Cash Flows Explained

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n Warren Buffett's latest letter to shareholders, he provided a pretty blunt criticism of accounting earnings numbers. You see, well his company berkshire hathaway had made twenty four point eight billion dollars in operating profit in 2018. The company only reported earnings of four billion dollars. Primarily the result of a loss in unrealized capital gains. So even though the business had effectively made 24.8 billion dollars, they had to report a small earnings number because of the market value of some of their investments went down. This is just one example of the noise included in a company's net income number found on their income statement.

 It's why many investors prefer to look at a company's cash flow statement when analyzing performance. You see a company's ability to generate cash is an important factor to consider when researching an investment idea. And looking at a firm's cash flows can clear whether a business is actually making money or if they're simply abusing accounting rules to inflate their earnings number. So let's go over cash flow statements and why cash is king.

 A cash-flow simply refers to cash that a company has paid out or received. in other words it's any revenue gain expense or payment the company has actually realized, that has actually impacted their bank account. In a perfect world one would expect that cash flows would be identical to the revenue expenses listed on the income statement. But this is rarely the case. Gains and losses on the income statement can be non-cash and sometimes a business may accrue expenses or revenues for which cash has yet to change hands.

 For example, a company may have a bill they need to pay next year. And while this would be recognized immediately on their income statement, the cash flow is only recognized once the money actually leaves the company's bank account. This makes cash flows a lot more straightforward than net income. If a company pays out or receives cash, it's including cash flow if not it isn't. And many analysts give a lot more weighting to company's cash flows than their earnings. Amazon is a great example of this. In 2014 the company actually reported negative earnings meaning that according to their income statement, they were losing money in reality. however the firm achieved record operating cash flows and added 5.9 billion dollars of cash to their balance sheet.

 But obviously where this cash is coming from is important here and increasing cash is great, but we need to know if the amount is coming from an increase in sales or a bank loan that the company took out for this reason. The cash flow statement groups its cash flows under three different classifications. 

The first of which is the cash from operating activities. By far, the most important grouping. This amount is a fundamental measure of the amount of money the business has made from their operations. And oftentimes when people are simply referring to a company's cash flows they're actually referencing CFO. The amount includes cash received from sales minus cash paid to suppliers and employees as well as interest paid on debt and the taxes paid to the government. it's basically a measure of a company's operating profit. And like any other profit number a high and growing CFO likely signifies a growing business, while a shrinking CFO signifies a shrinking business. Worse yet a negative CFO means that a firm's operations are actual losing money and if it doesn't improve, well a company is almost certain to eventually go out of business.

 The second classification is cash from investing activities. This amount includes anything that involves the purchase or sale of longer-term assets such as property, plant or equipment. It's essentially any money that has been spent to grow the business, maintain the firm's current assets, acquire other companies or invest in different securities. For example company A would include the purchase of a company delivery van, the acquisition of a competitor and the purchase of money market investments under its CFI. Cash flows from investing are typically negative because they often involve a company investing money into its growth or at the very least into maintaining their business. But it can occasionally be positive if a company is receiving cash from its investments or when a firm is actually selling its assets.

 The final cash flow is cash from financing activities. This is where you will find the amount of money the company has raised through share issuances, bond issuances or other forms of debt. If a company takes out a loan, the money they receive will show up here as a positive cash flow. This is also where you would deduct share buybacks, dividend payments and a companies principal repayments on their debt level. So a positive cff means that a business is raising money possibly to grow its operations and a negative cff means that a business is paying money out either to its shareholders in the form of share buybacks and dividends or to its creditors in the form of principal repayments which will lower its debt level.

 So those are the three types of cash flows, and when you net them together you end up with the company's net change in cash. The amount by which the firm's cash balance changes in a given year. There's also a fourth honorary member of the cashflow family known as free cash flow or SCF.  It's loved among value investors. Free cash flow is simply equal to company's ocf their operating cash flow minus capital expenditures or the money from CFI that the company spends on longer term assets like company vehicles or buildings. This number is important, because it essentially shows how much money a company has after covering its obligations. it's money that is free from any commitment. It can be used by the firm to pay dividends, buy back shares, pay down debt or pursue acquisitions and it's a profit measure that gets a lot of attention from analysts. 

A company with strong free cash flows is usually able to self fund growth initiatives without taking on extra debt. Whereas a firm that has consistently negative free cash flow is likely spending more money than its generating. And will eventually need to raise funds. So those are cash flows in a nutshell. but perhaps, you don't fully understand why analysts give the measure so much merit. After all, all the confusing rules and assumptions in net income are meant to reflect a company's financial situation. is that not good enough?

 Well the income statement is useful to an extent but cash flows offer a more complete picture and can provide valuable insights into the quality of a company's earnings or how sustainable they are. Let's go through an example. Imagine you have two bagel companies company A and company B. let's assume that the companies have identical balance sheets and for 2020 they both record earnings of 10 million dollars on in their income statement. One might assume that these companies have similar financial strength, but even with these similarities the two can vary drastically. Which we can see by looking at their cash flow statements. For example on company A's cash flow statement you can see that the firm has a high CFO that is able to fund its CFI and actually returns money to its shareholders and creditors in its cff. On the other hand company B has a lower CFO and a steep CFI. So they're spending a lot more money than they're making from their operations and they are taking out debt to finance the spending, which is shown in their CFF. So even though the companies have the same earnings number, company A appears to be in stronger financial situation. It goes to show why it's important to understand both the company's profitability and their cash flows.

 Companies with higher cash flows tend to have more reliable business models. And have fewer problems when it comes to funding their business. Cash flows also provide some insight into a firm's earnings quality. If a business is reporting too high profits but they have a low or negative operating cash flow such as with company B, then it's possible that they are inflating their bottom line. Now the nature of a company's cash flows can vary drastically based on the industry they operate within. And there are different rules for things like interests and lease payments depending on specific factors. But even at a high level with this basic understanding you can learn quite a bit about a firm's financial health, just by looking at their aggregate cash flows.

 So next time you look at a company, make sure to check out their cash flow statements to see how each of the three numbers cash flows from operations, investing and financing have changed over time. Also, be sure to compare a company's cash flow to their earnings. if the two are close to one another or if CFO is higher than net income, then the company probably has higher earnings quality. Looking at free cash flow will additionally show you whether a company has money to spare or if they are spending more than they are generating from their business. Net income can give you a quick rundown on a company's performance in a given year, but for the full picture it's better to count the cash.

Thanks for reading. if you have any feedback or topics you want me to cover in the future, leave a comment down below.