Examining the cashflow statement
As a recap, we have looked into the various approaches used in analyzing a business; we also looked into how to make some quick brief analysis on the income statement(P&L) and balance sheet.
In this lesson, I will briefly introduce on the cashflow and its importance before proceeding into detailed review of the statement.
As we had noted in previous lessons, when you are buying shares, technically, you are buying a business. A business is supposed to earn profits for owners which can then be distributed to owners after they consent as dividends or can be retained for reinvestment.
Businesses/shares have traditionally been valued by investors as a multiple of earnings. Fundamental investors simply calculate how much the business would make during the time they invest then adjust for interest rates and inflation etc. (simply because money right now will not be worth as much in the future). The usual relationship is that when the rate of interest is high, the multiple paid for a business becomes low. Yet earnings are only part of pretax cashflow which is often a minor part. Cashflow is the primary criterion in determining the value of a business that is a candidate for acquisition/investment and there should be given as much emphasis as other items of the financial statements.
Just to lay a little bit more emphasis, when valuing a business, cash will always be king. The usual procedure is that we look at the value of the cash that can be taken out of a business during its remaining life time or over the period we want to invest, and then adjust. The value we get is called the intrinsic value. The calculation of intrinsic value, though, is not simple as I may have implied. This is because intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. So the market is always adjusting towards a moving target rather than a fixed valuation. That may be part of the reason why stock prices in the market are constantly moving. We will get into more details on cashflow valuation in a different lesson.
Why cashflow matters
The rules of accounting are not meant to create an income statement that tracks cash flow; rather, they’re meant to track earnings as defined for tax or financial-statement purposes. That means they may show income that the business has not yet received as cash or show expenses the business has not yet incurred, meaning that the underlying cashflow becomes blurred and may not show the real liquidity position of a business.
This is not to mean that an investor should only consider cash flow statements. Ideally, cash flow statements should be used together with information from the Profit and Loss, Balance Sheet and footnotes to assess the cash-generating ability of the firm. Some of the reasons why the cashflow statement should be used alongside the income statement and balance sheet are
- Inventories in the balance sheet are recorded as assets rather than expenses implicitly assuming that they will be sold in the normal course of business. If a business is ‘dying’, this might not be the case.
- The recording of revenue from credit sales in the income statement and the valuation of receivables assume that the firm will continue to operate normally. Failing firms may find that customers are unwilling to pay.
- When doubts start arising that a business may not continue running for long, revenue recognition and asset valuation can no longer be taken for granted. The cashflow statement acts as a check on the various assumptions made in the other statements some of which include the above stated.
Besides, if a business looks good on the profit and loss statement but has to plough back all its earnings into the business in order to generate that kind of income, then it won’t be worth near as much as a business that’s generating excess cash. This is because when calculating earnings, a company does not have to restrict to just the cash it receives but can include cash that it anticipates it will receive.
Case example of potetial impact of bad cashflows using Samuel’s business
In our previous illustration on Samuel’s business, let us assume that he somehow managed to grow his business into a huge sausage selling empire.
The first thing that may happen when his business isn’t generating cash is that supplies start getting squeezed. This is because they are not getting paid because little or no cash is coming into the business. Remember suppliers run businesses also and they too have financial obligations either to the owners or creditors. If the business has been maintaining good relations with the supplier, they might not start making much noise
When suppliers to Samuel’s business realize that the business is really hurting them by not paying them, they start now making noise and may change a few things. They may start requiring that they be getting prepayments for the products they sell to the business. They may also start limiting the amount of products they sell to the business to cut risks of losing.
By then, the business may start getting into trouble because if there isn’t any cash, the next step the business will take in order to survive is to try and get a line of credit from a bank or other lenders. They may do this by increasing an existing one or try to borrow some additional money. When the lender reads the financial statements of the business, they will see that the business owes a lot of money to suppliers. So they will quickly figure out that the money you get will simply be used to pay money you owe to suppliers and signal that your business isn’t really doing well. But the more you need the money, the less the banks want to loan the business and if they do, they might place a higher risk on the business and then they will have to ask for more interest. More interest drains cash from the business and therefore the business reports lower net earnings. If the business is not growing fast enough, it becomes problematic because then the ability to pay down the loan it took reduces.
We will look into how we can quickly review the cash position of a business using the cashflow statement in the next lesson.