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Net Cash: Simplest, Most Crucial Part of the 10-k’s Cash Flow Statement

Unfortunately, specific information on how the derive the net cash from a 10-k’s cash flow statement is practically missing from the internet right now. Let me debunk all of the confusion and options surrounding cash and cash flow analysis, explain the definitions, and tell you why I think the popular opinion of using cash flow to determine intrinsic value is flawed.

net cash

There’s various definitions of net cash online, like Investopedia’s “total cash – total liabilities”, or Business Dictionary’s “cash on-hand – current liabilities”.

You can see that immediately, the specific definition of net cash is debatable. We see a commonality between the top two results on Google, but the fact that there’s a discrepancy between either representing total or current liabilities means the definition of net cash may be different depending on who you talk to.

It’s not like net income, which everyone defines as revenue minus expenses. Or shareholder’s equity, which is specifically defined as total assets minus total liabilities.

Also understand that net cash is a different definition of net cash flow. Net cash flow refers to the change in the cash balance between 1 year to the next. I understand this is starting to get really confusing, especially because the word “cash balance” and “net cash” aren’t actually on the 10-k annual report for every company. Let me take the biggest company right now, $AAPL, and show you their cash flow statement and define these terms based on that.

cash flow statement example

Now, when I say cash balance, I’m talking about the “cash and cash equivalents, beginning of the year” and “cash and cash equivalents, end of the year”. You can use either one of these, depending on which year you are looking at. Notice the beginning of the year cash balance for 2016 is the same as the end of year cash balance for 2015. This makes sense, we are just reporting how much cash a company has “in the bank”, or the cash balance.

Net cash flow is the change in the cash balance between the beginning of the year and the end of the year for the same year. You can see they put this number as “Increase/(Decrease) in cash and cash equivalents” on the 10-k, near the bottom of the page.

Another way to calculate net cash flow, which is a good sanity check to help us understand exactly what is going on with the cash flow statement, is to add all 3 of the following metrics:

  • Cash generated by operating activities
  • Cash used in investing activities
  • Cash used in financing activities

Now let me explain each metric in the simplest of terms.

Operating activities describe the core of a business. It’s what you would think when you just look at how a company produces its profits. For a retail store, this could be the sales brought in minus the cost of employees and inventory. I’m using a basic definition and it’s a little more involved than that. But you get the point.

Investing activities describe how the company “invests” in its business for the future. This can include buying income producing assets, acquiring another company, and buying and selling its own stock or the stock of other companies. Think of Warren Buffett’s Berkshire Hathaway as a company who buys a lot of other companies shares. Insurance companies do this often too.

Financing activities describe any changes in debt, includes the dividends paid out to company shareholders, and includes the cash a company receives from diluting its shares (issuing more stock). You can see in this example that Apple both paid off some long term debt and received some cash for getting into more debt. As long as debt levels are low, this isn’t much of a problem.

Cash Flow Statement Takeaways

A negative number for operating activities can indicate severe problems within a business. In this case, the company’s core business model is likely failing. This can be due to a lack of demand or too many expenses just for the running of the business, either case isn’t a good sign.

You’ll notice that there are negative numbers both for investing activities and financing activities. This isn’t necessarily a bad thing, as there a lot of factors that would cause a company to report these as negative. In a basic sense, a highly negative investing activities number could indicate a company that is investing greatly in its future.

A highly negative financing activities number could just mean the company is rewarding its shareholders with dividends and little dilution of stock, which makes the value of the stock you (as shareholder) hold higher. Of course, a highly negative financing activities number could also indicate a company loading up a lot of debt quickly– which is highly concerning.

Don’t worry.

I won’t go into each specific possibility, because that would be largely time consuming and useless. The most important takeaway from all of this is that as long as the “cash and cash equivalents at the end of the year” is sufficiently high enough for us, the extent to which the numbers from these 3 categories are high or low doesn’t bother us.

It’s simple and effective and I’ll explain in a bit.

We want “cash and cash equivalents at the end of the year” to be sufficiently high because this effectively shows that the company has an “emergency fund”– enough cash to keep the business running or afloat during years of suboptimal earnings.

In personal finance, it’s always recommended you have some money as a cash balance in your checking account to support you through a layoff or major expense (repair, medical, or otherwise) without forcing you to go into a lot of debt.

With companies, it’s the exact same way. A high cash balance indicates an adequate emergency fund for the company. A low cash balance won’t be bad for a company when things are going smoothly, but as soon as their core business model performs poorly (even temporarily), there are going to either take on more debt or slow the growth of buying income producing assets.

While many investors care about net cash flow (remember the change in cash balance), I don’t because I really don’t care how much they change the cash balance year to year. Even a big negative move in cash balance for one year isn’t necessarily concerning– especially if the company had a large cash balance and will continue to have a sufficient cash balance.

In the same token, just because a company has a large net cash flow in one year, that doesn’t necessarily mean good things for the business. Maybe they had such a low cash balance that even increasing it wouldn’t create a sufficient buffer or “emergency fund”… or maybe it indicates a company that doesn’t see any good ROI on additional investments inside or outside the business.

So I care much more about cash balance at the end of the year. Which brings us back to the definition of net cash. My bold claim is this:

Net cash = Cash and Cash Equivalents at the End of the Year

My reasoning behind this is that if you define net assets [total assets minus total liabilities], it’s talking about the positive balance of a company’s assets. You can also call this or compare this to a company’s net worth, again “net” implying the positive difference.

If you define net income [Revenue – Expenses], you are defining the positive balance of a company’s income. Looking closely at an income statement will show you that this net income number is an after tax figure. Again, similar to the personal finance definition of “gross” and “net”, with the “net” referring to the positive balance of income after taxes are taken out.

So, why is net cash widely defined as having anything to do with liabilities. It should be the positive balance of the “cash”. We’ve already defined the cash balance to be “cash and cash equivalents at the end of the year”.

It simply makes sense this way.

When you talk about current and total liabilities, it is talking about what a company owes… but it’s not directly talking about the impact to the cash balance immediately. There can be current liabilities that are due in 3 or 6 months, but the cash isn’t yet taken out of the company’s cash balance.

So if we are talking about strictly cash, it shouldn’t include liabilities because they haven’t hit the cash balance yet. “Net cash” should be talking about the cash a company holds right now, which when you are reading the annual report will simply be end of year cash and cash equivalents.

I digress….

How to Determine Sufficient Net Cash

We’ve now defined the basics behind the cash flow statement, the difference between cash and cash flow, and the definition of net cash. So now let’s examine its practical application.

Like most financial data figures in an annual report, we want to compare the numbers to a company’s share price. This will help us compare companies regardless of their size, and will signal any red flags of low net cash.

The ratio I use to do this is the price to cash (P/C) ratio. Again, the internet definition [or lack thereof] for this ratio concerns me. The search results of “P/C ratio” only bring up the put call ratio used in options trading. And a search of “price to cash ratio” brings up a bunch of definitions for price to cash flow ratio. We’ve already determined that we don’t care much about cash flow.

But, a company like FINVIZ does define the P/C ratio– and they do so as the price divided by the cash. Which is how I define it too.

P/C ratio = Market Capitalization / Net Cash

If you aren’t aware, market capitalization is used as “price” because it is just the share price multiplied by the shares outstanding. It gives us the total value of the market price.

The price to cash ratio will ideally be below 10, but it isn’t much concerning above 10 and below 20, or even around 25. I use this ratio like I do all of the other price-based ratios. We are using all of the ratios combined not to get a certain number-defined valuation, but to make sure the company is fairly priced on a variety of valuation metrics.

This idea is somewhat contrarian. I personally don’t care if a company is really strong on one or two metrics, because if the company is extremely overvalued on even just one of the metrics from the 3 financial statements, it could potentially be hiding its problems and propping up other categories to look good. Propping up is often done with earnings, which is the most widely looked at metric on Wall Street.

So, I’m just scanning the P/C ratio to make sure it isn’t at like 50 or 100. If the P/E and P/B are below 2 and the P/C is at 100, we instantly know that the company has a lot less net cash than its shareholder’s equity and net income. This indicates a low cash balance and small “emergency fund”.

That’s simply it. We’re checking a company to make sure net cash isn’t too low. It’s nice if a stock has a lot of cash [a super low P/C], but that alone doesn’t make it a good buy.

Which brings me to the problems with popular cash flow analysis.

Less Important Cash Flow Metrics

A big portion of the investing community uses the cash flow statement when determining a company’s valuation or intrinsic value. I respect many successful investors who do this.

Many famed angel investors and “sharks” use cash flows to determine a specific valuation for a business. And there are “time valued” approaches to even basic investment calculations, such as estimating a range of ROI and examining the change in cash flow from the investment.

Cash flow analysis may also be useful in more accurately analyzing low capital intensive businesses or businesses that don’t require a lot of assets to be successful.

I choose not to play.

My reasoning again is because I don’t like to laser focus on one or two metrics to make a valuation edge. Rather, like Buffett, I’d prefer to “buy a wonderful company at a fair price” instead of buy “a fair company at a wonderful price”. This means just screening to see if a company has any red flags from a valuation standpoint. If not, it may not be heavily discounted but it likely is fairly priced.

Secondly, a cash flow analysis may be more important to a fledgling startup competing in a fiercely competitive marketplace with no recourse to raise capital through selling more shares or take on big loads of debt quickly. Conversely, a publicly traded company can do such a thing.

An investment in a startup is inherently way more risky than a large public corporation, and thus high increasing cash flows may be the best evaluation for reducing downside risk, especially in “David vs. Goliath” situations.

Common analyses for angel and startup investors– and credible value investors– may be a DCF valuation or focus on operating cash flow. A more cut to the chase analysis, especially for a company with limited investing and financing opportunities or no dividends paid to owners. But again, little to no regard to the net cash balance.

Thirdly, it’s true that cash flows would be better indicators of success for a company with little assets. But there are provisions to publicly traded companies like this, such as goodwill on their balance sheet. If the estimation of a company’s business is too small compared to its cash flows or earnings numbers, I see that as more of a red flag than an opportunity. There should be some sort of balance.

I mean isn’t there a severe assumption of risk in a company with little assets but large revenues and earnings? Think about a company like Clorox [with a current P/B over 60] suddenly losing major demand to a competitor with better technology or sudden viral marketing. With little net assets, the company– after paying its liabilities– would leave little to no value to shareholders.

And…

Using net cash and the P/C ratio is the simplest use of our time. If the whole point of cash is to give a cushion, then it makes sense that we should focus on the cash balance.

We’ll use other metrics to ensure a company is growing sufficiently. And if a company is using too much debt to finance that growth, we’ll quickly see it in the change of shareholder’s equity.

Remember, always use all 3 financial statements: income statement, balance sheet, and cash flow statement… and its crucial metrics: revenue, net income, shareholder’s equity, long term growth, total liabilities, dividend paid, EPS, and net cash.