Welcome to session 17 of the Investing for Beginners podcast. In today’s session, we will be discussing a very interesting topic that is near and dear to my heart, an in-depth analysis of the cash flow statement. If you are not an accountant, never fear because this will help explain some of the terms and give a better explanation of how they function.
In today’s session we will learn:
- What a cash flow statement is
- How it relates to the other financial statements included in the companies 10-k
- Breaking down the sections of the cash flow statement
- Highlighting some of the important line items to look for
- The differences between free cash flow and net cash
In this session, we are going to talk a little bit about Berkshire Hathaway, in honor of the recent annual meeting that they hold every year. We will look at how Warren Buffett, the master, lays out his cash flow statement.
Andrew: I think it’s important to understand where the cash flow statement lands when it comes to the financial statements in general. Every company needs to submit an annual report, and this is any company that is listed on any us stock exchange, they are all regulated by the SEC and are all required to submit what’s called a form 10-k. Which is an annual report, it shows the past three years of financial data on the income and the cash flow, and then the last two on the balance sheet.
When you hear these different statements that we are referring to. there are three major ones that are broken down into an income statement, which let me explain in a simple way what each of these three mean.
There is an income statement, balance sheet, and a cash flow statement. A great way to understand what happens on a business level is to compare to how it happens on a personal level because we all know how the personal level of finances work because we all live it. When you look at an income statement that’s the same as looking at someone’s tax return. What’s going to be on an income statement is how much money somebody makes as a salary from their job. Simple enough, really when you look at companies in the stock market, it’s the same way. It’s calculating how much they are earning every single year; it factors things like taxes, other accounting terms like depreciation and interest and all those types of things.
At the end of the day, you have this thing called the bottom line, and that’s the called the bottom line. Or another way to say profits, and it’s the bottom line on an income statement. That tells you how much a company earned, what their profits are and it’s the same way with you in your life. How much you bring home from your job, you can think of your gross income as what the revenue row is on the company’s income statement and then however much you pay in taxes. Then you have a net income, and that’s the same as the net income on the company’s income statement.
The next one would be the balance sheet if you think about a balance sheet for a company it is the same as a persn’s net worth. If you the person would add up everything you own minus all of your debts that gives you your net worth. Let’s say you have a spreadsheet; you have your house on there, the resale value of your car, and then maybe a couple of brokerage accounts, maybe a savings account or two, maybe a couple of retirement accounts. Then you have your debts, credit card, student loan, home equity line of credit and add all those things up on a spreadsheet they make your assets minus your liabilities which equals your net worth.
For a company it is the same way. They have a balance sheet, and there are all these different rows and columns, and all these different numbers. If you look closely enough, you will see it has the same concept as if you were making a spreadsheet at home. You have a row that’s called total assets, and then you have a row called total liabilities. Then when you subtract the total liabilities from the assets, you get what’s called shareholder’s equity. And that can be seen as the same as the net worth of a company.
If the company were to close tomorrow, basically they would take all their assets, and they would sell them off and pay off all of their liabilities. Whatever was left would be distributed out to all the shareholders. When we talk about Benjamin Graham and value investing, intrinsic value and then finding a margin of safety, emphasis on the safety. And that margin is the difference between the intrinsic value.
We start by using the price to book value, or book value is the same as shareholder’s equity. Because it is on the most basic level a way to show what a company is worth, because of that exact scenario. If you were to liquidate a business and sell everything off just like if somebody were to pass away and their estate were be divided up. The debts would be paid off, and the rest is distributed out. Bottom line, the balance sheet is the same as the net worth of a company and the same as the net worth of an individual. It is a great basic way to figure out what a company is worth, what they own, what they owe.
The last one that we want to focus on today is the cash flow statement. In a sense, this one is more like your checking account. You have your earnings that are coming in from your job, things go in and out of your checking account, but you always need to have some liquidity in your checking account. Because if all your bills come due at once and then you don’t have enough money in there, you are going to have a liquidity problem.
This is what they have in the stock market with businesses. When businesses don’t have cash, real live, cold, physical cash. Then they often have to take on a lot of debt to get cash quickly, and in some cases, you’ll see companies go bankrupt because they have these short-term liquidity problems. The cash flow statement can tell you exactly what the cash balance is in the account. What their checking account balance is. And it is also a good indicator, in a way it can sometimes indicate what’s going to go on in the income statement. If you have a couple of good years of cash flow, sometimes that can indicate you’ll see it reflected in the earnings a year or two later. It’s one of those accounting things I don’t want to get into.
I like to look at the cash flow statement as a checking account, and I am going to tie it into the end and why it makes my philosophy about the cash flow statement different than a lot of the investors out there. A lot of really respected investors and successful investors use the cash flow statement to predict either the value of the business or the value of how much cash they’re going to get into the business, and they will use that to predict where earnings are going to go. And what kind of growth you are going to see.
I’ve talked about before how on Shark Tank this is something they like to do a lot. It works well, particularly with businesses that are growing. And again, if you want to go to the blog and check out one of the articles I did about net cash. I go in depth and into detail about how for growing, small companies, companies in that growth stage use their cash flow statement as a valuation metric can be beneficial to people in that stage.
But I take a different stance when it comes to looking at the cash flow statement overall. And seeing it as more of a checking balance than as a predictive measure. That all said, we are still going to cover in a general way and kind of a step by step approach but try to keep it simple as I have just known.
So that you can pull up a cash flow statement on your own at home and not feel completely overwhelmed. All those lines of jargon and numbers can be completely overwhelming if you don’t understand how it works and ties together. Today we’re going to try to create a guide map for you today.
Dave: I like how you put that, I think a guide map is something that is critical to something like this. I know for myself when I started to try to work through these documents myself, it was confusing. There is a lot of accounting and makes me wish I paid more attention in my accounting classes in college.
But when I started reading through these, it was one of those situations where I had to look back at what each term meant. Eventually, you get to the point where you understand what the terms mean and how they work.
One thing that I wanted to add to everything that Andrew was laying out about how the statements work. Think of them all flowing into each other. The income statement flows into the balance sheet flowing into the cash flow statement. One kind of feeds into the other, one thing that I like to keep in mind with the balance sheet is when you are looking at those numbers, and they are kind of big numbers. The balance sheet is a snapshot of the value of the business for one day.
The income statement and cash flow statements are living breathing entities, but the balance sheet is a stable, static one day look the value of the business. Even though it is an annual statement, it is more of a snapshot of the business for that particular day when they filed this report. The cash flow statement is a living, breathing thing just like our checking accounts are, I think that is a great analogy that Andrew used.
The cash flow statement is broken up into four different parts. We have cash flows from the operating activities, investing activities, financing activities, and finally cash and cash equivalents at the end of the year. The parts in between those I am going, being honest with you, they can change from company to company.
Although every company has to file these reports with the sec, they don’t all break them down as minutely or as clearly and concisely as Berkshire Hathaway do. Warren Buffett and Charlie Munger are fastidious about this kind of thing, and they are very active about making sure that they break everything down and it’s, to use a political term that is very popular lately it’s very transparent. They try to make sure everybody understands this is where the money is going and what it is being used for.
Buffett and Munger understand we as shareholders have the right to see what is going with our money when we invest in Berkshire Hathaway. There are two shares of Berkshire Hathaway; there are the A shares and B shares. Berkshire A shares give you voting rights in the company, and the B shares do not. The Berkshire is selling for a cool $243,000 a share, so more than Andrew and I are worth combined. The Berkshire B is more for peasants like us which is still selling at $160 a share right now.
The point I am trying to make with this, as we are talking about this, I would highly recommend that you go to sec.gov and type in Berkshire Hathaway and pull up the 10-k for Berkshire. That way you can follow along with us as we are talking through this.
Now as somebody who has taught himself how to do this and has gone through this with other companies when I’ve been writing articles. I can tell you from experience that there are some companies that are not as clear as Berkshire’s is. I don’t know if they are doing it intentionally or if they are just not as clear as Buffett is. This is a little bit of a treat because as you are looking at it, everything is laid out, and it makes sense from where things are coming and going. With all that Andrew why don’t we start by talking about cash flows from operating activities.
Andrew: Operating activities are going to define what the core of the business is. A business can do a lot of different things, especially one like Buffett’s Berkshire Hathaway. Where they are taking big chunks of cash either buying businesses outright. Sometimes they will buy ownership stakes and then sometimes they will buy individual shares of a company in the stock market if they want a piece of.
When we talk about operating activities, basically operating activities is excluding other aspects like what I just talked about trying to buying a company out. Things like debt, and other financial shenanigans. The operating activities are going to be the core business if you take a grocery store, how much money they are bringing into the cash register minus how much they are paying their employees, minus how much it costs to keep the lights on, minus how much they pay for the food. In a nutshell that would be operating activities.
In Berkshire’s operating activities cash flow portions, at the top line they net income, which is the bottom line from the income statement that all the analysts on Wall Street care about, other than earnings per share, which his a derivative of net earnings.
That is going to give us the core of the business, there are a couple of other things on here, investment gains and losses, this generally wouldn’t be in the operating activities but because they are a conglomerate and they own a lot of companies, and they include this part in operating activities. There are different from the grocery store example in that their core business is almost buying businesses outright.
Dave: They are a bit of a mixed bag because they own businesses outright like Kraft Heinz, which is, in essence, a grocery store company, they have other businesses like Geico which is insurance. They have a lot of different businesses under their umbrella, but the investment gains and losses are because their core business is buying other businesses.
Andrew: A lot of different companies it would go in the investing section. The other big section I wanted to highlight from operating activities, is depreciation and amortization. The depreciation and amortization, those terms everybody can kind of figure out depreciation. The value of your car goes down every year because as the parts break down and become less reliable the value goes down.
Dave: Amortization is where you take, let’s say you buy a computer, and you spend a $1000 on the computer. The accounting rules allow you to fix a value for that to amortize that over a ten year period. So let’s say you pay $1000 for the computer, you are allowed to write off $100 a year for ten years, and once that is done, then you have $1000 available to buy another computer after the ten years is up.
Andrew: both of those things, the amortization is more of a tax thing, depreciation is more dealing with the asset value. There’s a term called EBITDA, which if you are a beginner you might not have heard of if you are done a little more research you may have heard of it. It is another valuation metric; we don’t cover it all that much between Dave and I.
It can be useful, and when you hear EBITDA, it’s talking about earnings before interest taxes depreciation and amortization. At the end of the day, these things are going to reflect in what the balances look like at the end of the day, I know this can b confusing, but this is the price we pay for trying to understand this information.
The depreciation and amortization I believe it doesn’t show in the income statement, but it needs to be accounted for somewhere. Everything flows through each other, and they have checks and balances. I will give you an example; I like to keep things simple because you can spend hundreds of hours analyzing every single number and not coming up with an actionable thing for your investing.
It is obviously important to spend time researching but let’s try to get an overview, don’t worry we will give it you at the end. We are just trying to give you little bits and pieces where you can understand the big factors of the cash flow statement.
Depreciation and amortization, just think of it as being checked and balanced from another part of the balance sheet or income statement. The amortization probably won’t show in net earnings but will affect how much cash they are getting into their checking account.
Those are the big items to pay attention to; we do have income taxes here at the bottom. Where again, these things are going to affect what the cash flow looks like for the company. And it gives you more than the income statement because that statement, it doesn’t include these tax specific things like the income taxes, amortization and depreciation, and so on. Accounting for the fact that you need to make repairs on equipment, or that equipment is being replaced and that is why it is being included.
Dave: Let’s move onto the cash flow from investing activities, as you can notice here, there are a lot of purchases, now one of the things that I like about how they lay this out. We were talking a little bit about when Buffett and Munger will buy a company. Right here they have a line item where is said the purchase of Kraft Heinz common stock. So in 2015, they laid out $5 billion 258 million to buy common stock in Kraft Heinz. In 2015 they bought that company along with another purchaser, but the nice thing about this is they lay this out so you can see that outlay of money that they used to buy that company.
Notice also that they have purchases of US treasury bills, equity securities, and you notice these are all in parenthesis which means it is a negative number, so that means this money has been taken out of their account and given to the US Treasury to purchase those, so that is a negative against their cash flow. Just like when we buy gas, groceries, or stocks it is cash out of our account. But in the case of stocks, it is still an asset because we have it and we can sell it if we ever need it. But as far as the cash flow goes, the money is going out of our account.
The cash flow from investing activities is going to show all the investing activities have, some companies when you are going through their 10-ks, you are not going to see as much of this as you will with Berkshire Hathaway. Let’s say you look at someone like Apple, for example, they may have fewer line items on theirs because they may not be investing as much money as other companies. It depends on the companies, and each of these activities is going to be different as you see as you go through the cash flows.
Typically the activities from the operating activities are going to be the biggest chunk. When we look at the investing activities and financing activities, they may be less or more. You will see all the different items in here, and you’ll notice at the bottom the net cash from investing activities is a negative number, which means they’ve outlaid more cash than they had in their account.
As the cash flow statement works it way down you will notice some sections will positive and others negative, which can help you determine how management is spending their money.
Andrew: I would just add the investing activities, I tend to notice they are negative quite often, which makes sense because as they invest more in assets, it will be cash that is outlaid, as opposed to selling these securities which will bring more cash back into the company.
Andrew: The third section we are going to talk about here is the financing activities. IT is very similar to the investing activities that we just covered, but this is going to talk more about what’s going on in the balance sheet when it comes to the liability side. The debt, when the repay short-term debt or long-term debt. Or when they take out debt, like taking out a loan at a bank and that is cash in hand. That is cash you can deposit into your account right then and there.
This is the section where they’re going to talk about that. Again, it’s not necessarily good or bad depending on of the numbers there. You need to look at the bigger picture to make that decision, if you see a higher number there, it could be a good thing, but it also could mean that they are taking on a ton of debt so want to compare it with the balance sheet to see if the debt to equity is really rising or falling. And if it is rising too much, but it is making our cash flow nice, then maybe that’s not that a great of a thing.
You can go to a bank right now and take out a credit card cash advance, and suddenly you have $20,000 in your account. Is that a good thing? No! Sometimes taking out a loan to 2% could be a good thing. These are things you need context for, when you look at this section this is what they are talking about, and you group all these things together and that will give you the final section which we will cover now.
Dave: Now we have the cash and cash equivalents at the end of the year. This is, in essence, the bottom line of the cash flow statement. You will notice right above there we have cash and cash equivalents and the beginning of the year and that was obviously a bigger number, and then you’ll notice we have the increase slash decrease in cash and cash equivalents. There is a negative number there as well.
The cash and cash equivalents at the end of the year, this is how much free cash flow the company has made at the end of the year, and this is what drives what the company can use to reinvest back into the company. Or if it is a company that pays dividends, for example, this is money you have left over at the end of the year in your checking account. What the company chooses to do with it is really up to the management.
This is where the rubber meets the road if you will, with how we view companies and management, with what they do with this free cash. Andrew and I big proponents of dividends, Berkshire does not pay a dividend, and Buffett has his specific reasons why he doesn’t do that. We have discussed this is in the past, but Buffett is a fantastic capital allocator which means he is amazing at using that money to buy other businesses to generate more assets for his company, which increases the value of his company and so on. Not everybody is Warren Buffett, just like not everyone is Michael Jordan, there are just one of them.
The cool thing about this is this is where you can tell what kind of management you have. Because you can see if it is a more mature company like Coke, Coke chooses to use the majority of their cash and cash equivalents to pay a dividend at the end of the year. I am going to back up a little bit here, cash is obviously the green stuff, but cash equivalents breaks down into other cash-like things such as CDs, savings accounts, accounts receivables, investments that you have cashed in.
The thing that I like about how Berkshire lays out their statements that I have yet to see elsewhere, which is cool. At the bottom of this, they have cash and cash equivalents comprised of the following: Insurance and other is one line item, railroad, utilities and energy, finance and financial products is the final line item. So they break the final number down into which aspects of their business are generating the most cash flow.
Andrew: To wrap up, cash and cash equivalents at the end of the year, this is the one that I am going to look at when it comes to me doing a valuation based on the cash flow statement. I have several ratios that I like to use for the income statement, several I like to use for the balance sheet. But if we go back to the metaphors that I made for the three financial statements. I am concerned when it comes to the cash flow having a checking account balance is the same way I am concerned with having a checking account balance in real life.
Obviously, the goal is to try to get the income as high as we can get it. Whether that means getting a second job, raise whatever that may be. That is going to unlock a big chance for us to have wealth in the future and the more that you can increase income stream the faster you’ll grow wealth. The faster it will all compound and the wealth you have in your balance sheet you can use to buy stocks. And this will create more income streams for you.
A big part of why I like to focus on dividend stocks is because it is creating these income streams and it is making that first financial statement of our life, the income statement which is bringing cash flow into our finances. That is why there is such a focus there and why I don’t see a true investment unless it is creating an income stream for me. And those income streams are just going to grow and compound over time, and that is how wealth is going to be built.
Wealth is not going to be built focusing on increasing the balance sheet numbers it is going to be by the income numbers. On the other side of that, if I am just focused on just having a checking account balance, and I want to make sure our company has that. The primary reason a company would need to have cash is so that they can survive liquidity moments. Times, where they have expenses, pop up where they need to run the business where maybe a big shipment comes in that you need to pay for, some emergency; there are all these types of factors that can cause disruptions in the business that a company needs cash flow for.
Again where a lot of different investors like to use cash flow as a predictor, and it can be a great tool for that. I am primarily concerned with making sure there’s a cash balance, which there is an emergency fund. In the personal finance world, they like to talk about having a three to six-month reserve in case you lose your job. What is losing your job, it is losing the income stream, and that income stream is again that first financial statement.
The Same thing with a company comes across a year where they don’t sell as much product as they usually do, but they will likely have the same expenses they had the year before. If you had a really bad year and needed to recover from it, do you want to take out more debt like we said, if it is at a high-interest rate it is going to hurt the business more? Or are we going to have enough cash on hand to burn through some of that cash, get through the rough patch, and continue in a nice growth pattern for the long term plan?
That is why I just focus on this cash and cash equivalents at the end of the year. In that blog post that I mentioned, I call this net cash, and it’s funny because most everything in the finance world and the stock market is very defined. Earnings meet earnings, assets means assets, but when you come to the cash flow statement, that term net cash there were two or three different definitions with different parts of the cash flow statement for the same term. It is a toss-up and why you need to be careful if you are going to do this stuff in depth with a scientist dissection type of mindset.