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Understanding financial statements – cash flow statements

In the last instalment of our three-part series on how to understand financial statements, we look at how cash flow statements work and why they matter to investors.

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

Why is profit different to cash?

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 costs that affect 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 ten 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.

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

There are other ‘non-cash’ movements associated with an income statement too, like when a company is forced to write off the value of an asset through an impairment, that reduces profit.

For example, in the second quarter of 2020, after the oil price crash caused by the Covid-19 pandemic, Royal Dutch Shell reported an $18.1bn loss. But this included an impairment charge of $16.8bn post-tax ($22.3bn pre-tax). Shell’s assets are valued based on assumptions about their future earning power – and lower oil prices would mean lower profits. Hence, the value of the assets were written down.

But no cash actually changed hands. Despite losing $18.1bn, Shell recorded an operating cash inflow of $2.6bn for the quarter.

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.

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 needed. 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. An example:

Operating profit £5,000,000
Non-cash 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. 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, or 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 suggests the business has cash left over to give back to shareholders, pay off debts, invest in research & development (R&D) or use to acquire other companies.

It can be useful to determine 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.

Summing it up

We’ve now gone through the three major financial statements in company accounts: the income statement, the balance sheet and the cash flow statement.

Together these three statements tell you a lot about a company’s finances, and you should always check them before buying shares in a business. You never want to make a rushed investment decision only to find your new company has suffocating debts, or only paper profits.

Remember though, financial statements shouldn’t be used in isolation, and often come with notes giving extra detail. And it’s important not to get so caught up in the financials that you lose sight of other considerations, like the company’s competitive position or valuation.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for advice. Investments can rise as well as fall in value, so you could get back less than you invest.

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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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