Stock Investing: Fundamental Analysis Using Free Cash Flow Statement
Ever heard the phrase “Cash is king!” ? There is something comforting to investors about cold, hard cash. What if I told you that the free cash-flow of Facebook had been increasing by more than $2 billion for the years 2014–17? In this article, I will explain the key parts of a cash-flow statement and how it meticulously tracks the cash coming in and going out of a company.
In the most simplest terms, cash-flow statement is all about showing you the money. There is nothing more reassuring as an investor than knowing a company is bringing in cash, and not using accounting tricks to boost up their net income or revenues with the income statement. At the end of the day, it’s cash that pays the bills.
Why is cash-flow statement important?
You might be thinking why do we need to look at this statement. Following are the reasons cash-flow statement deserves a spot in fundamental analysis:
- Cuts through the tricks of accounting: As I explained in my article on income statement, calculating company’s profit is a complex process and a lot goes on behind the scenes as accountants classify expenses and revenue. In contrast, cash is cash.
Remember: You either make profits or you don’t.
- Connect the different financial statements together: The income statement and the balance sheet are somewhat independent because they measure different aspects of business like company’s profits and company’s financial health. Cash flow statement gives you a complete view of the company by using information from both the income statement and balance sheet.
- Highlights cash generated from actually doing business: Cash flow statement clearly tells you the cash coming into a business is the result of a company selling its products or services.
Key Parts of a cash-flow statement
There are three different parts in a cash-flow statement:
Cash flows from operating activities
This section of the cash flow statement tells you about how much cash the company brings in or uses, during it’s normal course of business.
Tip: If an item on the cash flow statement is positive, that means the company generates cash. If an item on the cash flow statement is negative, usually surrounded by parenthesis, that means the company uses cash.
Lets understand the Operating Activities section by looking at the cash-flow statement of Facebook (Ticker: FB) from 2013–17 in Figure 1 below.
- Depreciation and Amortization: Depreciation is an expense included by the company on its income statement that doesn’t actually cost the company cash. Usually, depreciation is added back to net income as the first step to measure the company’s cash flow. On the other hand, amortization is the erosion of value of intangible assets like patents or trademarks.
Tricky concept: Understanding depreciation can be tricky. Think of it this way. Every year, the value of your car falls. It’s a real expense, because it is technically costing you money. But when your car depreciates in value, you don’t get a bill for it. You don’t have to write a check, and it doesn’t cost you cash immediately. Hence, while measuring cash-flow, depreciation is added back to net income.
- Tax adjustments (also called as deferred income tax benefit): When a company actually writes a check and pays taxes, which are not recorded on the income statement, it must subtract the amount from net income. Since the company used cash for paying taxes, this amount is subtracted.
- Accounts receivable: If you see accounts receivable rise, that means customers are mostly buying on credit instead of paying cash. This eats up the company’s cash because the company is essentially giving customers a credit card.
Tip: A big rise in accounts receivable in comparison to the increase of a company’s revenue can be a tip-off.
- Accounts payable: A company may buy materials or supplies to conduct business on credit without using cash. When a company’s accounts payable increases, it is considered a boost to cash and added to net income.
Tip: Watch out if you observe that accounts payable is rising relative to a company’s cost of goods sold (as discussed in my article on income statement). It might mean that the company isn’t paying its bills on time, which may inflate its cash.
- Net Operating Cash Flow: After adjustments to the net income to add back items that did not use cash and subtracting those that did, what is left with is the company’s cash from operations or net cash provided by operating activities.
Tip: When net cash provided by operating activities is positive, it means the company generated cash from it’s normal course of business. However, if it is negative, that means the company burned cash.
Cash flows from investing activities
This section of the cash flow statement shows you how much cash the company is using to keep its factories, stores or facilities presentable.
Lets understand the Investing Activities section by looking at the cash-flow statement of Facebook (Ticker: FB) from 2013–17 in Figure 2 below.
- Capital Expenditures: Generally, a company lumps in all their investments in improving, enhancing or updating their facilities into a single item on the cash-flow statement called capital expenditures (or cap ex for short)
Cash flows from financing activities
This section of the cash-flow statement tells you how much cash is plowed into a company by lenders and investors. This section also tells you cash that’s flown out of the company, including to pay cash dividends to investors or to pay down debt.
Lets understand the Financing Activities section by looking at the cash-flow statement of Facebook (Ticker: FB) from 2013–17 in Figure 3 below.
- Increasing or decreasing the company’s debt load: This sub-section tells you whether or not a company is generating cash by issuing debt or using cash by repaying back debt. A company might choose to pay down debt if it feels it has borrowed too much.
- Buying back or repurchasing the company’s stock: A company might use cash to take shares out of the hands of the public by buying them. This reduces the number of shares outstanding, thus, making each share more valuable.
- Paying out dividends to shareholders: At times if a company is generating a stable cash flow and has more cash than it needs, it might decide to return the cash to shareholders by issuing dividends. These payments consume cash.
- Net Financing Cash Flow: Net cash provided by financing activities tells you whether the company was a net gainer or user of cash after considering all the above money raising events.
- Free cash flow: It is calculated by subtracting capital expenditures from cash from operations. This is a useful tool that can tell you a great deal about a company’s generation or burning up of cash.
Free cash flow = Cash from operations — Capital expenditures
Quick way to monitor a company’s cash flow
Here’s a quick way to monitor a company’s cash flow:
Compare a company’s net income with its cash from operations.
If a company is generating as much cash as it’s reporting in net income, then it can be a good indication that the company has high-quality earnings.
Note: If cash from operations is greater than net income, it means that the company generates more cash than it reports to shareholders as earnings. It is an indication of high-quality earnings.
If cash from operations is less than net income, it means that the company generates less cash than it reports to shareholders as earnings. It is an indication of low-quality earnings.
Summing it up
Hopefully, by now, you would have realized how cash-flow statements can be brutally honest about the business of a company. Knowing how to track the cash flowing in and out of the company can improve your fundamental analysis skills and help you find companies with good stable businesses that generate stable cash-flows that you can hold for the long term.
With this article, I have concluded on further writing about using fundamental analysis for stock investing. Please check “Other Articles by me” section below for all my articles.
I do have more investing related topics lined up, however, I would love to hear from you about what investing topics you would be interested in reading about.
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Thank you for reading.
The content in the above article is for information and educational purposes only. It is not intended to be an investment advice. Please consider the risk involved and your personal financial situation before investing or seek a duly licensed professional for investment advice.
Other articles by me
- Fundamental Analysis Using Key Ratios: https://email@example.com/stock-investing-fundamental-analysis-using-key-ratios-ed02f32e88ae
- Fundamental Analysis Using Company’s Income Statement: https://firstname.lastname@example.org/stock-investing-fundamental-analysis-using-companys-income-statement-37b0d80531f1
- Fundamental Analysis Using Company’s Balance Sheet: https://email@example.com/stock-investing-fundamental-analysis-using-companys-balance-sheet-153531d98f8b
Amrut is a Full Stack Software Engineer who is passionate about tech and software development in Web and Mobile. He likes to write about coding, investing, finance and neuroeconomics. He strongly believes in adding value to people’s life through quality work. He also loves to watch and discuss about American Football.