A business with positive cash flow indicators means fundamentals are sound and profitable

Last week, we took a look at the income statement and balance sheet. This week, we are looking at the cash flow statement. As its name suggests, the cash flow statement shows the inflow and outflow of cash in a company for a period of time.

The main components of the cash flow statement include cash from operating activities, cash from investing activities and cash from financing activities.

The cash flow statement differs from the income statement because the latter includes non-cash accounting items such as depreciation, while the former strictly involves cash movement in and out of the company.

The cash flow statement needs to be read in conjunction with the income statement. Sometimes, the net profit in the income statement – for property companies and plantations mainly but not exclusively - includes non-cash items such as revaluation gains.

Operating cash flow (OCF) is the net cash flow from operating activities after adjusting for non-cash items and working capital changes. OCF relates closely to Free Cash Flow (FCF), which is operating cash flow after deducting capital expenditures of the business.

Our example Singapore Telecommunications’ (SingTel) OCF and FCF are positive despite its net income being negative. In 2QFY2020 ended Sept 30, 2019, the telco had an impairment charge of $1.26 billion for its investment in Bharti Airtel.

If the OCF and FCF of a business is positive, this is a good indication that the fundamental business in itself is profitable on an overall basis. OCF and FCF can be extended to margin analysis, similar to profit margins.

The higher the margins, the better because it indicates the amount of cash generated per dollar of revenue before and after capital expenditures. The formula for

Operating Cash Flow margin = OCF ÷ Revenue

and

Free Cash Flow margin = FCF ÷ Revenue

Again, this has to be compared against the industry average and benchmark. OCF and FCF yields are also a good indicator of stock attractiveness.

Ratios such as earnings per share (EPS), return on equity (ROE), return on assets (ROA) use items from both the income statement and balance sheet. The formula for ROA is

Return on Assets = Net Income ÷ Total Assets

while

Return on Equity = Net Income ÷ Shareholders’ Equity

ROE and ROA reflect the profitability of a company by looking at asset efficiency and how well the company uses its assets to generate profits. Ideally, a growing ROA and ROE over time is preferred; and much like margins, higher ROA and ROE compared to the industry average is a favourable indicator.

EPS is another key indicator that shows how much profit the company is generating for each share. The formula is

EPS = Net Income ÷ Total Shares Outstanding

Total shares outstanding can usually be found in the notes to the financial statements. EPS is used in the calculation of Price to Earnings ratio (P/E) or

P/E = Share Price ÷ EPS

P/E reflects the number years it takes to get back one’s investment. A higher P/E reflects stronger projected growth; while a lower P/E reflects a potentially undervalued stock. In 1HFY2020, our example SingTel did not have a P/E as its EPS is negative for its 2QFY2020 and 1HFY2020.

The reciprocal of P/E is the earnings yield:

Earnings Yield = EPS ÷ Share Price

OCF and FCF yields are similar; as they are computed by the formula OCF per share or FCF per share divided by the share price. Higher yields mean that the company’s fundamentals are attractive relative to the share price, or in other words cheap. Yields can be compared to the risk-free-rate; usually represented by the five-year or 10-year government bond yields; and these fundamental yields must be higher than the risk-free-rate to be an attractive investment.

Generally, prolonged and recurring negative operating cash flow is a red flag in financial analysis as there is constant cash outflow from the fundamental business. If OCF is positive but FCF negative, this indicates that the company is significantly reinvesting cash into the company in hopes of expanding and making it more efficient. Assuming a business does well and generates strong operating cash flow, it can either store it as reserves for a rainy day, pay shareholders dividends or reinvest the cash into more capital to grow the business.

Cash flow is used in one of the most popular business valuation methods, the discounted cash flow (DCF) method, which is a method used to estimate the value of a company today based on projected future cash flows discounted to today.