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Understanding cash flow statements

Revenue is vanity, profits are sanity, but cash is king – or so the saying goes.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Revenue is vanity, profits are sanity, but cash is king – or so the saying goes. That’s because cash is what customers pay in, and what shareholders get as a dividend.

What goes on a cash flow statement?

Cash flow statements are divided up into three sections. Operating cash flows, financing cash flows and investing cash flows.

They do pretty much what they say on the tin. For example, operating cash flows reflect the day-to-day operations of the business. Think the money coming in from product sales minus the costs of doing business.

Sounds a lot like profit, right? But cash flows and profits are different.

Why is profit different to cash?

Adjusting factors mean profits can be sliced and diced in lots of different ways, but you can’t mess about with cash. It’s either there or it’s not.

For example, two key components of profits, depreciation and amortisation, are not cash charges. They’re simply adjustments designed to smooth the cost of assets out over their usable lives.

Think about a company that invests £1m in a new processing machine. Rather than take a one-off cost of £1m against the income statement, it will depreciate the value of the asset over its useful life. If that’s 10 years, the company might choose to evenly depreciate the cost at a rate of £100,000 a year.

That smooths the cost base. But of course, the only cash outflow is the initial £1m. See the example below.

Years Cash flows Depreciation
1 -£1,000,000 -£100,000
2 £0 -£100,000
3 £0 -£100,000
4 £0 -£100,000
5 £0 -£100,000
6 £0 -£100,000
7 £0 -£100,000
8 £0 -£100,000
9 £0 -£100,000
10 £0 -£100,000

Scroll across to see the full table

There are other ‘non-cash’ movements associated with an income statement too.

For example, when a company is forced to write off the value of an asset through an impairment, that reduces profit.

In 2017, Rolls-Royce reported one of the biggest losses in British corporate history, £4.6bn. But £4.4bn of that was from the movement in the value of derivative contracts.

Because Rolls had a significant proportion of revenue coming from US-dollar based deals, forward currency contracts were taken out to protect itself against possible adverse exchange rate changes. As it turned out, Rolls would have been better off without its hedges. Hence the value of those contracts had to be reduced by £4.4bn.

But no cash changed hands in that adjustment. As its CEO said at the time “This has no impact on what is really going on in the business and cash, it is just an accounting measure”. Indeed, that year’s operating cash flow was £1.4bn.

So how do we get to cash?

An operating cash flow statement transitions from operating profit to cash flow. To do this, it adjusts for all the non-cash factors within operating profit, adding or subtracting where required. And since operating profit is calculated before interest and tax, we need to deduct the tax and interest paid, and add back any interest earned on cash deposits.

Operating profit £5,000,000
Exceptional items £1,000,000 Add
Depreciation £500,000 Add
Amortisation £275,000 Add
Net interest costs £100,000 Deduct
Tax £750,000 Deduct
Change in payables +£50,000 Add
Change in receivables +£75,000 Deduct
Operating cash flow: £5,900,000

Starting with operating profit, the first step is to adjust for non-cash exceptional items, then add back the depreciation and amortisation expenses we discussed earlier.

Then we take account of interest and tax payments, and adjust for other non-cash movements.

Companies can book revenue before the cash has actually turned up, and record costs before a payment has actually been paid. Think about when you buy something on a credit card. The transaction happens, but the bank won’t take any cash on the day.

The two items to keep an eye on are receivables and payables, both of which are recorded on the balance sheet. Receivables appear as assets because they reflect money owed from customers, and payables are liabilities, i.e. money owed to suppliers.

We’re interested in the change in the numbers from year to year. If the company’s payables rise and receivables fall, that means it’s deferred payments to suppliers, and improved collections from customers. Alternatively, falling payables and rising receivables are bad news for cash flow.

What you end up with is called operating cash flows. This reflects the cash that’s come into the company’s coffers from operating activities.

What do financing and investing cash flows tell us?

But of course, we need to think about financing and investing activities too.

By looking at the financing and investing cash flow sections, we can find out about a company’s longer-term investments in property and equipment, as well as financial comings and goings – think loan repayments, investments in other companies, proceeds from rights issues and share repurchases.

In Investing Cash Flows, you’ll find Purchase of Property, Plant and Equipment. Again, the meaning is straightforward, it’s the cash the company has spent on new sites and equipment.

If this is deducted from operating cash flow, we get a useful metric called free cash flow. It shows what’s left over from operating cash after expansion and upkeep costs. A positive balance implies the business has cash left over to give back to shareholders, pay off debts or invest in R&D or acquiring other companies.

It can be useful to ascertain if a company’s free cash flow is, and has consistently been, greater than the dividend paid. That’s another figure you will be able to find on the cash flow statement, under financing cash flows.

This article, like our insight emails, isn’t personal advice. If you’re not sure an investment is right for you, you should ask for financial advice. A cash flow statement should always be read with care and in conjunction with other financial statements. Remember to look beyond the current year to see how things have changed.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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