Understanding Cash Flow

The significance of cash flow in assessing a firm

When we start to take an interest in investing in the stock market, we quickly come across concepts such as revenue, net profit or dividends. These are important elements in assessing a company, but they do not capture the full 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 to cover current expenses. This is why, when analyzing a firm, it is worth looking at cash flow too.

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

This is important because information about sales or profit alone does not yet indicate when the money actually comes into the firm. A company may sell a good or a service and record the sale in its financial report, even though payment from the customer is received only later. This is exactly why analyzing 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 accounting rules, but it does not yet reflect how much money actually came into its account during the same period. It may happen that a company reports sales and profit in a financial report, even though some customers have not yet paid. 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 information about profit alone is not enough to assess whether an enterprise has the money needed for daily operations.

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 analyzing a company, it is not worth stopping at information about profit alone. You also have to check whether a real inflow of cash into the firm underlies this profit. If a company shows profit over a longer period but has weak cash inflows from its operations, it is worth analyzing 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. They are often also available on the stock exchange's website or on financial services that gather companies' reports.

A financial report consists 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 flowed out 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, namely whether the core business generates revenue. The second shows the expenses and inflows related to the purchase or sale of property and the firm's development. The third concerns financing, meaning, for example, loans, debt repayment, or dividend payments.

To understand a company's cash flow, you do not have to analyze the whole financial report at once. It is enough to know that the data on the firm's inflows and expenses are found in the cash flow statement, which is 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 payment for them, this should be visible precisely here.

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 through a loan or sell part of its property, but over the long term, what matters most is whether its core activity generates 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 for the current costs of this activity. This is usually a good signal. It shows that the company has a more solid foundation for further operations. 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 sales volume, 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 construction of a production hall, the development of IT systems, the acquisition 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, however, good to look at this part more broadly. If a firm constantly invests large amounts but does not generate cash from operating activities, the question arises of how this development is financed. 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 activities are the third section 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 cash 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 favorable.

How to understand positive and negative cash flows

When we look at the cash flow statement, it is easy to assume that a positive number indicates a good financial situation for the firm, and a negative one a bad one. 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 favorably. It means that the firm's core activity generates more revenue than it spends on its current operations. To put it more simply, the company earns cash on what it does day to day. A negative cash flow from operating activities requires more attention because it may indicate that the firm is not receiving sufficient cash from its core activities.

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, such as machines, buildings, or other necessary resources. Positive investment 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 profits but different cash situations

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 also worth checking whether money actually comes into the firm from its day-to-day activities.

The first company sells its products or services and regularly receives payment from customers. This money 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 actually receives the money. The second company also shows a profit, but customer payments arrive with a 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 yet differ in actual cash inflows. This is exactly why, when analyzing 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 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 cash flow from operating activities, meaning information about how much cash the firm actually generated from its day-to-day operations. 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 period and has positive cash flow from operating activities, its results are 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 a profit but cash inflows from its daily operations remain weak, it is worth examining the cause of this discrepancy 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 during that time, received customer payments later, or sold part of its property. Only a comparison of several periods lets you better assess whether the company regularly generates cash or only looks favorable at one point in time.

It is also worth checking whether, after the expenses related to development, any money remains with 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 a profit in the report but also has real money from its operations.

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 also worth checking whether the firm has sufficient funds for daily operations, 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 generates real funds, not just good figures in the report.

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

For an Elegant Investor who is only just learning to analyze companies, this is a very important moment in understanding the topic as a whole. Information about profit alone is not enough to assess a firm's financial situation. You also have to check whether the enterprise actually receives revenue from its activities. Thanks to this, it is easier to distinguish a company that looks good in the report from one with stronger financial foundations.

The most important conclusions

Cash flow in a company shows the real movement of cash. Thanks to this, you can better assess whether a firm actually receives money from its core activity, whether it invests sensibly, and whether it does not rest excessively 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 analyze companies, cash flow is one of those topics that help you better understand how an enterprise works. When we see where the firm's money comes from and what it is spent on, it is easier to assess whether the company has solid foundations for continued operations. This is exactly why the cash flow statement is worth treating as an important part of analyzing a firm, and not as an additional table of figures that can be skipped.