Cash Flow Statement

Cash Flow Statement – What’s the Big Deal?

I do cherish the good ol’ days when things were more slow and simple. Yeep, this is coming from someone raised in the 1980s, my friend. My my my… time does fly!!! Similar to when Eddie Murphy was actually funny, but that’s another story (hope you enjoyed the ‘Annie in the Hot Tub’ pic). On to today’s entry about the Importance of Cash Flow Statements for businesses and other principals of the business such as lenders, investors (including owners), and even employees.The focus of the Cash Flow Statement is to disclose the business’s ability to 1) create a consistent stream of earnings (notice I did not say sales… though sales are needed if there’s to be any earnings) and 2) prove its ability to return an investment for owners and other principals involved with the business. Let’s dig in, shall we…

WHY DOES THE CASH FLOW STATEMENT EXIST?

Aside from the Investopedia technical reasons for the Cash Flow Statement, it’s different forms, and origin… let’s talk straight from the main street. As any business owner(s) worth a salt will tell you, cash flow is everything in business. From the sale all the way to the deposit of funds in the business bank account, cash dictates many actions that a business can take. For most main street businesses, cash is needed to ensure proper payment of recurring vendors for inventory, supplies, other operating costs (i.e. rent, equipment leases, utilities, insurance, etc.), and the all important tasks of paying employees on time and fairly. The Cash Flow Statement shows where the cash comes from and where it goes, and it accomplishes this task by categorizing the cash into 3 areas: 1) Operations, 2) Investing, and 3) Financing. Each of these categories impact the business either for the short or long term.

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OPERATING CASH FLOWS

Opeating Cash Flows, in my opinion, tell you a lot about a business’s profitability and efficiency in managing short term operations. In other words, it’s a great barometer for management’s ability to optimize the business model in lieu of the market opportunity from both a micro and macro perspective. The question to ask in assessing Operating Cash Flows is “Has management handled operating and market risk in such a way as to maximize sales and profit (both gross and net) potential for the reporting period?” Often, I find in assessing Operating Cash Flows in the context of this question will lead to more questions for management to consider. Although you find Management Discussion and Analysis narratives with SEC required 10-K and 10-Q reports, I find it great when small to mid sized private companies include operational narratives with financial statements.

INVESTING CASH FLOWS

After assessing Operating Cash Flows, I love digging into the Investing Cash Flow section. Here you typically find how a business reinvests it’s profits and / or investor / loan proceeds to grow it’s asset base. A business’s asset base enables it to create and grow income which turns into profits. Depending on the management strategy, businesses look to buy and / or replace equipment and even acquire real estate in the pursuit of maximizing earnings. Also, in this section of the Cash Flow Statement, you sometimes discover sales of capital assets such as real estate and equipment. From an analysis standpoint, you really don’t want to see a business lose a material portion of its asset base because it has a negative impact on future earnings and threatens the going concern value of the business.

FINANCING CASH FLOWS

Last, but not least is the Financing Cash Flows section. Here we are able to discern the stability of a business’s capital structure. Every business has a ‘boling point’ when it comes to capital structure. For most businesses, too much debt and obtaining the wrong equity structure (and investors) spells disaster. There’s not a standard for the right mix of debt and equity for a business and honestly it’s really relative to the underlying business model. The significant point for any business is to understand the impact on earnings that its capital structure has. Does having too much debt strain earnings due to abnormally high interest payments and / or restrictive debt and collateral covenants? Is the equity capital needed to grow and expand market share really a benefit or more of a cost in spite of the number of zeros in the check due to the return and control expectations of investors?

 

In conclusion, learn to read and interpret the activity of the numbers in each section of the Cash Flow Statement. Besides assessing the strength of a business’s ability to increase earnings and subsequently its cash position, you will find out the long term viability and direction of the business. Never hurts to know where you stand and where you’re going in life. Until next post…

 

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