Cashing in on the flow

Written by Rajesh Naidu | Updated: Apr 27 2008, 07:42am hrs
When it comes to judging a company on the basis of its historical data, the chances that you as an investor may flip through the cash flow statement is quite slim, if not in the probability of one. In fact, the traditional mindset of delving deep into the profit and loss account and the balance sheet, inevitably emerges as an indispensable tool to see the performance of a company.

However, though this information is crucial and cannot be done away with, a study of the cash flow statement of a company can be quite enlightening in terms of its growth path, strength, and a prominently clear and vividly insightful trend that a company follows when it comes to channelising cash it gets access to. Here is an analysis of what the trends are and resulting developments, which you as an investor can read by reading into the cash flows of a company.

The nitty-gritty

You must note that value of a company today is the present value of its expected future cash flows. Therefore, understanding past and current cash flows helps you determine the value of the company. It assesses a company's operating performance and financial condition. Explains Venkatesh Subramanium a chartered accountant, In understanding cash flow you can assess an ability of a company to maintain current dividends and its current capital expenditure policy without relying on external financing.

Cash flows can be generated from three sources: operations, investments, and financing.

What it entails

Cash flows can be classified into two categories: free cash flow and net free cash flow. Free cash flow is the cash flow left over after the company funds all positive net present value projects. Positive net present value projects are those projects (ie, capital investments) for which the present value of expected future cash flow exceeds the present value of project outlays, all discounted at the cost of capital.

In other words, free cash flow is the cash flow of a company less capital expenditures necessary to stay in business. Net free cash flow (NFCF) is free cash flow less interest and other financing costs and taxes. In this approach, free cash flow is defined as earnings before depreciation, interest, and taxes, less capital expenditures. Capital expenditures encompass all capital spending, whether for maintenance or expansion, and no changes in working capital are considered.

Says Subramanium, Investors must note that the basic difference between NFCF and free cash flow is that the financing expenses-interest and, in some cases dividends-are deducted. Another difference is that NFCF does not consider changes in working capital. Net free cash flow gives you an idea of the unconstrained cash ow of the company.

Insights

It is seen that a young, fast growing company may have negative cash flows from operations, yet positive cash flows from financing activities (ie, operations may be financed to a large part with external financing). As a company grows, it may rely to a lesser extent on external financing.

While a mature company generates cash from operations and reinvests a part or all of it back into the company. Therefore, cash flow related to operations is positive

(ie, a source of cash) and cash flow related to investing activities is negative (ie, a use of cash). As a company matures, it may seek less financing externally and may even use cash to reduce its reliance on external financing (eg, repay debts). See charts

The sources of financing the company's capital spending. Does the company generate internally (ie, from operations) a portion or all of the funds needed for its investment activities If a company cannot generate cash flow from operations, this may indicate problems up ahead. Reliance on external financing (eg, equity or debt issuance) may indicate a company's inability of to sustain itself over time.

A company's dependence on borrowing. Does the company rely heavily on borrowing that may result in difficulty in satisfying future debt service

Quality of earnings. It is seen that a large and growing differences between income and cash flows suggests a low quality of earnings.

Cash flow information may help you identify companies that may encounter financial difficulties. A study by Largay and Stickney that analysed the financial statements of the US-based company WT Grant during the 1966-1974 period preceding its bankruptcy in 1975 and ultimate liquidation, noted that financial indicators such as profitability ratios, turnover ratios, and liquidity ratios showed some down trends, but provided no definite clues to the company's impending bankruptcy. It stated that a study of cash flows from operations, however, revealed that company operations were causing an increasing drain on cash, rather than providing cash. This necessitated an increased use of external financing, the required interest payments on which exacerbated the cash flow drain. Cash flow analysis clearly was a valuable tool in this case, since WT Grant had been running a negative cash flow from operations for years.

Proven and acknowledged

The importance of cash flow analysis in bankruptcy prediction is acknowledged by the study by Benjamin Foster and Terry Ward, who compared trends in the statement of cash flows components-cash flow from operations, cash flow for investment, and cash flow for financing- between healthy companies and companies that subsequently sought bankruptcy. They observe that healthy companies tend to have relatively stable relations among the cash flows for the three sources, correcting any given year's deviation from their norm within one year.

They also observe that unhealthy companies exhibit declining cash flows from operations and financing and declining cash flows for investment one and two years prior to the bankruptcy. Further, unhealthy companies tend to expend more cash flows to financing sources than they bring in during the year prior to bankruptcy. These studies illustrated the importance of examining cash flow information in assessing the financial condition of a company.

Though we can classify a company based on the sources and uses of cash flows, more data is needed to put this information in perspective. What is the trend in the sources and uses of cash flows What market, industry or company-specific events affect the company's cash flows How does the company being analysed compare with other companies in the same industry in terms of the sources and uses of funds

To be continued