Cash Flow

Cash flow is an important prognosticator for holders of the company's stocks and bonds because cash is needed to invest for future growth, to pay dividends to stockholders, and to pay interest and other liabilities to prevent bankruptcy. Cash flow is also necessary for investment funds, such as master limited partnerships and REITs, that pay periodic dividends or distributions, since these incomes can only be paid out of a positive cash flow. Without a substantial cash flow, investment funds may have to pay a lower dividend, or even suspend payments, which will cause the value of the investment to decline.

The ability to generate cash emanates from the company's operational performance and financial flexibility, such as the ability to borrow, issue equity, and sell assets. Cash is money, of course, but can also include coins, currency, cashier's checks, certified checks, money orders, personal checks, and bank drafts. Cash equivalents are also included because they can be immediately converted to cash. The Financial Accounting Standards Board (FASB) defines cash equivalents as commercial paper and other debt instruments with remaining maturities of 3 months or less.

Calculating Cash Flow

The cash flow of a business is the total amount of cash actually received in a given period minus the total amount of cash actually paid out in that same period. Positive cash flow is the receipt of more cash than was paid out; negative cash flow results from paying out more cash than receiving. Earnings potential is the ability of a company to earn a positive cash flow now and in the future, which is a significant factor in its stock price and future performance.

Cash Flow = Cash Received - Cash Paid

Neither the income statement nor the balance sheet shows the amount of cash that a business receives or pays out. In accrual accounting, which most companies use, income is listed when it is earned, even before it is actually received, and expenses are recorded before the money is actually paid out. Depreciation or amortization, for instance, is an expense that doesn't require the immediate payout of cash. Thus, net income alone, which is the income after all expenses are subtracted from all income in a given time period is not an accurate representation of how much cash a company has, or even how much it is generating.

There are 2 methods of determining cash flow, which sometimes called cash earnings. The direct method takes each item listed in the income statement and adjusts it from accrual to cash accounting. The indirect method is generally easier, starting with net income or net loss and adding back non-cash charges, such as depreciation, amortization, and deferred charges; then the result is adjusted according to the sources and uses of cash during the relevant period. The indirect method involves aggregating the information contained in 2 balance sheets, the income statement for the period, and the statement of shareholders' equity.

Cash Flow = Net Income + Depreciation + Other Noncash Expenses

Thus, a company that reports a loss can actually have a positive cash flow. However, eventually the company will have to earn a profit because depreciated or amortized items will eventually have to be replaced.

Sources and Drains of Cash: Operations, Investments, Financing

Changes in cash position are the result of 3 types of activities: operations, investment, and financing. For global companies, currency fluctuations may increase or decrease cash, but the changes from currency fluctuations are generally minor.

Cash flows from operations are generally more consistent and indicative of financial strength. Cash from operations equals the cash generated from working capital, which is the net change in current assets minus current liabilities. If the cash flow from operations is positive, then the company is able to generate enough cash from its operations to pay expenses; if negative, then the company would have to access other sources of cash to pay its expenses, which will be limited if it cannot earn enough cash from operations, which is its business.

Cash can also be generated by selling assets or liquidating investments. Companies receive cash when they sell assets such as land, buildings, and equipment or from the sale of held securities, such as stocks and bonds. Companies pay cash for capital investments or for financial assets.

A company can also obtain cash through financing, by issuing debt or stocks, either common or preferred stocks, or it can pay cash to buy treasury stock, which is its own shares, to pay down debt, or to pay dividends.

Statement of Cash Flows

A company's cash flow — which details all changes affecting cash from operations, financing, and investments — can be found in its annual reports, under Statement of Cash Flows, or Sources and Applications of Funds Statement. The Statement of Cash Flows measures both the company's ability to generate cash and the effectiveness of the company's cash management.

The FASB requires that cash flow statements of the previous 3 years be disclosed, since cash flows for single periods can be manipulated to some extent, by delaying the payment of debt or dividends, or by selling investments. Such maneuvers can significantly increase cash flow for the period, but would be difficult to sustain, because payments delayed in 1 accounting period must be paid in the next period and only so many assets can be sold.

Some important transactions are not included in the cash flow statement, such as the purchase of machinery with a note payable, or acquiring land or paying off debt with capital stock. The FASB requires that such significant transactions, even though they do not affect the cash account, be clearly described in the footnotes to the financial statements.

Using Cash Flow to Evaluate a Company

Companies use cash to pay for capital expenditures or other investments. Generally, if a company is increasing capital expenditures, it indicates that is it is expecting better business, such as more sales. On the other hand, if it is selling major assets, then it expects a decline in business or needs a source of cash: both red flags for the potential investor.

Some investors use EBITDA — earnings before interest, taxes, depreciation, and amortization — as an indicator of company health rather than net income. EBITDA can be calculated by taking earnings before interest plus taxes, which is operating income, then add back non-cash expenses, such as depreciation and amortization. If the EBITDA is positive, then the company will have money to pay interest and other expenses. However, if EBITDA is negative, then the company will either have to borrow or issue more common or preferred stock.

That EBITDA may not be enough to indicate the solvency of a company was demonstrated by Enron, for instance, which had positive EBITDA in the years before it filed for bankruptcy, but after subtracting interest, taxes, and capital expenses, yielded a negative cash flow, meaning that Enron could not cover its debt over the time period.

A better measure of company health than EBITDA is the free cash flow, which is the cash flow minus capital spending, such as investments in net working capital and long-term assets. Free cash flow is harder to manipulate than net income and even harder to manipulate over several accounting periods. Net income can be overstated by capitalizing expenses instead of deducting them as current expenses, for instance.

Generally, companies will be cash positive or cash negative over several accounting periods, but if the company issues stocks or debt extensively, it may not be receiving enough cash from operations. Stocks and debt are usually issued so the company can make major purchases, such as that of another business or to make a major new investment in its own business, which requires a greater outlay of cash then can be obtained from its operations. Any company that issues stocks or debt for normal operations is probably having financial difficulty.

The cash flow adequacy ratio (CFAR) measures free cash flow compared to debt over the next 5-year period. CFAR is cash flow after taxes, interest, and capital expenditures, equal to the free cash flow divided by the average annual principal debt maturities over the next 5-year period. CFAR should be analyzed for a number of years. If it is greater than 1, then the company has sufficient cash flow to pay its debts over the time period. If greater than 0 but less than 1, then the company is generating insufficient cash flow to pay its debt over the period. A negative CFAR is a red flag that will lead to the company's demise, unless it is turned around.

If a company is having financial difficulty, it can always cut its dividend payment, though its stock price will probably decline. However, such a price drop could be an investment opportunity if the company cut its dividend to conserve cash so that it can survive a rough period. If the stock is selling at a discount to its intrinsic value, then it may be a buy, but the investor should investigate the reasons for the dividend cut.