LEVEL: BEGINNER
Cash flow is one of the most important aspects of a company’s financial life that investors should pay special attention to before deciding whether to invest in a stock or not. Companies report their cash flow to the Securities and Exchange Commission (SEC) in forms known as the “10-Q” and “10-K”, which are filed quarterly (Q for quarter) and annually. These forms can be found on the SEC’s webpage (sec.gov) through the SEC’s EDGAR System. See How to Use EDGAR for more information on how to access reports.
What is Cash Flow?
“Cash flow” simply refers to the amount of money going in and out of a company over any period of time. Cash flow is not by itself a sign of a company’s health, and more cash flow is not always better. Some companies have much larger amounts of money going in and out than others, and you can never judge a company just based on how much revenue (incoming cash) it receives and how much expenses (outgoing cash) it sends out.
Although cash flow does not directly tell you how profitably or healthy a company’s business model is, it remains an important metric for determining the company’s future. If you see more cash flowing into the company, that might seem good–but more cash flowing out would suggest that the company is getting bigger, but not necessarily more profitable.
Also, cash flow is an important measurement of whether a company can fulfill its various financial obligations. There are three primary obligations that an investor should pay close attention to: dividend payments, operation costs, and outstanding debt.
Cash Flow and Dividends
Cash flow will have an almost immediate effect on dividends, which is one reason why cash flow is of important to value investors looking for dividend-yielding stocks. A company whose cash flow increases will face pressure from investors to raise dividends, so that investors get a larger portion of the company’s profits.
On the other hand, companies who cannot fulfill their obligations to pay dividends because of less cash flow will face a difficult decision: keep paying the dividend and go into debt, or cut the dividend and see investors sell off the stock.
To avoid this situation, companies typically pay much less in dividends than they earn from operations, and they will raise dividends cautiously, only when revenues have risen significantly.
To see the dividends a company owes shareholders, look for the “dividends paid” item on the “Consolidated Statement of Cash Flows” section of the company’s 10-K and 10-Q filing.
Cash Flow and Operations
It costs money to make money, and any company that receives cash also has to send cash out to purchase inventory or raw materials, pay employees, pay for taxes, and pay for liabilities (outstanding bills for orders received, for example) or any other costs involved in running the business.
When revenue rises, operations tend to rise as well, so investors pay close attention to these operation costs to determine how much cash the company will have on hand to fulfill its obligations and keep the company running. This is partly important because it’s a sign of management’s ability to handle the company’s operations efficiently, responsibly, and sustainably. It’s also important because companies who do not have enough cash on hand to maintain operations will quickly need to find cash to continue operating, which sometimes means going into debt. Expansion will also be impossible for as long as the company lacks enough cash to invest in new or more operations.
To see the outgoing cash flow from operations, look for the “adjustments to reconcile net earnings to operating cash flows”, “cash effects of changes”, and “cash provided by (used in) investing activities”. These are different aspects of a company’s cash flow, and will list incomings and outgoings relating to the company’s business activity.
Cash Flow and Debt
Almost all companies have debt in one form or another, and all companies have liabilities, including common stock, preferred stock, and corporate bonds. All forms of debt and financial obligations a company has outstanding will be listed under the “cash provided by (used in) financing activities) section of the consolidated statement of cash flow.
At first glance, positive numbers in this category may seem good and negative numbers may seem bad, but that is not always the case, and sometimes positive numbers are a bad thing. For instance, “net issuances”, “issuances”, and “long-term debt proceeds” include money that a company receives from new debts. Higher numbers might suggest that a company is borrowing a lot of money, which may be a sign of sickness, not health.
However, this number also needs to be compared to “repayments” and “long-term debt repaid”, which refers simply to how much debt a company has paid off in the period. If these numbers are negative and high, this is a good thing–it means the company has had enough cash on hand to pay its debts.
The Bottom Line
At the end of the consolidated cash flow statement, you will see the “balance at beginning and end of period” lines, which tell you if the amount of cash that the company has on hand has gone up or down. If there is an increase, the company is probably healthy, and if the increase is larger than in the previous period, it might signal that the company is getting better at having cash on hand, whether through higher profitability, more operations, or wise cash management. But be careful–sometimes the number is higher just because the company has gone into debt, which is why it’s important to look carefully at the cash flow statement to see exactly how the company is getting money, and where that money is going.
Likewise, a decrease in cash on hand is not always bad–a company that is aggressively expanding and will be profitable in the future may not be profitable now, because it is spending so much money on building new factories, developing new businesses, or spending more on marketing. It’s important to understand both where the cash is going and why as part of the company’s larger strategy. Then an informed investor can decide to buy, sell, or wait.