Businessman Investor

Touching base with the rational business psyche of stock market investors

Tuesday, August 16, 2011

Showing You the Money and the Natures of Cash Flow

This is Part 3 of a Series. Go to Part 2: Cash Qualifying the Income Statement

Note: When looking at the Cash Flow Statement, generally, a positive (+) number means a cash inflow while a negative (-) number is a cash outflow. This may not be true, however, with Operating Cash Flow reporting under the Indirect Method; the positive and negative numbers may not be actual inflows or outflows but just adjustments (don't worry, this will be further discussed).

The Cash Flow Statement—you know it’s there, reported as one of the primary financial statements filed by a listed company. But let me ask you, why, for the love of finance, do we not look at it as much as the Balance Sheet and Income Statement?! It lacks that clean appeal of the Income Statement! It’s just not as intuitive.

The Natures of Cash Flow: Operating, Investing, and Financing. Of these three, Operating Cash Flow makes explicit that money-making ability of a business. Photo courtesy of LitratoNiJuan.
Then again, you have to give credit to it for delineating the natures of cash flow into three basic categories: Operating, Investing, and Financing. Of these three, the internal cash-generating capacity of the business can be observed under Cash Flow from Operating Activities. This is where the money-making faculty of a business is most visible and this is where you want to focus on. It includes collection of revenues, payments of inventory to suppliers, and payments of operating expenses—the very heart of the going-concern business: collecting, paying, and ultimately, milking profits into cash. This also captures all cash gains and losses realized whenever fixed assets (i.e. capex) or other investments are sold (further discussed under Investing Activities). If its ending net figure is a large positive number (approximate or even larger to Net Income), you know that the business is indeed raking up not just profits, but cash profits. It’s what makes a business a money machine.

Cash Flow from Financing Activities, on the other hand, identifies the cash financing aspect of the company. This includes cash externally sourced from investors or creditors (existing or new ones) or those withdrawn by them. Here you can also see loans being paid off (but not inclusive of interest payments since these are already captured under Operating Activities), as well as dividends distributed to shareholders, cash paid for share buybacks, etc.

Cash Flow from Investing Activities identifies cash being used for investments. This is sort of a grey area relative to Operating Activities if you think of it. For clarity and ease of understanding, I’d personally further categorize this cash activity into two—that is: Capital expenditures and Non-core business investments.

Non-core business investments are cash placements on marketable, liquid investment vehicles, instruments, or other medium, which are not related to the main core business of the company. These are real estate (i.e. investment properties), bonds, stocks, etc. They are investments but they hardly have anything to do with the knitty-gritty of the daily business grind. While placements or purchases of these are shown as cash outflows (-), whenever any of them are sold or liquidated, the original cost/principal of the investment is reflected as a cash inflow/proceed (+) under Investing Activities—the resulting loss or gain from the sale is always captured under Operating Cash Flow.

Capital expenditures (or capex), on the other hand, are large cash spendings directly and significantly related to the core business operations. These are usually factories and equipments (i.e. property, plant, and equipment) and are, by their very nature, depreciable fixed assets. These cash outlays build that critical enterprise infrastructure to support and enable smooth-sailing business operations. While purchase of capex/fixed assets are shown as cash outflows (-), sale of capex/fixed assets are reflected as a cash inflow (+) under Investing Activities; resulting loss or gain from the sale is likewise captured under Operating Cash Flow; thus as I've told you, Operating Cash Flow always captures all cash gains and lossesContinue to Part 4: The Money Machine Making Free Cash Flow

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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