Doc Maher shows you how to track the cash flowing in and out of a company – and why it matters.
Welcome back to my series on fundamental analysis, a way of evaluating companies as investments based on their financial statements and other measures of economic health. (Here’s more on why traders use fundamental analysis and what they’re trying to find.)
Fundamental analysis is often mentioned in the same breath as a foil to technical analysis, which is a way of evaluating companies for investment based purely on trends in pricing chart data.
So far we’ve explained how to read a company’s balance sheet as well as dug into some key statistics like EPS, P/E, and PEG.
Follow the cash
Today’s post takes a closer look at what’s known as a cash flow statement. It’s no secret that cash hasn’t been exactly flowing in the markets lately. Companies that lack adequate cash can no longer count on easy credit to make up the difference and pay for its ongoing operations. It’s a relatively simple equation in a tight credit market like we have now: not enough cash can sink a firm fast into bankruptcy. We’ve seen that happen lately with giants like Bear Stearns, Lehman, and many others.
The cash flow statement helps investors answer questions like: Is the company generating enough cash needed to fund growth? Is growth outpacing cash generation, requiring additional financing? Is the company generating enough cash to cover its short-term needs?
Real-world example: CAT’s cash flow statement
To pull up a company’s cash flow statement, here’s where to go on TradeKing’s website: Quotes + Research > Quotes + News + Research. Enter your company ticker symbol, then click the Financials tab, then choose Cash Flow Statement.
Here is a screenshot showing the cash flow for Caterpillar (NYSE:CAT) from 2003 – 2007. A word of caution: not all numbers are as they appear. What do I mean by this? For example, a number like $3,040 would normally be read as positive, and therefore one might assume this is cash coming in to the company. However, this number actually represents cash flowing out (see the first ‘OUT’ in green). If you just focus on the numbers without regard for the descriptive text, you will not get an accurate figure. So deciphering a cash flow statement is not as simple as netting the positive and negative numbers. I have added notations in green to help explain this. Why is it done this way? I don’t really know, but one could argue it gives the CPAs job security.
In getting back to the data and the lesson at hand, there are three big categories of cash flow to pay attention to here. Cash generated by and used by the company’s operations is summarized in the “Net Cash Flow – Operating Activities” line. That line includes cash flowing in as well as cash-out.
The company’s long-term investing of cash is detailed in the “Net Cash Flow – Investing” line. That consists of cash flowing out.
The third and last part, the “Net Cash Flow – Financing” line, shows the cash a company raised through from financing activities. That’s cash that came in.
The very bottom line shows the net change in the company’s cash position. If you add the line to the cash on the balance sheet from 2006, you’ll get the current cash position on the 2007 balance sheet.
Cash-flow nitty-gritty
That’s the top level of categories, so let’s dig into the specifics a bit. The cash flow statement starts with “Net Income”; this figure comes from the “Income Statement”. You’ll notice next they add back in “Depreciation, Depletion & Amortization”. These costs impact the company’s profitability but aren’t, literally speaking, cash flows out of the company. You could fairly call these paper losses.
Depreciation is taken in to account when determining a company’s net profit, because it’s assumed that the things being depreciated have lost value; however, CAT doesn’t have any cash movement related to this. The rest of the top of the statement provides a more detailed explanation as to where cash came from and was used in operations.
Things like a change in Accounts Payable and Inventory can change the company’s cash position – that’s in play for our example. CAT had an increase of $618 million in bills that they haven’t paid (in other words, that’s cash they still have on hand). On the other hand, they saw a decrease in cash due to an increase in inventory of $745 million (meaning increasing inventory cost them some cash). The subtotal for Net Cash Flow – Operating Activities is a cash in flow to CAT of $7,935 million.
From the second part of the statement, we see that CAT added $3,040 million in new fixed assets. For a commercial vehicle and truck manufacturer like CAT, that translates to things like additional plants and equipment. When you net the INs and OUTs, the subtotal here is $4,408 million cash that flowed out of CAT.
Now for cash flow for financing. Keep in mind that “financing” might mean cash is coming in, if the company takes on new debt, or flowing out, if they choose to pay down debts. In this case, CAT reduced its long-term debt $10,888 million, so that’s cash that went out. However it also borrowed $11,039 million long-term and that’s cash that came in. The total here represents the cash that came into CAT. Since this number is negative, the subtotal of $2,969 million in cash left CAT in relation to these activities.
If we look across the last few years we can see that generally CAT’s cash has gone up. However in 2006, it went down by $578 million. What happened? The Net Income was almost the same as 2007. The cash flow from financing is very close. Cash-out due to investing was lower. However, the cash provided by operations was very different. Looking closer, you’ll see the “Funds from Operations” was also very close, so the difference lies in that “Funds from Other Operating Activities” category. Drill down even further, you’ll see it was almost all in a mysterious category called “Decrease/(Increase) in Other Operating Activities”. What’s this? Frankly, I don’t know, but it produced a billion more dollars in 2007 than in 2006 -- and that made a big difference in the company’s cash position. This figure might well be explained in the company’s annual report, but it’s one to follow up on. It’s vagueness like this that can make cash flow statements hard to comprehend.
Here’s another interesting item: in 2004 CAT’s “Receivables” went way up, by $7.6 billion. This means that they had $7.6 billion more cash that was owed to them by customers that had not been paid in 2004 than in 2003. Something obviously changed very dramatically here. However, since that amount did not change in 2005 or after, it may have been only an accounting change. If not, that means CAT now has $7.6 billion more in accounts receivables than before 2004 and that situation hasn’t changed. Are they having a harder time collecting from customers? Does this indicate some major change in their business? Another item worth digging into with more analysis beyond this statement.
Next time: key fundamental ratios
In addition to the various statements we’ve reviewed in this series, analysts also look at certain key ratios. My post on income statements explained what Operating Margin, Profit Margin and Gross Margin mean. My next post will explore the Quick Ratio, a measure of liquidity, Inventory Turnover, an asset management ratio, and the Debt Ratio. We’ll discuss what each ratio measures, why analysts watch these figures – and why you might want to, as well.
Until next time.
"Income Trader"
Doc's previous posts: Time to Buy Ford LEAPS Calls? and Understanding the Income Statement
Click here for a list of previous TradeKing All-Star blogs.
Nicole Wachs contributed to this post.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
