What to Look for in a Cash Flow Statement

Cash flow statement demonstrates the flow of cash coming into a business and going out from a business. It differs from income statement because cash flow statement is recorded on a purely cash basis. In income statement, if a business booked a sale of a product or a service and was yet to receive cash from the customer, the business would record it as sale in its income statement. On the other hand, if the business purchased raw materials for the products they sold or incurred cost for the service they provided, they would record this expense as cost of sales or cost of service regardless of whether the transaction was on a credit basis or cash basis. This method of accounting is called accrual accounting which is the most used method of accounting for income statement. So, cash flow statement gives you a different perspective. Since, it records how much cash is coming into a business and going out from the business through operating activities, investing activities and financing activities, you can make some important interpretations which will give you guidance on the future performance of the companies you are looking into and it also helps you measure the earnings quality of the companies.

Let's get to the basics first.

A cash flow statement is separated into three segments: (i) Operating Activities, (ii) Investing Activities, (iii) Financing Activities.

Operating Activities

Operating activities record cash transactions related to the daily operation like cash payment to suppliers, employees and cash receipt from customers. There are two methods of preparing cash flow statement namely direct method and indirect method.

Direct method shows the specific cash inflows and outflows related to its operating activities. Its line items are cash receipts from customers, cash paid to suppliers, income tax paid etc.

Indirect method shows how cash flow from operations can be obtained from reported net income by making some adjustments. To derive operating cash flow from net income, adjustments are made for non-cash items, non-operating items, and the net changes in operating accruals. For instance, depreciation and amortization which are non-cash charges in income statement are added back to net income. Increase in accounts receivable and other operating assets are deducted from net income and vice versa while increase in account payable and other operating liabilities are added back to net income and vice versa.

 

Investing Activities

Investing activities record purchasing and selling of long term assets and other investments including purchase of property, plant, equipment, invest in intangible assets, acquisition of another company, investment in equity and debt securities etc.

Financing Activities

Financing activities include obtaining or repaying capital from or to shareholders and creditors. A company can obtain capital from issuing common stock, right shares or debt instruments like bonds. These items are recorded in this segment. Cash outflows include cash payments to repurchase stock (e.g., treasury stock) and to repay bonds and other borrowings.

 

Now that we know the basics, let's get into the fun stuffs.

Dissecting Operating Cash Flow

Let's assume, a donut factory requires different types of ingredients to prepare the donuts. It includes flour, egg, butter, sugar etc. The company procures these ingredients from different sources. Donut factory has some estimates for every year on how much donuts they are going to prepare and how much they can sell. On that estimate they purchase the required ingredients from its suppliers in different intervals depending on change in estimates. Some of these ingredients make it to the final product and some of these remain unutilized by end of the year which can be used the next year. The unutilized ingredients are recorded as inventory and isn't included in the income statement. However, in cash flow statement, total purchase of ingredients throughout the year is recorded regardless of whether these ingredients have made it to the final product and sale or not.

The donut factory sells these donuts to different types of customers. The company sells the donuts directly to the customers and in bulk to other chain shops. When the company sells the donuts directly to customers, they collect cash instantly. However, when the company sells the donuts to other chain shops, they only get cash when the chain shops are able to sell them to final customers. In income statement, the donut factory will recognize sale once the donuts are delivered to both types of customers even if they don't receive the cash. The company would record the portion of sale that hasn't been converted to cash as account receivables in its balance sheet asset side. But in cash flow, the cash from customers are recorded once the cash is collected from the customers not when the donuts are delivered to customers. If the donut factory has large portion of customers coming from chain shops and these chain shops fail to make the sale before the product expires then there can be big discrepancy between sale number in the income statement and value of cash collected from customers in cash flow statement.

This is one of the reasons analysts and investors should look at their subject company's cash flow statement to check on how successfully and at what cycle (number of days) the company is generating cash. If the cycle is long, then it's a disadvantage to the company because for managing the expense for its day to day operations it would need other source of financing. If the cycle is short, the company's own source of cash flow that it is generating from the sale can be adequate for meeting its operational expense.

Understanding Investing Activities

In the investing activities segment you get to see items like purchase of property, plant, equipment, acquisition cost etc. These items indicate how much the company is investing. If the amount is substantial, you ask where the company is investing. Depending on the nature of investment and size of investment, you then go deep to understand how it will affect future growth. A company making continuous investment is most likely operating in a higher growth trajectory whereas a company making relatively lower investment is most likely has fewer options to generate growth or have reached a plateau.

Figuring out Free Cash Flow (FCF)

Generally, deducting the cash flow operations by the capital expenditure (e.g. purchase of property, plant, equipment from investing activities) one can derive free cash flow. Free cash flow is important for investors because it gives an indication of the company's valuation. Free cash flow is the cash flow available for the company to repay creditors or pay dividends and interest to investors. Value investors try to gauge future free cash flows and discount them to derive valuation of the company.

A Case Study: Netflix Hunting for Positive Free Cash Flow

The shows or movies that you watch on Netflix are regarded as content assets in Netflix Inc's financials. Some of these content assets are their very own production which they call Netflix original and some of these contents are licensed from other productions. The streaming giant is giving its viewers the array of choices to watch shows, movies and documentaries and in return the company is charging a subscription fee. But to produce or purchase these content assets, the company has to make an upfront payment and every year at least till now, they are spending a big buck for building up their content assets. Especially enhanced competition from other streaming services have pushed Netflix to speed up its Netflix original production. However, the cash they collect from their subscribers fall short. Hence, when you look at Netflix's cash flow statement, you will see that their cash flow from operations have been negative. However, the year 2020 was an exception for the company. In 2020, because of the pandemic, Netflix spent less on production as most productions had to be put off. Meanwhile, their subscriber number increased quite significantly which also boosted their cash flow from customers. As a result, the streaming giant was able to generate a positive cash flow from operations after many years.  

Netflix, Inc. Statement of Cash Flows

Particulars (USD mn)	2018	2019	2020
Cash flows from operating activities:
Net income	1,211	1,867	2,761
Adjustments
Additions to content assets	-13,043	-13,917	-11,779
Change in content liabilities	1,000	-694	-757
Amortization of content assets	7,532	9,216	10,807
Depreciation and amortization	83	104	116
Stock-based compensation expense	321	405	415
Foreign currency remeasurement loss (gain) on debt	-74	-46	533
Other non-cash items	82	228	293
Deferred income taxes	-86	-94	70
Other current assets	-200	-252	-188
Accounts payable	199	96	-42
Accrued expenses and other liabilities	150	158	198
Deferred revenue	142	164	193
Other non-current assets and liabilities	2	-123	-194
Net cash provided by (used in) operating activities	-2,680	-2,887	2,427
Cash flows from investing activities:
Purchases of property and equipment	-174	-253	-498
Change in other assets	-165	-134	-7
Net cash used in investing activities	-339	-387	-505
Cash flows from financing activities:
Proceeds from issuance of debt	3,962	4,469	1,009
Debt issuance costs	-36	-36	-8
Proceeds from issuance of common stock	125	72	235
Other financing activities	-2	-	-
Net cash provided by financing activities	4,049	4,506	1,237
Other effects	-40	0	36
Net increase in cash	989	1,232	3,195
Cash, cash equivalents and restricted cash, beginning of year	2,823	3,812	5,044
Cash, cash equivalents and restricted cash, end of year	3,812	5,044	8,239

 Source: Netflix, Inc. Financials

For Netflix, positive cash flow from operations is very important. Since they are making a lot of upfront expenses and generating less cash from operations, they have to finance this shortfall through large issuance of debt that you can find in their financing activities. This can't be a sustainable business case for Netflix. And in fact, Netflix is hunting for that sustainable positive cash flow from operations and positive free cash flow regime. And they expect it to happen soon enough. 

In Netflix's letter to shareholders by end of full year 2020 it said, "We believe we are very close to being sustainably FCF positive. For the full year 2021, we currently anticipate free cash flow will be around break even (vs. our prior expectation for -$1 billion to breakeven). Combined with our $8.2 billion cash balance and our $750m undrawn credit facility, we believe we no longer have a need to raise external financing for our day-to-day operations." 

It is pretty much possible for Netflix to sustainably generate positive free cash flow if subscriber number increases to a level where the cash generated from customers will surpass the upfront payment required to be made each year for acquiring content assets. And if that happens, Netfilx will be able to finance its daily operational expense from its own source which will take the burden off from its swelling debt. And that is what the investors of Netflix aim for.

 

Understanding Financing Activities

In the financing activities segment, you get to see from where and at what volume capital is obtained. In case of Netflix, obtaining capital from issuance of debt is a big part. The debt is usually issued to finance its expenditure for its content assets. Moreover, this segment also shows how the company is repaying its debt and how much dividend it is paying to its shareholders. Usually if a company falls short substantially in generating positive cash flow from operations, the company has to make up for it by issuing debt. The company can also obtain capital from issuing common stocks, preference shares, right shares etc. On the contrary, if a company is generating healthy cash flow from operations, it has the capacity (fully or partially) to finance its working capital and capital expenditure from its own source.In this case, the company will have low exposure to debt.

Seek More

Cash flow statement can give a very good picture of how a business is running and where it is heading. For instance, Netflix's cash flow statement tells a lot about their business model and what it aims for. Depending on different types of business models, you will find their cash flow statements to reveal their narrative. From there, you can make reasonable assumptions and filter out noises that are present in income statement.