💰Corporate Finance Analysis Unit 3 – Cash Flow Statement Analysis

What's the Deal with Cash Flow Statements?

• Cash flow statements provide a detailed view of a company's cash inflows and outflows over a specific period (usually a quarter or a year)
• Helps investors and analysts understand how a company generates and uses cash, which is crucial for assessing its financial health and viability
• Complements the information provided by the balance sheet and income statement, offering insights into a company's liquidity and solvency
• Consists of three main sections: operating activities, investing activities, and financing activities
  • Each section provides a breakdown of the cash flows related to specific aspects of the company's operations
• Allows stakeholders to identify potential red flags, such as consistently negative cash flows from operations or overreliance on external financing
• Enables comparisons between companies within the same industry, helping investors make informed decisions
• Provides a more accurate picture of a company's financial performance than the income statement, as it excludes non-cash items (depreciation and amortization)

Breaking Down the Cash Flow Statement

• The cash flow statement starts with net income from the income statement and adjusts for non-cash items and changes in working capital
• Non-cash items include depreciation, amortization, and stock-based compensation, which are added back to net income
• Changes in working capital (accounts receivable, inventory, and accounts payable) are accounted for to reflect the actual cash impact
• The statement is divided into three main categories: operating activities, investing activities, and financing activities
  • Each category provides a detailed breakdown of the cash inflows and outflows related to specific aspects of the company's operations
• The sum of the net cash flows from each category results in the net change in cash and cash equivalents for the period
• The ending cash and cash equivalents balance from the previous period is added to the net change to arrive at the current period's ending balance
• The cash flow statement is typically presented in a vertical format, with cash inflows listed as positive numbers and cash outflows as negative numbers

Operating Activities: Where the Money's Made

• Operating activities include the cash flows generated from a company's core business operations, such as the production and sale of goods or services
• Key components of operating cash flows include cash received from customers, cash paid to suppliers and employees, and income tax payments
• Positive cash flow from operations indicates that a company is generating sufficient cash to maintain and grow its business
• Negative cash flow from operations may signal financial distress or unsustainable business practices
• Non-cash expenses (depreciation and amortization) are added back to net income to calculate operating cash flow
• Changes in working capital accounts (accounts receivable, inventory, and accounts payable) are included to reflect the actual cash impact of these items
• Analyzing trends in operating cash flow over time can provide insights into a company's ability to generate sustainable cash flows and maintain profitability

Investing Activities: Spending to Grow

• Investing activities include cash flows related to the acquisition or disposal of long-term assets, such as property, plant, and equipment (PP&E), as well as investments in securities and other companies
• Cash outflows in this section typically include capital expenditures (purchases of PP&E), acquisitions of other companies or assets, and purchases of investments (stocks, bonds)
• Cash inflows may include proceeds from the sale of long-term assets, divestitures of business segments, and the sale of investments
• Analyzing investing cash flows can provide insights into a company's growth strategy and capital allocation decisions
  • High levels of capital expenditures may indicate that a company is investing heavily in its future growth
  • Consistent acquisitions may suggest an aggressive expansion strategy
• Comparing a company's investing cash flows to its industry peers can help assess its relative level of investment and growth prospects
• Negative cash flows from investing activities are common and not necessarily a cause for concern, as they may reflect a company's efforts to expand and improve its operations

Financing Activities: Playing with Debt and Equity

• Financing activities include cash flows related to the issuance or repayment of debt, the issuance or repurchase of equity, and the payment of dividends
• Cash inflows in this section may include proceeds from the issuance of bonds, loans, or stock
• Cash outflows may include the repayment of debt principal, the repurchase of company stock (treasury stock), and the payment of dividends to shareholders
• Analyzing financing cash flows can provide insights into a company's capital structure and financing strategies
  • High levels of debt issuance may indicate that a company is leveraging its balance sheet to fund growth or operations
  • Stock repurchases may suggest that a company believes its shares are undervalued or that it is returning excess cash to shareholders
• Comparing a company's financing cash flows to its industry peers can help assess its relative level of financial risk and capital structure
• Positive cash flows from financing activities may be a red flag if a company is consistently relying on external financing to fund its operations or growth

Key Ratios and Metrics to Watch

• Operating cash flow to net income ratio: Measures the quality of a company's earnings by comparing its operating cash flow to its net income
  • A ratio greater than 1 indicates that the company is generating more cash than it reports in net income, which is generally a positive sign
• Free cash flow (FCF): Calculated as operating cash flow minus capital expenditures, FCF represents the cash a company generates after investing in the maintenance and growth of its business
  • Positive and growing FCF is a sign of financial health and flexibility
• Cash flow coverage ratio: Measures a company's ability to meet its debt obligations using its operating cash flow
  • Calculated as operating cash flow divided by total debt, a higher ratio indicates a greater ability to service debt
• Cash return on assets (ROA): Measures how efficiently a company generates cash from its assets
  • Calculated as operating cash flow divided by total assets, a higher ratio indicates more effective asset utilization
• Cash flow per share: Measures the amount of cash generated per share of common stock
  • Calculated as operating cash flow divided by the weighted average number of shares outstanding, this metric allows for comparisons between companies of different sizes
• Dividend payout ratio: Measures the percentage of a company's cash flow that is paid out as dividends
  • Calculated as dividends paid divided by operating cash flow, a lower ratio may indicate a more sustainable dividend policy

Real-World Examples and Case Studies

• Apple Inc. (AAPL): Known for its strong cash generation, Apple consistently reports positive and growing operating cash flows, driven by its profitable iPhone and services businesses
  • In fiscal year 2020, Apple generated $80.7 billion in operating cash flow, demonstrating its ability to generate significant cash despite the challenges posed by the COVID-19 pandemic
• Amazon.com, Inc. (AMZN): Amazon's cash flow statement reflects its focus on long-term growth and investment
  • The company consistently reports high levels of capital expenditures and negative free cash flow, as it invests heavily in its e-commerce infrastructure, cloud computing business, and other growth initiatives
• General Electric Company (GE): GE's cash flow statement has been a key focus for investors in recent years, as the company has struggled with declining operating cash flows and high levels of debt
  • In 2018, GE reported negative $2.7 billion in operating cash flow, raising concerns about its ability to meet its financial obligations and invest in its future growth
• Tesla, Inc. (TSLA): Tesla's cash flow statement reflects its rapid growth and heavy investment in electric vehicle production and technology
  • The company has reported negative free cash flow in most quarters, as it invests heavily in expanding its manufacturing capacity and developing new products (Model 3, Model Y)
• PepsiCo, Inc. (PEP): PepsiCo's cash flow statement demonstrates its ability to generate consistent cash flows from its diversified portfolio of beverages and snacks
  • In 2020, the company generated $10.6 billion in operating cash flow, allowing it to invest in its business, pay dividends, and repurchase shares, while maintaining a strong balance sheet

Pro Tips for Cash Flow Analysis

• Always start by reviewing the operating cash flow section, as it provides the clearest picture of a company's ability to generate cash from its core business
• Look for trends in operating cash flow over time, and compare a company's performance to its industry peers
• Be cautious of companies with consistently negative operating cash flows, as this may indicate unsustainable business practices or financial distress
• Analyze investing cash flows to understand a company's growth strategy and capital allocation decisions
  • High levels of capital expenditures or acquisitions may indicate a focus on long-term growth, but also increase financial risk
• Review financing cash flows to assess a company's capital structure and financing strategies
  • Heavy reliance on debt or equity issuance may be a red flag, especially if a company is using external financing to fund operations rather than growth
• Calculate and monitor key cash flow ratios and metrics, such as free cash flow, cash flow coverage ratio, and cash return on assets
  • These metrics provide valuable insights into a company's financial health, efficiency, and sustainability
• Consider the company's industry and growth stage when analyzing its cash flow statement
  • High-growth companies (startups) may have negative cash flows as they invest in their business, while mature companies should generate stable, positive cash flows