Evaluation of the cash flow statement should involve an overall assessment of the sources and uses of cash between the three main categories as well as an assessment of the main drivers of cash flow within each category, as follows:
- Step 1: Evaluate the major sources and uses of cash flow, including operating, investing, and financing activities.
- Step 2: Evaluate the primary determinants of operating cash flow.
- Step 3: Evaluate the primary determinants of investing cash flow.
- Step 4: Evaluate the primary determinants of financing cash flow.
Step 1. Evaluate the major sources and uses of cash flow
For a mature company, it is expected and desirable that operating activities are the primary source of cash flows. Over the long term, a company must generate cash from its operating activities. If operating cash flow were consistently negative, a company would need to borrow money or issue stock (financing activities) to fund the shortfall. Eventually, these providers of capital need to be repaid from operations or they will no longer be willing to provide capital. Cash generated from operating activities can be used in either investing or financing activities. If the company has value-creative investment opportunities, it is desirable to use the cash in investing activities. If the company does not have profitable investment opportunities, the cash should be returned to capital providers, a financing activity.
For a new or growth stage company, operating cash flow may be negative for some period of time as it invests in such assets as inventory and receivables (extending credit to new customers) to grow the business. This situation is not sustainable over the long term, so eventually the cash must start to come primarily from operating activities so that capital can be returned to the providers of capital. Lastly, it is desirable that operating cash flows are sufficient to cover capital expenditures。
In summary, the major points to consider at this step are:
- What are the major sources and uses of cash flow?
- Is operating cash flow positive and sufficient to cover capital expenditures?
Step 2. Evaluate the primary determinants of operating cash flow
Analysts should examine the most significant determinants of operating cash flow. Companies need cash for use in operations (e.g., to hold receivables and inventory and to pay employees and suppliers) and receive cash from operating activities (e.g., payments from customers). Increases and decreases in receivables, inventory, payables, and so on can be examined to determine whether the company is using or generating cash in operations and why.
It is also useful to compare operating cash flow with net income. For a mature company, because net income includes non-cash expenses (depreciation and amortization), it is expected and desirable that operating cash flow exceeds net income. The relationship between net income and operating cash flow is also an indicator of earnings quality. If a company has large net income but poor operating cash flow, it may be a sign of poor earnings quality. The company may be making aggressive accounting choices to increase net income but may not be generating cash for its business. Analysts also should examine the variability of both earnings and cash flow and consider the impact of this variability on the company’s risk as well as the ability to forecast future cash flows for valuation purposes.
In summary:
- What are the major determinants of operating cash flow?
- Is operating cash flow higher or lower than net income? Why?
- How consistent are operating cash flows?
Step 3. Evaluate the primary determinants of investing cash flow
Analysts should evaluate each line item. Each line item represents either a source or use of cash. This enables analysts to understand where the cash is being spent (or received). This section will reveal how much cash is being invested for the future in property, plant, and equipment; how much is used to acquire entire companies; and how much is put aside in liquid investments, such as stocks and bonds. It will also tell show how much cash is being raised by selling these types of assets. If the company is making major capital investments, analysts should consider where the cash is coming from to cover these investments (e.g., is the cash coming from excess operating cash flow or from the financing activities described in Step 4). If assets are being sold, it is important to determine why and to assess the effects on the company.
Step 4. Evaluate the primary determinants of financing cash flow
Analysts should examine each line item to understand whether the company is raising capital or repaying capital and what the nature of its capital sources are. If the company is borrowing each year, analysts should consider when repayment may be required. The financing section will also present dividend payments and repurchases of stock that are alternative means of returning capital to owners. It is important to assess why capital is being raised or repaid.
