The significance of cash flow in assessing a firm

When we start to take an interest in investing on the stock market, we very quickly come across concepts such as revenue, net profit or dividend. These are important elements of assessing a company, but they still do not show the whole financial situation of a firm. A company may show sales and profit in a financial report and at the same time have too little cash for current expenses. This is why, when analysing a firm, it is worth looking at cash flow too.

Cash flow shows how much money came into a firm and how much money flowed out of it in a given period. It is about real money that goes into the company's account or out of it. Thanks to this it is easier to assess whether the firm actually receives payment from customers, whether it has the means to pay for its daily activity, whether it invests in development and whether it uses loans or other financing.

This is important, because the mere information about sales or profit does not yet show when the money actually comes into the firm. A company may sell a good or a service and record this sale in a financial report, even though the payment from the customer appears only later. This is exactly why analysing cash flow helps you better understand whether a firm only looks good in the statement, or actually has the cash needed to operate.

Profit alone does not show whether a firm has real money

At the start of learning about investing it is easy to consider that the most important information about a company is profit. Since the firm earns, you may get the impression that its situation is good. Such a conclusion, however, is sometimes too quick.

Profit shows how much the firm earned according to the rules of accounting, but it does not yet show how much money actually came into its account in the same time. It may happen that a company shows sales and profit in a financial report, even though some customers have not yet paid it. In such a situation the firm looks good in the statement, but is still waiting for a real inflow of cash. This is exactly why the mere information about profit is not enough to assess whether an enterprise has the money needed for daily operation.

It is easiest to see this in a simple example. Let us imagine a firm that sold goods for 100 thousand units of currency. This sale can already be shown in the report. If, however, the customer pays only in two months, the firm still does not have this money in its account. In the report sales appear, but the cash has not yet come in. For the firm's current functioning this is an important difference.

This is why, when analysing a company, it is not worth stopping solely at the information about profit. You also have to check whether a real inflow of money into the firm stands behind this profit. If a company shows profit over a longer time, but at the same time has weak cash inflows from its activity, it is worth analysing its financial situation more closely.

Where you can find data on a company's cash flow

Information about cash flow can be found in a company's financial report. Listed companies publish such reports regularly, most often as quarterly, half-year and annual reports. They are publicly available, so every Elegant Investor can look into them. Most often they can be found in the investor relations section on a given company's website. Often they are also available on the stock exchange's website or in financial services that gather companies' reports.

A financial report is made up of several parts. One of them is the cash flow statement. It is precisely there that a company shows how much money came into the firm and how much money flowed out of it in a given period. In other words, this document shows where the firm had cash from and what it spent it on.

The cash flow statement is usually divided into three parts. The first concerns the firm's daily activity, meaning whether the core business brings in money. The second shows the expenses and inflows connected with the purchase or sale of property and with the firm's development. The third concerns financing, meaning for example loans, the repayment of debt or the payment of a dividend.

To understand a company's cash flow, you do not have to analyse the whole financial report at once. It is enough to know that the data about the firm's inflows and expenses are found in the cash flow statement, meaning in one of the parts of this report.

Operating activity, meaning money from the day-to-day business

Operating activity shows the flows connected with the company's core activity. It is here that you can see whether the firm can earn cash on what it does day to day. If it sells products or services and receives money for them, it is precisely here that this should be visible.

This part of the statement is especially important, because it shows whether the business model itself works well. A firm can, after all, raise financing from a loan or sell part of its property, but over the long term what matters most is whether its core activity brings in cash.

If the flows from operating activity are positive, it means that more money comes into the firm from the daily business than flows out of it on the current costs of this activity. This is usually a good signal. It shows that the company has more solid foundations for further operation. If, on the other hand, the operating flows are negative, it is worth checking the cause. Sometimes it is a temporary situation, connected for example with the firm's development, a larger scale of sales or a change in payment dates. Sometimes, however, such a result may mean that the business does not turn sales into real cash to a sufficient degree.

Investing activity, meaning spending on development and property

Investing activity is the second part of the cash flow statement. It is about money connected with the purchase or sale of the firm's property. This can be the purchase of new machines, the building of a production hall, the development of IT systems, the purchase of another company or the sale of part of the assets held.

In this part negative values often appear, and this fact alone should not immediately raise concern. A negative investing flow often simply means that the firm is spending money on development. This can be sensible and necessary, if the company does it in a thought-out way and has the means to finance such development. It is good, however, to look at this part more broadly. If a firm constantly invests large amounts, but does not generate money from operating activity, the question appears of what this development is financed from. The investment alone is not yet a sign of quality, because what also counts is whether the company has healthy sources of financing and whether the investments will translate into better results in the future.

Financing activity, meaning where a firm gets its capital

Financing activity is the third part of the cash flow statement. It is here that you can see whether the company raises money from loans, bonds or share issues. Here you also see the repayment of debt, the payment of a dividend or the buyback of its own shares.

This part is significant, because it shows the firm's relationship with external capital and with the owners. If a company takes on new debt, an inflow of money appears here. If it repays this debt, we see an outflow of funds. If it pays a dividend, this too will be visible in this part of the statement.

The mere presence of positive or negative values does not yet say whether the situation is good or weak. You have to look at the whole. If a firm has strong operating flows and at the same time repays debt or pays a dividend, this may indicate financial maturity. If, however, a company regularly uses new loans only to keep its current functioning going, the picture becomes less favourable.

How to understand positive and negative cash flows

When we look at the cash flow statement, it is easy to instinctively consider that a positive number means a good financial situation of the firm, and a negative one a bad situation. In practice this is not always so. The meaning of these values depends on which part of the report they appear in and what they result from.

A positive flow from operating activity is usually assessed favourably. It means that the firm's core activity brings in more money than the firm spends on its current functioning. To put it more simply, the company earns cash on what it does day to day. A negative flow from operating activity requires more attention, because it may mean that the firm does not receive a sufficient amount of money from its core activity.

In the investing part a negative flow is often something natural. It means that the firm is spending money on development or on the purchase of property, for example machines, buildings or other needed resources. A positive investing flow may appear when a company sells part of its property. Such a result is neither automatically good nor automatically bad. You have to check what exactly it results from.

In the financing part a positive flow may mean that money came into the firm from a loan, a borrowing or a share issue. A negative flow may in turn mean the repayment of debt, the payment of a dividend or other expenses connected with financing the firm. This is why the plus and minus signs alone are not enough. You always have to see what exactly a given cash flow concerns.

Two companies with similar profit but a different cash situation

Let us imagine two companies that show a similar profit in the report. At first glance it may seem that both firms are doing similarly. Such a conclusion, however, is not always accurate. To better assess a company's financial situation, it is worth checking also whether money actually comes into the firm from its daily activity.

The first company sells its products or services and regularly receives payment from customers. From this money it pays the current costs of running the firm, and part of the funds is still left to it. Thanks to this it can finance development or repay debt. Such a situation shows that the firm not only records sales in the report, but also really receives money. The second company also shows profit, but money from customers comes in with delay or in too small an amount. The firm therefore has profit written in the report, but at the same time has less cash for daily expenses. To keep its current functioning going, it uses a loan or other financing. In such a situation profit alone does not yet show the full picture of the firm.

This example shows that two companies may look similar in the financial report and at the same time differ in terms of the real inflow of money. This is exactly why, when analysing a firm, it is worth looking not only at profit, but also at cash flow.

What is worth looking at when you read a company's financial report

When you start to read a company's financial report, it is worth paying attention to two pieces of information. The first is net profit, meaning the amount showing how much was left to the firm after subtracting all costs and taxes in a given period. You will find this information in the part of the report showing the firm's result for the quarter, half-year or year. The second is the cash flow from operating activity, meaning the information about how much cash the firm actually obtained from its daily activity. You will find this information in the cash flow statement, meaning in the part of the report showing the firm's inflows and expenses.

If a company shows net profit over a longer time and at the same time has a positive cash flow from operating activity, it means that its results look more credible. The firm not only shows a positive result in the report, but also really receives money from its core activity. If, on the other hand, a company shows profit, but the cash inflows from the firm's daily operation stay weak, it is worth checking the cause of this difference more closely.

It is also good to look at data from several years, and not only from one report. A single period may look different from usual. The firm may have spent more money on development in that time, received payment from customers later or sold part of its property. Only the comparison of several periods lets you better assess whether the company regularly generates cash, or only looks favourable at one moment.

It is also worth checking whether, after the expenses connected with development, part of the money is still left to the firm. Such a situation may matter when assessing whether the company has the means to repay debt, pay a dividend or invest further. The most important thing in this part is to understand one relationship. It is good when the firm not only shows profit in the report, but also has real money from its activity.

What cash flow says about a firm from the perspective of long-term investing

In long-term investing it is not enough to see that a company is growing or showing profit. It is worth checking also whether the firm has real money for daily operation, development and meeting its obligations. It is precisely cash flows that help with this. Thanks to them it is easier to assess whether the company's activity gives it real funds, and not only good figures in the report.

This does not mean that the cash flow statement alone is enough to assess the whole firm. When analysing a company it is still worth looking also at sales, profit, debt, margins and the way the business operates. Cash flows, however, give a very important addition to this picture. They show whether real inflows of money into the firm stand behind the results visible in the report.

For an Elegant Investor who is only just learning to analyse companies, this is a very important moment in understanding the whole topic. The mere information about profit is not yet enough to assess a firm's financial situation. You also have to check whether the enterprise really receives money from its activity. Thanks to this it is easier to tell a company that looks good in the report apart from a company that also has stronger financial foundations.

The most important conclusions

Cash flow in a company shows the real movement of cash. Thanks to this it helps you better assess whether a firm actually receives money from its core activity, whether it invests sensibly and whether it does not rest to an excessive degree on external financing. This is an important topic, because profit alone does not yet give a full picture of an enterprise's situation.

For an Elegant Investor who is learning to analyse companies, cash flow is one of those topics that help you better understand how an enterprise works. When we see where money comes into the firm from and what it is spent on, it is easier to assess whether the company has solid foundations for further operation. This is exactly why the cash flow statement is worth treating as an important part of analysing a firm, and not as an additional table of figures that can be skipped.

Sources:

Investopedia (definitions of cash flow and the cash flow statement, https://www.investopedia.com), International Financial Reporting Standards Foundation (international standards for financial statements, https://www.ifrs.org), Corporate Finance Institute (educational resources on operating, investing and financing cash flows, https://corporatefinanceinstitute.com), U.S. Securities and Exchange Commission (investor education on cash flow statements, https://www.sec.gov), CFA Institute (investor education on financial statement analysis, https://www.cfainstitute.org)

Take the quiz