The first step in finding potential investment opportunities is to be able to go through and evaluate a company’s financial reports. In this article we evaluate the Cash Flow Statement, one of the most useful of the three financial statements.
Before you begin investing in individual companies you must have a basic understanding of what these 3 financial statements tell you. There is no better way to truly assess a company’s standing than taking the time to read these reports.
In this article we will go through several examples of evaluating a company based on its cash flow statement and help you determine what information is significant. By being able to comb through these documents, you will know information that only a small percentage of investors know. Many investors are lazy and purchase stocks based on TV news coverage or co-worker tips (Probably why most underperform the market). Very few buy based on research of a company’s financial statements.
The cash flow statement is the primary source of data for many analysts and investors. Often a company’s profit or earnings per share is the headline number that gets all the attention, but that can be subject to a lot of accounting tricks and gimmicks. When looking at a company’s cash flow statement you get much greater detail of the day to day operations of the company and get to see the detailed flow of money through the business.
Let’s start with an example company. For this article we will look at Praxair, Inc. Ticker Symbol PX – A company that sells atmospheric gases such as helium and oxygen.
(Incase you are wondering – I have no investments in Praxair)
Getting into the Report
Let’s run through the terms that make up a company’s cash flow statement and discuss why they are important.
Below we are going to be showing examples from Praxair’s Cash Flow Statement from their 2011 10-k report, which can be found here. (On page 51)
(click to enlarge)
Parts of the Cash Flow Statement
Let’s quickly discuss the terms on Praxair’s Cash Flow Statement and common on other company’s Cash Flow Statements:
There are primary 3 elements of a company’s cash flow:
Cash Provided by Operations – Represents the change in the company’s cash reserves due to day-to-day operations of the business. A lot of numbers come together here, many of which are copied over from the income statement and balance sheet.
The net cash provided by operations represents the total amount of money that flowed into the company during the year minus items like depreciation, amortization, or other non cash charges.
Note: This is different than the company’s profit as reported on the income statement! (More on this later)
Cash Flow from Investments – Represents the change in the company’s cash reserves due to money spent to keep the company running (Also known as Capital Expenditures – such as buying supplies and materials, repairing equipment, etc). Other examples include money used to acquire other companies, money received from selling part of its business or money spent or received from buying or selling equipment, property or other fixed assets.
Cash Flow from Financing Activities – Represents the change in the company’s cash reserves due to receiving money from loans, buying or selling stock or money being paid out as dividends to shareholders.
Most terms seen on the cash flow statement are self explanatory, or have been seen on the company’s balance sheet statement or income statement. There is one significant new term listed here:
Capital Expenditures – Also known as CAPEX, are expenses on physical (tangible) assets needed to run the company’s operations. Expenses may be new equipment, repairs for old equipment, upkeep on its buildings, etc.
Note, CAPEX is different than other operational expenditures (OPEX) that appear on the income statement under Sales. (OPEX may also be included in “Selling, General and Administrative” costs). Operational Expenditures include expenses such as advertisements, employee’s salaries and other non-asset expenditures.
A company’s CAPEX can give a potential investor insight on how a company is able to keep expenses under control, maintain margins and invest in its future. There is a lot to consider looking at a company’s CAPEX. A large jump may mean a significant investment by the company that will increase output and sales in the future, however high CAPEX could also be a sign that the company will not be able to maintain high margins because it can not control costs. A low CAPEX could signify that the company is able to maintain high margins, but it may be a sign of the company not investing enough to keep the company growing in the future.
Evaluating a company based on its Cash Flow Statement
There are several basic ratios and calculations with these numbers that investors can use to compare different companies to determine value or investment opportunities.
Operating Cash Flow (OCF) – Operating cash flow is the cash received by the company from selling its products after operational expenses.
You will find several ways to calculate OCF:
OCF = EBIT (earnings before interest and taxes) – taxes paid + depreciation and amortization
Or sometimes you will see OCF defined as
OCF = Revenue – Cost of sales + Depreciation and Amortization – Taxes
Below we can see that Praxair starts with their net income and adds back in depreciation, amortization and change in working capital
Praxair’s Operating Cash flow for 2011 was $2.455 Billion. (Remember all numbers are in millions)
This will be shown for you on all cash flow statements so don’t worry if the calculations look a bit confusing.
Just remember cash flow is much different than earnings. Things like amortization and depreciation take away from a company’s reported income, but they don’t result in any change in cash for the company, so they are added back in to calculate cash flow. A company may report a large loss due to writing down the value of an asset, but at the same time may be adding significantly to its cash pile. Many would even argue that cash flow is more important that a company’s reported net earnings!
Free Cash Flow (FCF) – Free Cash flow is the cash left over after capital expenditures (CAPEX).
Remember, companies can not function without cash to pay their bills. Loans can provide cash during certain times, but eventually a company will need to be not only profitable, but able to add cash to its balance sheet on its own if it is to stay solvent.
Free Cash Flow measures how much cash is left after a company accounts for all its expenses and investments. Calculating free cash flow is easy:
FCF = OCF – CAPEX
Free cash flow is what is left to pay dividends to stock holders, pay back loans or add to its cash balance.
Net Change in Cash / Net Cash Flow – At the very bottom of the cash flow statement is how much cash the company is adding (or taking out, if the company has negative net cash flow) to its bank account. This is the final amount of cash the company is left with after paying all its bills, paying shareholders, paying its loans, etc.
Looking at Praxair’s cash flow statement, after all is said and done they added $51 million to their bank account, adding this onto the $39 million in the bank account at the start of the year gives a total of $90 million.
Notice that the company’s balance sheet (in the black box below) had 90 million listed as cash and cash equivalents!
To make it easier to compare one company’s cash flow with another’s, analysts will typically calculate cash flow per share.
For example, if we want to find Praxair’s Free Cash Flow per share:
Praxair’s FCF is $2455 Million – $1797 Million = $658 Million
Per the company’s income statement, Praxair had just over 302 million shares outstanding.
Praxair generates about $2.17 of cash for each share. Investors can compare this value to the FCF per share of other companies in Praxair’s industry. If one of Praxair’s competitors generates $4 in cash per share, it may be a sign Praxair is overvalued (assuming equal market caps).
FCF per share is just one of many ways investors will attempt to value a business, and should not be your sole reason for investing in a company.
Cash is the lifeblood of a company. A company can survive temporarily by taking on loans to cover expenses, but eventually the company will have to generate cash to pay its bills. At the end of the day if a company is unable to generate enough cash it will be insolvent.
Too many investors only look at a company’s income statement for the net profit or earnings per share number (EPS) and nothing else. The cash flow statement will tell the real health of the company. A company may be generating no cash, but be reporting a large net profit; likewise a company could be reporting a net loss but be adding cash to its balance sheet.
A negative cash flow once in a while is not necessarily a bad thing for a company. A one time negative cash flow may be signaling a large investment by the company which could signal stronger business in the future.
Numbers such as free cash flow should be compared to other companies in the same industry. Certain industries will have relatively low or high cash flow depending on the business model. It may be deceiving comparing cash flows of a software company and furniture maker.
After reading, hopefully you feel comfortable doing basic evaluations of a company based on its cash flow statement.
The cash flow statement may very well be your best asset when evaluating companies.
There are several resources that have helped me over the years in reading and understanding company cash flow statements and other financial reports:
• The Interpretation of Financial Statements– By Benjamin Graham
This book is always by my side when I have company financial statements open. Gives real life examples, along with a great definitions section in the back of nearly every term you see on a financial statement. It does not discuss cash flow statements separately because they were not commonly released in Graham’s time. However it does still define terms you will run into reading a company’s cash flow statement.
A very in depth guide for learning how to read company financial statements. The book contains real life examples of balance sheets, income statements and cash flows along with definitions of every term that will appear on those reports. This book walks you through the creation of a hypothetical company, “AppleSeed Enterprises, Inc” and how the balance sheet, income statement and cash flow statement evolve as the company grows. Great for investors of any level, and necessary to truly understand financial reports.