Cash flow vibrations

10 Mar 2023

In the previous post we started to analyze the Cash flow statement. From it, we learned about the existence of three cash flows - operating cash flow, financial cash flow, and investment cash flow. Like three rivers, they fill the company's "lake of cash" (that is, they go with a "+" sign).

However, there are three other rivers that flow out of our lake, preventing it from expanding indefinitely. What are their names? They have absolutely identical names: operating cash flow, financial cash flow, and investment cash flow (and they go with a "-" sign). Why so? Because all of the company's outgoing payments can also be divided into these three rivers:

Operating payments include the purchase of raw materials, the payment of wages - everything related to the production and support of the product.

Financial payments include repayment of debt and interest on it, payment of dividends, or buyback of shares from shareholders.

Investment payments include the purchase of non-current assets (say, the purchase of additional buildings or shares in another company).

If the inflows from the three rivers on the left are greater than the outflows into the rivers on the right, then our lake will increase in volume, meaning that the company's cash balances will grow.
If the outflows into the three rivers on the right are greater than the inflows from the rivers on the left, the lake will become shallow and eventually dry up.

So, the cash flow statement shows how much our lake has increased or decreased over the period (quarter or year). This report can be presented as four entries:



Each value of A, B, and C is the difference between what came into our lake from the river and what flowed out of the lake by the river of the same name. That is, the value can be either positive or negative.

How can we interpret the meanings of the different flows? Let's break down each of them.

Operating cash flow. In a fundamentally strong company, it is the most stable and powerful river. The implication is that it should be the main source of "water" for our lake. Negative operating cash flow is an indicator of serious problems with the business because it means it is not generating money.

Investment cash flow. This is the most unpredictable river, as sometimes it can be very powerful and sometimes it can flow like a thin trickle. This is due to the fact that the purchase or sale of non-current assets (recall that these may be buildings, equipment, shares in other companies) does not occur as regularly as operational activities. A sudden negative investment flow tells us about some big purchase. Shareholders do not always view such events positively, as they may consider it an unwise expenditure or a threat to dividend payments. Therefore, they may start to sell their shares, which causes their price to drop. If a big purchase is perceived as an opportunity to reach the next level and capture more market share, then we may see exactly the opposite effect - an increase in share price.

Financial cash flow. A negative value of this cash flow can be seen as a very positive signal because it means that the company is either actively reducing its debt to creditors, or using the money to pay dividends, or spending the money to buy its own stock (*), or maybe all of these together.
(*) Here you may ask, why would a company buy its own stock? Management sometimes does this when they are confident in the success of their business and want to support the growth of their stock. The company becomes a major buyer of its own stock for some time so that it begins to grow. The process itself is called share buyback.
Positive financial cash flow, on the other hand, signals either an increase in debt or the sale of its own stock. As far as debt is concerned, you can't say that loans are bad for business. But there has to be a measure. But the sale by a company of its own shares is already an alarming signal to the current shareholders. It means that the company doesn't have enough money coming out of operating cash flow.



There is another type of cash flow that is not a separate "river," but is used as information about how much cash the company has left to meet its obligations to creditors and shareholders. This is Free cash flow.
It is simple to calculate: just subtract one of the components of the investment cash flow from the operating cash flow. This component is called Capital expenditures (often abbreviated as CAPEX). Capital expenditures include outgoing payments that go toward the purchase of non-current assets, such as land, buildings, equipment, etc.
(Free cash flow = Operating cash flow - Capital expenditures)
Free cash flow can be characterized as the "living" money that a company has created over a period, which can be used to repay loans, pay dividends, and buyback stocks from shareholders. If free cash flow is very weak or even negative, it is a reason for creditors, shareholders and investors to think about how the company is doing business.

This concludes my discussion of the cash flow statement topic. Next time, let's talk about the magic ratios that you can get from a company's financial statements. They greatly facilitate the process of fundamental analysis and are widely used by investors around the world. We will talk about the so-called Financial Ratios. See you soon!