Cash Flow Analysis for Investment Decisions

Cash flow is one of the most important financial statements and can reveal a lot about the company. Therefore, analyzing the cash flow of a company can help investors make better investment decisions. Through this article, I hope to provide investors with an idea of ​​cash flow analysis in a very understandable way so that all investors can perform their own analysis before making any stock selection.

Before continuing to explain how cash flow analysis can help you make better investment decisions, I would like to inform readers about the basic difference between income statement and cash flow. In the income statement, revenues are recognized as soon as a product is sold. In the cash flow, revenues are recognized only when the payment of the product is made.

For example: company "A" sells cars. The selling price of a car is Rs. 1, 00,000. Suppose the company sells a car. In the income statement, the price of that car is immediately added to the income of the company. This is independent of the fact that the payment is made after 1 or 3 months. But in the cash flow, the cash inflow will be shown only when the payment is made.

Therefore, the cash flow provides a real picture of the cash the company receives. On the other hand, the income statement only records revenues as soon as sales are made.

With this basic difference explained, I would now like to continue and explain the structure of the cash flow. Post this It would explain what elements you should consider in the cash flow to make sound investment decisions.

Cash flow structure:

The cash flow reports cash receipts and cash payments through operating, investment and financing activities, which are the company's main business activities.

Operational activities: this part of the cash flow shows the activities related to the profits of the company. Operating cash flow, as the name implies, provides the cash inflow and outflow resulting from the company's main business activities.

Investment activities: this part of the cash flow offers an overview of the investments made by the company. These investments involve the purchase of assets that would generate income in the future for the company. Investment activities also provide cash inflows resulting from the sale of assets or investments by the company.

Financing activities: this part of the cash flow provides the sources used by the company to finance its expansion or operations. These sources of funds acquisition can be debt or equity. It also gives investors an overview of when the company is making payments on its debt.

Analyzing the cash flow:

The three components of cash flow will become clearer as you explain how different components of cash flow can be used to analyze the company.

Next, it shows a sample cash flow that will help clear things up and also help me explain things.

The first important thing to consider in the cash flow is the "Net cash (used) provided by the operating activities". This provides the cash inflow or outflow for the company during the year from its main business operations. In the previous sample, $ 37,813 of cash was generated from the company's business during the year. What can investors analyze from this?

• Suppose that the company's income statement shows that it is making good profits. But when you look at the operating cash flow, you find that it is negative. This means that the company is making sales but has not been able to receive their payments. This is fine for a small company or for any company for a year or two. But if during 4-5 years the company shows gains in the income statement but generates a negative operating cash flow, then it is a bad sign.

• The company can obtain money to finance its expansion and its daily operations in 3 ways. These are debt, sale of shares or internal funds. These internal funds will be there only if the operating cash flow is positive. So avoid a company that has a large debt, can not raise money through capital in bad markets and also has a negative operating cash flow for several years.

• Within the operational activities look at the inventories. In the statement the sample is a negative of $ 20,344. A negative inventory figure indicates that the company's inventory level has increased over the previous year. Since the increase in the inventory of cash blocks (which company would have obtained if it were sold) is represented as a negative figure. Looking at inventory is very important, especially for industries such as the retail industry. So look at the trend for a few years. If the inventory keeps increasing, then it's a bad sign. This means that the products are being made but not sold.

Next, we move on to the cash flow of investment activities and see how investors can benefit from this section to choose the right company.

• In the sample declaration, the first element is the "purchase of property, plant and equipment". This is the capital expenditure that the company has made during the year. It is represented as a negative figure, since it is a cash outflow for the company (the company uses cash to buy assets). This is very important since it gives an indication of the future growth of the company's income. If a company does not make capital expenditures, it sees no margin for the growth of the industry or does not have funds to make capital expenditures. The first is the most likely case. Therefore, the ideal is for investors to look for companies that make heavy capital expenditures. These companies will also show solid revenue growth in the future.

Financing activities mainly tell investors what the company is using (debt or equity) to finance its expansion or operations. Also, if companies are paying their debts in good amounts, it is a very positive sign. It shows that the company is generating enough cash from the operating activities to finance its expansion and also to pay off its debt.

Free cash flow:

Investors can use a simple formula to calculate the free cash flow of the company. In general, the higher the free cash flow per share, the better it will be for investors and the healthier the company will be.

Free cash flow = Cash flow from operations + Net capital expenses - Dividends paid

All these parameters can be easily obtained from the cash flow. So any investor can sit down and calculate this.

Free cash flow per share = Free cash flow / Number of shares outstanding

This gives the amount of free cash that the company has for each of its shareholders. It goes without saying that the higher it is, the better it is for shareholders. In addition, it is a great reflection of the positive health of a company if its free cash flow per share is greater than or equal to its earnings per share calculated from the income statement.

Solvency ratio:

This is another very simple relationship that investors can calculate. It measures the capacity of the company to generate sufficient cash from operations to cover capital expenses, investment in inventory and also the payment of dividends in cash.

CAR = sum of cash flow from three-year operations / three-year capital expenditure + inventory + dividends

Once again, all these elements are easily available in the cash flow statement. Three years of data are taken to make the reading more reliable.

When the CAR (capital adequacy ratio) = 1, it implies that the company covered exactly all the cash needs without external financing.

A less than 1 CAR means that the company needs external financing. So let's suppose that a company has a CAR of 0.5. It means that the company needs half of the cash needs of external financing (debt or capital). Now suppose that the company already has a large debt and the price of its shares is too low for it to raise funds through capital. Then it is better to avoid the company. But if it is an emerging industry and banks are willing to finance the company even with a debt-equity ratio of more than 3 or 4, then it is a different thing. You should also observe what the growth rate of the industry is, and if the company is also growing at that rate or more, then.

I think that every investor can spend some time looking at the annual report and calculating and seeing these simple things. Surely it would help investors to make a better investment decision on their own.