A cash flow statement is one of the key documents an investor should look at when considering investing in company shares. The cash flow statement shows us the cash flowing in and out of the company over a specific period, usually a fiscal quarter or year. And this detail gives us insight into how the company generates cash and how well it manages it.
Armed with this data, an investor can confidently decide if the company looks like a good investment or not.
Here are some positive and negative indicators to keep an eye out for when studying a company's cash flow statement:
Operating Cash Flow
Operating cash flow is the cash a company generates from its core business operations. It shows us how liquid the company is in the short term.
Operating Cash Flow = Cash from Sales – Cash Spent on Operating Expenses
Strong operating cash flow indicates a healthy company because it suggests the company generates a decent amount of cash from its primary line of business.
Free Cash Flow
Free cash flow is another critical metric as it tells us how much cash the company retains after accounting for capital expenditures. Persistent and robust free cash flow tells us the company has the freedom and flexibility to invest in its growth and ongoing success.
Free Cash Flow per Share
Free Cash Flow per Share tells us how well a company converts its profits into free cash flow.
Free Cash Flow per Share = Free Cash Flow / Weighted Number of Shares in Issue
Investors want to see FCFPS relatively close to EPS repeatedly over several years. The two numbers will rarely be identical, but if FCFPS is persistently lower than EPS, it can be a warning sign that something is wrong. However, if FCFPS is higher than EPS, it can be an encouraging sign.
Increases In Cash and Cash Equivalents
When a company’s pile of cash and cash equivalents is rising, it is a positive sign that the business is thriving and making more money than it needs to spend.
Decreases In Debt
Debt can burden a company, particularly when operating in a challenging economy. When a company reduces its debt, this is good for the business and an encouraging sign for shareholders.
Less debt equates to more freedom and financial flexibility. It also makes it a more attractive business as it carries less financial risk.
Negative Operating Cash Flow
If a company generates negative operating cash flow, it generally means it is spending more than it earns. This is a red flag, and although it may be a temporary problem, it is worth paying close attention to.
Negative Free Cash Flow
Negative free cash flow is also a warning sign. For if a company spends more than it brings in, then progress is unlikely.
Negative free cash flow could also be a temporary problem caused by one-off costs, but it is worth watching as investors want to see the potential for long-term growth.
Decreases In Cash and Cash Equivalents
When a company is depleting its cash and cash equivalent reserves, it sends a warning sign that the business could be in trouble and spending more money than it is generating.
Increases In Debt
Rising debt is rarely a good thing. It can indicate a large acquisition, but it ultimately means the company is borrowing money to fund its operations or growth initiatives. This can be a red flag for potential investors as it may indicate that the company is not generating enough cash to support its growth and is taking on additional financial risk.
Cash flow statements provide essential information about a company's financial health and ability to generate and manage cash. In addition to the positive and negative indicators mentioned above, there are a few other vital things to look for when analyzing a company's cash flow statement.
Net Cash Flow from Investing Activities
Net investing cash flow includes the money a company has made or lost from its investing activities, such as buying and selling assets (property, plant, or equipment).
This metric can be good or bad, depending on the activity. If the company is generating a lot of cash from its investing activities, it could be selling off assets out of desperation for cash. Alternatively, it could be making smart business decisions and growing its business strategically.
Net Cash Flow from Financing Activities
Net financing cash flow includes the money a company has generated or lost from borrowing or repaying debt, issuing and buying back stock, or paying dividends.
When net financing cash flow is high, it could tell us that this company relies heavily on equity financing or debt to fund its growth trajectory.
This may be a warning sign to potential investors as it suggests that the company may not have sufficient cash flow from its main business activities to support expansion.
Changes in Working Capital
Working capital is the amount of money a company needs to carry out its day-to-day activities. A smaller working capital figure is generally better as it tends to mean the company is generating sustainable cash flow and displaying financial strength.
Therefore, changes in working capital reflect the difference between a company's current assets and its current liabilities.
A company consistently improving its working capital requirements may be carefully managing its short-term financial obligations. Consequently, it could be in a strong position to meet its ongoing operating expenses.
Alternatively, a company regularly generating negative changes in working capital may struggle to manage its short-term financial obligations and be at risk of financial pain.
In summary, analyzing a company's cash flow statement can provide valuable insight into its financial health and ability to generate and manage cash. By looking for positive and negative indicators, such as operating and free cash flow, changes in debt and cash and cash equivalents, and net cash flow from financing and investing activities, you can better understand a company's financial strength and its potential as an investment.
It's important to note that no single financial metric can provide a complete picture of a company's financial health and investment potential. Before coming to conclusions, we should consult multiple sources, including a company's cash flow statement, balance sheet, income statement, and broader economic and industry conditions.
As always, it's important to consider the company's overall financial health and do your due diligence before making investment decisions.