Saturday, February 14, 2009

Stock Analysis : Cash Flow Statement

Financial statements comprise three things namely Balance Sheet, Income Statement or Profit/Loss Statement and Cash Flow Statement. Experienced and successful investors say that they rely heavily on financial statements when deciding where to invest. Out of all the three statements, Cash Flow Statement is the very important but widely neglected one by beginners / retail investors. In this article, we will see the difference between these statements while explaining in detail about Cash Flow Statement.

Components and Differences

It is a myth that these statements contain some crazy financial stuff that only Auditors can understand, but in principle these statements are copycat to what we do in our family to manage the family budget (The difference is we do not prepare and do not complicate). Then you might ask what the Auditors do? They are of course essential as the companies get involved in too many transactions and also the company has to follow the laws to comply regulations. Now let’s see what they contain and the differences among the three.

All the three statements are inter-related but they are prepared separately to give clear picture to understand the financial health of the company in three different angles. Balance sheet is the statement that shows the overall financial position of the company at any particular point of time from inception. It has two components namely Assets and Liabilities (Just like what are all the assets our family has and what are the loans and other things that we need to repay). Profit/Loss statement includes Earnings and Expenses so that we can be clear about the Net Income. Cash Flow statements give you the detailed picture of both Cash inflow and Cash outflow of a company under three sections namely operations, investing and financing. All the three statements are equally important but Cash Flow Statement is even more important during the crisis times like what we have now.
The simple diagram below shows the relationship among three and components of these statements. You see a brown color stock investor box which shows that proceeds from the stock sales will be shown under financing section of cash flow but the total money raised through stocks will be shown under equity section of balance sheet. Similarly the bond investor’s box explains that proceeds from bond sales go to financing section of cash flow statement and interest paid to the bond holders go to the income statement while the bond debt goes to the liabilities section of the balance sheet. You can think of similar relationships from the diagram between these three statements.

The three green arrows indicate the three sections of Cash Flow Statement which are operations, investing and financing. The yellow part is the components in the income statement.

Why Cash Flow Statement is more important?

Assume a hypothetical situation where you have two neighbors Akash and Nilesh and you are a man with common sense. Akash works in L&T as an Assistant and earns Rs. 300 / day and he is able to meet daily family expenses and other costs but he does not have any major assets and debt. Nilesh earns Rs. 500 / day and he has a house but has taken a loan from HDFC and he is struggling to meet even family expenses. They both come and ask you Rs. 5000 and promise you that they would return it in a month. Who would you believe and give loan? Common sense investors would give it to Akash. In this particular situation, you would not be reading any financial statements to make a decision as you know these individuals and their financial situation. Nilesh might have stronger balance sheet than Akash but Akash has better cash flow and gets your confidence.

It’s the same case in corporate as well where experienced investors give more importance to the cash segment as it is very important for the day to day operations of the company. So, people think it is better to invest in a company which can survive in short term rather than a famous corporate giant who is all set to fail. In my view, you do not need to study complicated books to understand the basic principles which remain the same both at household level and firm level. That’s why legendary investors like Peter Lynch and Warren Buffet say that a guy with common sense will show better returns than many of the Analysts.

Cash Flow Statement

As I have pointed out earlier, Cash Flow Statement includes operational activities, financing activities and investing activities.



The above table is a cash flow statement from Satyam for the year 1999 and is shown as an example. The basic idea remains very simple. We deduct all cash outflows from cash inflows and show the net cash available for the company operations in a Cash Flow Statement. But I will explain one by one with respect to this example. Figures in parenthesis indicate cash outflows and figures without parenthesis show cash inflows.

1. Operating Activities

Section A in the table contains operating income and it starts with net income before interest, tax and after extraordinary items. The operating income usually comes from selling products and services. Since, the net income has been calculated already by excluding extraordinary items like depreciation, and loss on sale of fixed assets; they have added it back to remove the effect. Extraordinary items may include Amortization and many other things (All non-cash items), but in this example they have included only two. Then they have added whatever cash inflow they had and deducted all the cash outflows they had to finally arrive at Net Cash Flow from operating activities which was Rs. 9,782 Lakhs in 1999(Hope it was not a fictitious statement) . In short, operating activity is a Money raising activity.

2. Investing Activities

Investing activities (Section B) include activities that are carried out by the company for future growth either upgrading facilities or buying equipments or fixed assets. I am not going to explain what is in the table again. But the idea under this section is again to calculate the amount invested for the company and income if any and then arrive at net investment amount which stood at Rs. 16,574 Lakhs.

3. Financing Activities.

All the items related to the core finance come under this category in Section C including loans companies get from banks, raising money through stocks sale, IPO, dividends etc. Here too the idea is to calculate the net amount raised by deducting outflows from inflows. In the example Satyam had raised Rs. 9,302 Lakhs in 1999 through financing activities. This is again a Money Raising activity.

Finally to arrive at Net Cash / Cash Equivalents, you add Section A and Section C. In this example it was Rs. 19,084 Lakhs (Rs. 9782 + Rs. 9302). Then deduct the amount invested for that year from Rs. 19,084 Lakhs which is Rs. 19,084 – Rs. 16,574 = Rs. 2,510 Lakhs. This is the amount you are seeing in the example as well. Since they had Rs. 1,317 Lakhs from the previous year, you are seeing that amount added to this Rs. 2,510 Lakhs to get the final Cash / Cash equivalent of Rs. 3,827 Lakhs.

Cash Flow Statement and it’s relevance to the Stock Investment

We have discussed sufficiently about the basics of cash flow statements. But how it is relevant to our stock investment stand point? In fact I would say Cash Flow is the first important thing in the business without which no one could have started the business. Earnings are important and people value companies based on that. But not many think how a company managed to earn that money? A company with better cash flow in general would generate good earnings and that’s why experienced people go to the root of the problem. In some cases it might not be true (Initial Days, Capital Intensive Business). Company with a better cash position can outsmart peers and can take advantage of special situations.

For example Reliance Capital was late in to the Brokerage business, but they are threatening to rule the brokerage world just by virtue of having more cash flow. I do not think any other brokerage firms would have attained the same growth.

Another example is our fallen baby Satyam (Illegal outflow and Cash inflow shrunk). A company can be worth Rs. 50,000 crores but if it does not have Rs. 500 crores for day to day operations, then it will become bankrupt and is of no worth.

Subhiksha is a success story and within 10 years, the company fetched Rs. 1,500 crore value, but what happened now is a story well known to everyone. Company is in bankruptcy situation. So, cash flow is an important thing that you have to look in to while valuing a company or stock. Of course you have to study the balance sheet as well. Cash flow statement combined with balance sheet might give you a better idea about value when you compare a company and its peers. There are few ratios which you can look at if you do not study the entire statement.

Ratios

1. Price to Cash Flow Ratio
This ratio is similar to our PE Ratio but many think that PC Ratio is more reliable than PE Ratio. PE Ratio can be easily manipulated as it includes non cash items, depreciation etc. while same cannot be said about PC ratio. I do not know which side Raju has manipulated, but in general it is very hard to manipulate the PC Ratio.

Price to Cash Flow Ratio = stock price per share divided by Operating Cash Flow per Share

where, Operating Cash Flow per share = Net operating Cash Flow / Number of Shares

Example: Assume Yes Bank has Rs. 900 crore cash flow and it has 300 crore shares. Then operating cash flow per share would be Rs. 3 and it’s Price to Cash Flow Ratio would be 20 (60/3) based on the current stock price. Like PE Ratio, the interpretation remains the same. Lower the PC Ratio, better the stock value and it is a nice tool to have when you compare companies in the same sector or peers. In spite of the importance, PE Ratio rules the world.

2. Price to Free Cash Flow
It is a similar ratio with stringent guidelines.

Price to Free Cash Flow Ratio = Company Market Capitalization divided by Free Cash Flow

where, Free Cash Flow = Net Income + (Depreciation and Amortization) – (Changes in working Capital + Capital Expenditure)

Higher the P/FCF value, more expensive the company is.

These are the two important ratios which broking firms calculate but you can calculate your own ratios based on what importance you attach to different things.

For example you can calculate Cash Flow to Debt ratio or Cash Flow to Long Term Debt Ratio along the similar lines. But the basic idea remains the same across all the ratios which is better the cash position, better the value.

Conclusion: Cash Flow Statement is as important as balance sheet and PL Statement and serious investors should give at least a glance while making larger investment decisions. This does not mean, companies with better PE and PC ratio will always give you great returns but it is one among various measures you can use to evaluate a company so that you can eliminate the risk to a certain extent. I will try to explain balance sheet ratios and PL statement in another article. Thanks.

Kumaran Seenivasan
seenivasankumaran@gmail.com



7 comments:

Chirag Ali,  November 26, 2009 at 1:02 AM  

Dear Kumaran

Excellent and Lucid article.I can understand how much hardwork you put to write this article and i appreciate your effort.Thanks indeed

Chirag Ali

karuppiah December 17, 2009 at 12:22 PM  

Its a nice article. Thanks!!
Even after reading it I am finding it difficult to get the practical relevance of these numbers. It would be great if you can explain the numbers with some scenarios, like the Akash and Nilesh story. Thanks again!!

karuppiah December 17, 2009 at 12:23 PM  

one doubt.. How the cash flow from Investing activity can be negative? Either the company can invest if it has money or it cannot invest and it has to zero. Please clarify.

Raja August 7, 2010 at 4:15 PM  

Hi Kumaran

I desperately want to learn from this post. But the size of the image containing the cash flow stmt is not readable. Can it be enlarged at least it be enabled for save to computer ?

Regards
Raja

Kumaran August 7, 2010 at 9:21 PM  

Raja,

The post is applicable to most of the cash flow statements. If you are not able to see it, please download cash flow statement for any other company and try.

-Kumaran.

Raja August 8, 2010 at 2:27 PM  

Thanks Kumaran,

I like your blog. Gr8 things to learn from you as a person and as an investor. Currently reading all your past posts.
Do visit my organic kitchen gardening blog sometime :)

Regards
Raja

Chandu October 31, 2010 at 4:45 AM  

Excellent and simple.... good one to look into if you are really not aware of any basic facts of investing.... :) Thanks for the very useful and imp info...

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