Cash Flow is most important Financial Statement
Dalal Street loves Profit and Loss statement because that where one finds all the metrics such as quarterly revenue, EPS, EBIT, EBITDA and margins. Therefore, Profit and Loss statement should be the most important financial statement. Nope!
I believe the most important financial statement is the cash flow statement. Unfortunately, it does not get a same level of attention as given to income statement. The reason analysts look at revenue, EPS, EBIT, EBITDA and margins, is that they are trying to estimate a cash flow number for future. They attempt to deduce the future cash flow. While I do believe that all three statements have its own reason to exists, it is the cash flow statement that is the true reflection of the current state of companies business.
- Profit and Loss statement is the document which shows past history of corporation’s actions and past performance record. It demonstrates management’s dividend philosophy and strategy vis-à-vis EPS, profitability (gross margins, operating margins), payout factors, dividends, and dividend growth.
- Balance sheet provides insights into the future of the corporations. It demonstrates how effectively the assets are used and what resources are at its disposal for continued growth. The state of assets and liabilities will show what resources are available at its disposal.
- Cash flow is the statement showing current state and how it is able to sustain in present environment. It demonstrates corporation’s ability to generate cash and income from its actual products/services i.e. effectiveness of its continuing operations.
Balance sheet and P/L statements are prepared using accrual-basis accounting which attempts to match revenues with the associated expenses to generate those revenues (for the same time period). This leads to a higher probability of disconnect between cash and earnings
Let us take an example: During the quarter a company sells some surplus assets (e.g. land, building, machinery, etc) under a cash deal. The law firm who handled the paperwork did not bill the company by end of the quarter. Therefore, as per the rules, an expense will be recorded on P/L statement, and a liability to pay the law firm will be recorded on the balance sheet. Note there is still no cash transaction between the company and the law firm. Thus balance sheet and P/L statement are not the best places to look when we want to understand what is going on with cash.
I would like to think this as my own business venture. When I am running the business, balance sheet and P/L statement are good recording statements. However, in the end we all worry about how cash transactions are taking place. Are we still cash positive? Even a road side hawker or small time corner store guy understands the importance of cash flow!
One significant plus point about cash flow statement is that it is not based on accrual accounting. Instead it is a cash report focusing on actual inflows and outflows of cash. It adjusts out transactions that do not directly affect cash receipts and payments, such as adding depreciation back to net earnings. The cash flow statement allows investors like us to understand how a company’s operations are running, where the cash is coming from and how it is being spent
On a cash flow statement, transactions are categorized into three parts viz. (1) net cash from operating activities; (2) net cash from investing activities; and (3) net cash from financing activities. The accounting rules are very specific in defining what goes into each category and hence, it ensures consistency in relative comparison between companies.
Net Cash from Operating activities measure cash generated from core business operations i.e. the sale of the company’s products and services. It includes the income and costs associated with production, sales, delivery, as well as collecting cash from customers.
- For a healthy company, net cash from operating activities should always be positive and greater than the company’s net profit. Profits are considered of “high quality” when operating cash flow is consistently greater than net profit. If operating cash flow is less than net profit, this is a strong signal we need to look deeper into the financials with a critical eye.
Net Cash from Investing activities focuses on the purchase of the long-term assets the company needs to make and sell its products, along with any sales of long-term assets. This section also includes business acquisitions and strategic investments.
Net Cash from Financing Activities include the inflow of cash from the sale of stock or issuance of debt, as well as the outflow of cash as dividends, and repayment of debt.
Summary is…
As an investor, we should pay close attention to the cash flow statement. In today’s world of complex accounting rules, there is always room for engineering earnings (on P/L statement) and assets/liabilities (on balance sheet) are often misleading. We should stick to our simple fundamental arithmetic. The company is healthy only when it consistently generates more cash than it uses. A healthy company will be able to increase dividends paid, buy back shares, reduce debt, or acquire another company.
Being a dividend investor, I want to know my company is financially stable, financially healthy, generates cash, and hence capable of paying me a higher dividend year after year.
Do you use cash flow statement when evaluating the company? How do you interpret it?
cash flow
You have hit the nail on the head. If the analysts in Satyam saga had looked closely at the cash flow statements and then compared them with the P&L Account and the finally the balance sheet (in that order) then the fraud would’ve been detected much earlier.
Puneet,
Satyam is probably a good example of this. Thanks for stopping by!
Best Wishes,
I totally agree with this. Cash inflow and related out folw can allow us to determine the real value of a company by identifying the money they have and real per share earning figure. But, when analysis the cash flow, one should take care of having details of at least 10 years than only present one. Great article. Keep it up.
Sherin – The Money Maniac
http://www.investinternals.com
Sherin’s last blog post..The Money Maniac Blog Carnival – March 2009
Sherin,
Thanks