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Analyzing Your Cash-flow Statement

As an adjunct to last month’s discussion on forecasting cash flows for a budget, I want to turn this month to the cash flow statement.

It sometimes amazes me that so many chief executives (CEOs), who operate domestic small or medium enterprises (SMEs), simply ignore their cash flow statements. To be fair, these bosses are certainly concerned with their most recent cash balances and in their companies’ ability to cover their next set of payments. But the cash flow statement is far more than that. In fact, given the prevalence of accounting software in the market, the cash flow statement can be quickly produced for any inquisitive CEO, to provide a broader-based picture of the company’s cash flows than simply looking at the cash balance.

Some local CEOs are actually surprised to learn that a cash flow statement, along with an income statement and balance sheet, is actually a required disclosure document by most stock exchanges in the world. This means any senior corporate executives/owners interested in a stock-exchange listing had better become comfortable discussing the cash flow statement’s various components.

Specifically, based on the commonly used indirect method in calculating the statement, there are three components to the cash flow statement: cash flow from operations, investments and financing. In other words, the cash flow statement looks at all cash receipts and payments for the company during a particular period and segregates these inflows and outflows into three separate categories.

For example, operating cash inflows would include (not surprisingly) cash sales or collections in receivables, while operating cash outflows would include cash paid for raw materials for resale. Other types of operating cash flows would encompass flows from salaries, taxes, and even occasional cash refunds for defective goods.

What should you get from this information? There are many areas to look at. But, for a start, look at the cash inflows generated from your operating cash sales as a ratio of total sales to learn about the quality of your sales programme. If this figure is high, and is growing over time, your sales force is certainly doing a good job collecting cash for the company. Also, the final net cash from operations as a percentage of shareholders’ equity also tells you the value of the return to your shareholders, a good number to have if the owner is also the manager.

Cash flows connected to investment activities include buying and selling fixed assets and the trading of debt and equity of other entities. Here, an increase in fixed-asset purchases suggests the company is expanding. However, it’s important to ask if the new fixed assets are risky one-time purchases or if they can be used for multiple purposes, which should be more cost-effective. Buying into other companies, especially for majority stakes, also suggests that a firm may be merging to expand its balance sheet for diversification purposes.

Finally, cash flows from financing activities would include changes in long-term debt and shareholder equity. This is the key section to study when examining the various sources of funding and how reliable those sources will be under different market conditions.

For local SME’s, out of the three areas, cash flows from operating and investing activities are likely to be more important, especially given the embryonic nature of China’s capital markets. But the more immediate challenge is to convince the CEOs that the cash-flow statement should be on par with the income statement and the balance sheet.

Writing on finance and economics for the last 18 years, David Seto, CFA splits his time between Hong Kong and Beijing where he reads Chinese Classics and tries to revive his defunct band, Scarbelly. Any comments on his columns can be sent to dseto@btmbeijing.com.