Deciphering financial statements for non-financial professionals - Part 3

August 12, 2014

Revealing cash's kingdom

This third post in my Deciphering Financial Statements for Non-financial Professionals series addresses how you, as a financial statement reader, can use the statement of cash flow to understand a company's operations and general financial health. In this series of posts, I'll provide insight into financial reporting and related topics geared toward non-financial professionals who need to understand financial statements as part of their professional roles. I encourage you to also read the other installments in the series, past and future, particularly the introduction published on July 25, 2014 as that post sets the scene for the series and includes a number of resources you may find useful as you go along.

Some may find it useful to have a statement of cash flow available while reading this post, which can be found at page 6 of the sample financial statement available at this link.

Whoa! Shouldn't we be discussing the balance sheet first?

You may be wondering why I chose to discuss the statement of cash flow before the statements of financial position and operations, given that they typically precede the statement of cash flow in a typical set of financial statements. Personally, I feel that the statement of cash flow is the most valuable of the statements in terms of providing the user with an understanding of the current operations of the company. It strips away all of the non-cash accounting transactions to reveal the actual cash operations of the business. A peek under the hood, if you will. That being the case, I thought it warranted a little extra attention.

What's in the cash flow statement?

The statement of cash flow aggregates the company's cash flow-specific data into three general categories: cash flows from operating, investing and financing activities. As a bit of an aside, there are two methods of presenting the cash flow statement – the direct method and the indirect method. Without getting into the boring details, I'll just say that they're two different roads leading to the same destination and the major components discussed in this post are pretty much the same. It is interesting that, despite the fact that virtually every credible source of accounting guidance suggests that companies should apply the direct method, most companies apply the indirect method primarily because it's the simpler of the two methods to prepare. Now on to the purposes of the three categories…

Cash flows from operating activities

The first category presented in the statement is the operating activities. These are the cash flows that the company receives and pays out in the course of its operations. Buying raw materials, selling things it's made, paying its staff, etc. A net inflow of cash in this category is generally considered to be a good thing as it demonstrates that the company is bringing in more cash than it pays out, enabling it to grow organically and maintain itself through its operations. This is assuming, of course, that the cash coming in is not a result of the company not paying its accounts as they become due which would be evident through increasing payables or other liabilities. Should there be an outflow of cash in this category, or a reduction in cash inflows compared to previous years, you'll want to dig a little to understand the reason for this trend. Is a negative cash flow due to a one-time event such as a lawsuit? Is the company having a tough year and, if so, what's the cause and management's plan to turn things around?

Cash flows from investing activities

The next category presented is the investing activities. Many commonly think that ‘investing' in this statement refers to investing in other companies, such as day trading on the stock market. However, this is not the case. ‘Investing' in this statement refers to the company investing in its own future such as purchasing, or disposing, of equipment, buildings, etc. Depending on the type of company, you'll probably want to see some regular activity in this section as it demonstrates that management is growing the company and maintaining its infrastructure to provide for future operations. If the company relies primarily on equipment of some type for its operations, low or no expenditures in this area for a prolonged period of time may spell trouble for the company's future and is something to dig deeper into to understand.

Cash flows from financing activities

The last section typically presented is the financing activities. This area summarizes the sources of financing that the company may have received, such as loans or issuance of shares for cash. You won't likely see much activity in this section in the case of a seasoned, self sufficient company unless it has big expansion plans and needs cash to fund that growth. However, this will be an area of significant activity for a start-up or exploration/development stage company that is not yet self sufficient from its own cash flows. It's often difficult to draw many conclusions on this section by comparing to prior years as a company's financing activities can change significantly from year to year depending on its need for external financing. Similar to the other sections in the cash flow statement, if you see activity in this section that you didn't expect, you'll need to dig for information to understand what's going on.

What does it all mean?

When examining the statement of cash flow and financial statements in general, it's important to avoid tunnel vision. The truly important insight you will gain is derived by understanding how the different pieces of the financial statements correlate. For example, knowing that a company had significant cash inflows from financing activities, such as issuing new common shares, doesn't in itself tell you that much. But if the cash flows from operations have been declining in the lead up to raising capital, this may indicate the new capital is to get the company through, or out of, some trouble with operations. Alternately, if cash flows from operations are very strong while capital was raised, then the company may be raising that new capital to rapidly expand its wildly successful business. These types of correlations in the financial statements are vital to evaluating a company's operations and you'll see me come back to this point repeatedly throughout this series of posts.

Non-cash transactions

A discussion of the statement of cash flow wouldn't be a complete without mention of non-cash transactions. There are a wide variety of accounting transactions that don't involve cash including amortization of assets, accretion of debt, fair value adjustments, impairment charges, share-based payments and many others. Although such transactions have less of an impact on the company's immediate financial health than those involving cash, they are nonetheless important to understand in order to get a true picture of a company's operations and to compare it to its peers. For example, a company may use share-based payments to compensate and incentivize management and employees which reduces cash costs but potentially dilutes the value per share. A company may have great earnings but perhaps a big chunk of that relates to appreciation of certain types of assets whose value may or may not be realized until future periods when the company actually sells those assets. The information revealing these facts will be in the non-cash transactions. The statement of cash flow will either contain a table summarizing non-cash transactions at the bottom of the page or, more commonly, a reference to one or more of the notes to the financial statements that contain such information. Be sure to follow these references to understand what non-cash transactions have occurred and how they impact the company's financial results.

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