a mature company, because net income includes noncash expenses (depreciation and amortization), it is desirable that operating cash flow exceeds net income.
Step 3: Within the investing section, one should evaluate each line item. Each line item represents either a source of use of cash. This enables us to understand where the cash is being spent (or received). This will also tell us how much cash is being invested for the future in property, plant and equipment. How much is used to acquire entire companies and how much cash is being raised by selling these types of assets. If the company is making major capital investments, you should consider where the cash is coming from to cover these investments (eg in the cash coming form excess operating cash flows or from the financing activities).
Step 4: Within the financing area, we should examine each line item to understand whether the company is raising capital or repaying capital and what the nature of its capital sources are. If the company is borrowing each year, you should consider when repayment may be required.
Common-Size Analysis of the statement of Cash Flows:
In common-size analysis of a company’s income statement, each income and expense line item is expressed as a percentage of net revenues (net sales). For the common-size balance sheet, each asset, liability and equity line item is expressed as a percentage of total assets. For the common-size cash flow statement, there are two alternative approaches. The first approach is to express each line item of cash and second approach is to express each line item as a percentage of net revenue.
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