“There is a huge difference between the business that grows and requires lots of capital to do so and the business that grows and doesn’t require capital.”

—Warren Buffett, from Warren Buffett and the Interpretations of Financial Statements

Cash is king, and Buffett has built quite a kingdom, with the latest balance sheet reporting that he has $128 billion at his disposal.

The cash flow statement is one of the required reports for financial reporting for all publicly traded companies. Still, it is probably the most misunderstood of the big three and beyond calculating free cash flow.

There is a wealth of information contained in this statement, plus there are all kinds of ratios we can use to unlock that information to use for our gain. We can find the liquidity of a company, capital expenditures, and much more.

Want to find out how much a company spent on dividends or share repurchases? It is all there on the cash flow statement.

Running a cash flow analysis and determining where the money went is a little like we do every month, wondering where that $20 bill we had in our wallet went? The same applies to the cash flow statement; we can work down the list and discover some gems to help us determine the financial health of our company.

Determining where the cash went is essential, as well as for deciding what kind of free cash flow is available to use for other opportunities for reinvestment or purchases.

With the goings-on in the market as relates to the global pandemic, there has been a returned focus on companies’ balance sheets, and rightfully so. But a cash flow analysis can help you just as much, and frankly is not that difficult.

In today’s post, we will:

• Determine what a cash flow analysis entails
• Discover the difference between accrual and cash accounting
• Uncover the three different sections of the cash flow statement
• Discuss useful ratios to utilize to discover the financial strength of your company.

What is a Cash Flow Analysis?

A statement of cash flows shows us how a company spends its cash (outflows), and where a company receives its money (inflows). The cash flow statement includes all the sources of cash inflows a company will receive from operations and outside investment sources. Additionally, it will consist of all of the cash outflows that pay for activities and reinvestments during each period.

Cash flow analysis is the examination of a cash flow statement and analyzing all the inflows and outflows of cash from the business. A cash flow analysis will examine inflows and outflows from operations, financing activities, and investment activities.

In plain English, it means that we are examining how a company makes money, where the sources of cash are coming from, and what it means to the value of the company.

Before we start diving into analyzing a cash flow statement, we need to have a word about accounting. It won’t be boring, I promise.

Accrual vs. Cash Accounting

In accounting, there are two types of using the data to create our reports.

• Accrual accounting
• Cash accounting

Let’s discuss accrual accounting first.

Most companies use the accrual accounting method and is the method where revenue is reported as income when it is earned as opposed to when the company gets paid. Expenses are recorded when they happen, even though the expense has not been paid for yet.

For example, if we sell an iPhone, we record the income on the income statement even though we haven’t been paid for the phone yet. From an accounting standpoint, the company would earn a profit from the sale and pay taxes on the sale. However, no cash has been received. Another point is that there would be cash outflows initially because money needs to be spent on buying inventory and on making the iPhone.

Most companies extend credit to their suppliers to pay their invoices, with the standard terms being 30, 60, and 90 days, depending on the industry and relationship with the supplier. And this sale would be an account receivable on the balance sheet with zero impact on the cash until it is received.

Cash accounting is the other method of accounting. In the cash accounting method, you account for the sales when they are received and the expenses when they are paid.

On the income statement, a company’s profit is listed as net income; it is considered the bottom line for all companies. However, because of utilizing accrual accounting, not all net income means that all receivables have been received from their customers. In other words, even though the company is listing a profit, there still may be monies owed to them from distributors that have purchased their product but have not paid for them yet.

From a financial accounting standpoint, the company might be profitable, but if the receivables are not paid in time or are never collected, the company could have financial issues. Even the best companies can struggle to manage their cash flow adequately, which is why doing a cash flow analysis is a critical tool to have in our toolbox when evaluating companies.

Ok, now on to the three sections of the cash flow statement.

The 3 Sections of the Cash Flow Statement

The cash flow statement has three distinct sections, which are broken out into three particular components.

• Operations
• Financing
• Investments

Each of these segments has a particular impact on the business. We will discuss each section in turn.

Cash Flow from Operations (CFO) – This section records the net income from the income statement. Items included in this section are accounts receivable, accounts payable, and income taxes payable.

Cash flow from operations is the lifeblood of the business; it proves that positive cash flow can sustain the company before making any long-term investments, such as buying a new production plant.

In this section, we start with the net income and then make adjustments as cash changes hands. For example, if a supplier pays a receivable, it would be recorded as cash from operations. Changes in current assets and current liabilities are recorded here in the cash flow from operations.

Cash Flows from Investing Activities – In this section, cash flows from sales and purchases of long-term assets like property, plant, and equipment or PPE, we can include things like vehicles, buildings, land, and equipment.

Typically, when buying fixed assets like PPE requires a capital expenditure, which is considered a cash outflow. Included in these transactions are things like buying a new production plant and investment securities.

Cash inflows would flow from the sales of these assets such as fixed assets, business segments, or whole businesses, and the selling of investment securities.

Of particular interest in this section is the cash outflows for capital expenditures for maintenance, or purchasing of physical assets that support the continued success of the business.

Basically, this section outlines any cash paid out to invest in the business.

A note about free cash flows, the item capex, or capital expenditures is found in this section. To quickly calculate free cash flow, you can take cash flow from operations and subtract the capex from the investing section. Of course, we can get more granular, and we will uncover more in the upcoming section, but this is a quick and dirty way to approximate free cash flow.

Cash Flow from Financing Activities – the home of debt and equity transactions is cash flow from financing activities. Here we will find cash outflows for dividends, share buybacks, and purchases of bonds. We will also see cash inflows from the sales of stock. Any monies received from taking a loan or any cash the company used to pay down long-term debt will be recorded here.

For those of us who are dividend investors, this section is of importance because we can see cash dividends paid, and not the net income used to pay for the dividends. That is of concern because we want a company that can sustain its dividends from operations of the business, as opposed to taking on more debt.

For investors, this is probably our favorite section because we can see equity being returned to us, via dividends or buybacks and the source of those equity returns.

Ok, now that we have covered the basics of the cash flow statement, let’s move onto analyzing the cash flow of a business.

For more info on the cash flow statement, specifically on some of the more important line items, check out this great article by Cameron Smith.

Cash Flow Ratios Everyone Should Know

Analyzing the cash flow statement is usually pushed down to the last item to do, but let’s take a look at some ratios that can help us define the financial health of a business.

I said earlier that cash is king, keep in mind that earnings grow from cash, not the other way around. Wall Street focuses much of its attention on earnings and not cash when it should be the other way around.

When we analyze the cash flow statement using ratios, it is crucial to compare similar companies to each other, in other words, apples to apples. Using those kinds of comparisons will give you some anchors to tell whether or not that is a good number; in a vacuum, it is too hard to say.

Most financial experts define cash flow as the net cash with depreciation added back in. It is better to use the net operating cash flow from operations and add back the capex, as depreciation is a non-cash charge.

Ok, enough talk, let’s get to the ratios.

A note before we proceed, you can substitute free cash flow for any of the other cash flows in the following ratios.

The first ratio is:

Operating Cash Flow Ratio – With this ratio, we can determine how many dollars of cash we get from our sales. Unlike most balance sheet ratios, there is no defined “good” number to be above or below. Typically, we want a higher ratio than a lower one.

Operating Cash Flow Ratio = Cash Flows From Operations (CFO) / Sales (Revenues)

Ok, let’s use Visa to continue our exploration of their cash flow statement.

To find the sales, we are going to look at the income statement from their latest 10-k.

And the net cash flow from operations.

Our numbers for our ratio then:

• Sales = $22,977
• Cash flow From Operations = $12,784

Before we go, a note that all numbers will be listed in millions unless otherwise stated.

Back to our ratio:

Operating Cash Flow Ratio = CFO / Sales
Operating Cash Flow Ratio = $12,784 / $22,977
Operating Cash Flow Ratio = 55%

So for every dollar of sales, we produce $0.55 of operating cash flow, pretty impressive!

Quickly, I will put together the last two years of the same ratio to give us some context.

• 2018 CFO Ratio = $12,941 / $20,609
  • 2018 CFO Ratio = 62.7%
• 2017 CFO Ratio =  $9,317 / $18,358
  • 2017 CFO Ratio = 50.8%

Ok, that gives us an idea of how Visa has done creating cash flow from its sales over the last three years. Later we will compare all of these numbers to Mastercard to get a reference point.

Asset Efficiency Ratio

Remember Return on Assets? This ratio is similar, except we use cash flow from operations as opposed to net income. Using this ratio will tell us how a company uses its assets to create cash flow. It is best to use this ratio over a longer time to get a feel for the use of assets.

We already have our cash flow from operations, so now I will go to the balance sheet for our total assets.

Asset Efficiency Ratio = Cash Flow from Operations / Total Assets

2019 Asset Efficiency Rato = $12,784 / $72,574
2019 Asset Efficiency Ratio = 17.61%

Now, I will do the ratio for the last five years to give us a little historical perspective.

• 2018   18.69%
• 2017   13.71%
• 2016   8.7%
• 2015   16.72%
• 2014   18.68%

It looks like it has been pretty consistent over the six years, with one odd number in 2016.

Current Liability Coverage Ratio

Excellent ratio to test for solvency, another simple ratio, this ratio tells us about the company’s debt management.

For this ratio, we are going to use our cash flow from operations, as before, but we are going to subtract dividends paid to give us a more accurate picture of the operating cash flows.

Current Liability Coverage Ratio = ( CFO – Dividends Paid ) / Current Liabilities.

So we go back to the cash flow statement to find the dividends paid under the cash flows from financing section and then back to the balance sheet for the current liabilities.

Cash for dividends paid = $2,269

Current Liabilities = $13,415

We are plugging in our numbers for our formula.

Current Liability Coverage Ratio = ( 12784 – 2269 ) / 13415
Current Liability Coverage Ratio = 78.3%

Now, I will put together the same ratio over the last four years so we can get a flavor of their coverage ability.

• 2018 97.5%
• 2017 77.4%
• 2016 52.4%
• 2015 100.1%

The higher the number, the more we like it, if it drops below 100%, it is unable to pay for current liabilities, and this is a more accurate indicator of the company’s ability to pay its current liabilities than either the current or quick ratio.

We can use the same ratio with short-term debt and free cash flow. And this ratio is a great way to analyze the short-term stability of a company; for example, this would be an excellent ratio to deploy during this current market volatility.

Long-Term Debt Coverage Ratio

If we are going to measure short-term liabilities, we might as well look at a ratio for the long-term debt. It is a great practice to split the two liabilities short-term and long-term debt to get a real sense of what is owed short-term and long-term.

The higher the number, the more cash is required to pay off the debt from operations.

Long-term Debt Coverage Ratio = ( CFO – Dividends ) / Long-term Debt

We will go back to the balance sheet for the long-term debt, the other number we already have.

Long-term Debt Coverage Ratio:

• Cash From Operations – $12,784
• Dividends Paid – $2,269
• Long-term Debt – $16,729

Long-term Debt Coverage Ratio = ( 12784 – 2269 ) / 16729

Long-term Debt Coverage Ratio = 62.8%

Interest Coverage Ratio

The ratio above will tell us the ability of the company to pay its interest payments on its current debt. A company that is highly leveraged will have a low multiple, and a company with a superior balance sheet will have a higher multiple. If the interest coverage is less than one, then the company is running the risk of default.

Interest Coverage Ratio = ( Cash from Operations + Interest Paid + Taxes Paid ) / Interest Paid

We return to the cash flow statement for all the data for this ratio.

Numbers for our ratio:

• Cash flow from Operations – $12,784
• Interest Paid – $537
• Taxes Paid – $2,648

Now plugging in all the numbers:

Interest Coverage Ratio = ( $12,784 + $537 + $2,648 ) / $537
Interest Coverage Ratio = 29.7x

The above calculation tells us that Visa has 29 times the cash flow to meet its interest payments.

Cash Generating Power Ratio

Have to love the name of this ratio, something right up Andrew’s alley.

The above ratio is designed to illustrate the company’s ability to create cash solely from operations when compared to the total cash inflow.

The twist on this one is that we use the inflows of cash from the investing activities and financing activities, as opposed to total cash.

I will use Visa’s cash flow statement to illustrate how this works.

Cash Generating Power Ratio = Cash from Operations / ( CFO + Cash from Investing Inflows + Cash from Finance Inflows )

Our numbers from the cash flow statement:

• Cash from Operations – $12,784
• Cash from Investing Inflows – $4,018
• Cash from Finance Inflows – $162

Cash Generating Power Ratio = $12,784 / ( $12,784 + $4,018 + $162 )
Cash Generating Power Ratio = 75.2%

Let’s look at the next four years to get a five-year snapshot of the ability of Visa to generate cash.

• 2018  77.29%
• 2017  64.33%
• 2016  18.28%
• 2015  72.24%

You can notice as we look at the inflows of cash into Visa that they are surviving on their cash from operations, which is very comforting.

External Financing Index Ratio

The financing ratio tells us how dependent a company is on financing for its cash flow.

It compares the cash flow from financing to the cash flow from operations. The higher the number, the more dependent on financing the company is, and some of the most reliable companies will have negative numbers; they can pay back all of their financing from net cash, such as dividends and debt. In this case, the ratio will be negative, which is a good thing.

External Financing Index Ratio = Cash From Financing / Cash from Operations

Numbers from the cash flow statement:

• Cash from Operations – $12,784
• Cash from Financing – -$12,061

External Financing Index Ratio = -12061 / 12784

External Financing Index Ratio = -94.7%

Now that we have had a good rundown of some useful ratios for analyzing the cash flows of a company. Let’s take a look at a comparison by using the same numbers from Visa, and I will compare them to Mastercard to give us an idea of the strength of either company.

Using the chart above, we can see that both Visa and Mastercard have strength in their cash flow, and based on the analysis using our ratios, we can see that Visa has superior operating cash flows, current liability coverage, and external financing and the others are strengths of Mastercard.

Doing this kind of analysis is a great exercise to dig deeper into the numbers of any company you are investigating.

Final Thoughts

The ratios that we have learned today are all somewhat straight forward and easy to navigate. Doing this kind of cash flow analysis is another skill that we can add to our arsenal of investigative tools when looking at each section of the financial statements.

I would strongly encourage you to add this list of ratios to your investment checklist as you work through a company to discover its strengths and weaknesses.

Every company will have its strong points and weak points; our job is to uncover those in a systematic, rational way. And using a cash flow analysis is a great way to discover the ability of a company to grow, use, and generate more cash from its operations, financing, and investments.

Remember that cash is king, and the stronger the cash generation, the stronger the company.

Your homework is to do five cash flow analyses of any companies you wish and email them to me, and I will check your work.

I want to thank you for taking the time to read this article, and I hope you find some value in it to help you with your investing journey.

If you have any questions, please don’t hesitate to reach out.

Until next time, take care and stay safe,

Dave