What
is Cash Flow Analysis?
Cash flow analysis is the examination of cash inflows and
outflows of an entity. A company’s cash flow statement provides a bond between
the income statement and the balance sheet. It allows an analyst to determine
where the company’s cash was produced (inflows) and dispersed (outflows) during
a specific period of time (usually a year).
Why
is Cash Flow Analysis Important?
Cash flow calculations provide information on profitability,
quality of earnings, liquidity, risks, capital requirements, future growth,
dividends, etc.
Different
Types of Cash Flow
Let’s start with the three types of cash flow in the cash
flow statement:
Cash
Flow from Operations
Cash Flow from Operations measures the cash generated from
the core business or operations of the business.
Cash Flow from Operations (CFO) = Net Income + Depreciation
& Amortization +/- 1 Time Adjustments +/- Changes in Working Capital
Cash Flow from Operations is a line item in the Cash Flow
Statement.
Cash
Flow from Investing Activities
Cash Flow from Investing measures the purchases and sales of
long term investments including items such as capital expenditures,
acquisitions, or investments in other securities such as stock and bonds.
Cash Flow from Investing = Net Capital Expenditures of
Property, Plant, and Equipment (PPE) +/- Long Term Investments
Cash flow from investing activities will usually be
negative. For most companies this represents investment in itself. Cash flows would
only be positive when investments are disposed of.
Cash Flow from Investing Activities is a line item in the
Cash Flow Statement.
Cash
Flow from Financing Activities
Cash flow from Financing measures the activities that fund
the company and stakeholders (debt and equity holders). These activities
include issuing or buying back stock, issuing or repurchasing debt, and paying
dividends to shareholders.
Cash Flow from Financing = Cash Received From Issuance of
Equity or Debt – Dividends to Shareholders – Purchase of Outstanding Equity or
Debt
Cash Flow from Financing Activities is a line item in the
Cash Flow Statement.
Note: The above cash flows are segregated and detailed in
the Statement of Cash Flow. The sum of the three makes up the Total Cash
Flow for the entity.
Total
Cash Flow
Total Cash Flow = Cash Flow from Operations +/- Investing
Cash Flow +/- Financing Cash Flow
Total Cash Flow of the entity is the sum of the Cash Flow
from all activities including operating, investing, and financing activities.
It is the total you find at the bottom of the Cash Flow Statement labeled
“Change in Cash and Cash Equivalents." The Total Cash Flow of a period of time
will equal the difference between the entity’s cash balance at the beginning
and ending of the time period.
Cash
Earnings
Cash Earnings = Net Income + Non-Cash Expenses (i.e.
Depreciation & Amortization)
Cash Earnings of Net Cash Flow or Net Income plus
Depreciation (NIPD) is the profits (or loss) of the entity plus non-cash
expenses (i.e. depreciation and amortization).
This metric includes the financing and investing activities
that are included on the income statement, but excludes financing and investing
activities affecting the balance sheet.
Cash earning isolates the operations income. This is the
cash earnings power of company operations. Management can do one of three
things with cash earnings: 1) reinvest it in the business 2) pay down debt or
3) return it to shareholders through dividends or buybacks.
Owner
Earnings
Owner Earnings takes it one step beyond Cash Earnings by
subtracting the approximate amount of capital expenditures it takes to keep the
company a going concern. This is calculated:
Owner Earnings = Net Income + Non-Cash Expenses (i.e.
Depreciation & Amortization) – Average Annual Maintenance Capital
Expenditures.
(Note: An estimate is made of Maintenance Capital
Expenditures. This is the CAPEX required to maintain the company and does not
include CAPEX required for growth.)
What is left is theoretically for the company stakeholders
(debt & equity shareholders). Options would include reinvesting for growth,
debt reduction, dividends, and stock buybacks.
Owners’
Cash Profits
Owners’ Cash Profits is a slight variation of Owners’
Earnings. Here, Cash Flow from Operations is used instead of Net Income;
therefore changes in working capital are included in the equation.
Owners’ Cash Profits (OCP) = Cash Flow from Operations (CFO)
[Net Income + Depreciation & Amortization +/- one-time adjustments +/-
Changes in Working Capital] – Estimate of Maintenance Capital Expenditures
Free
Cash Flow
Free Cash Flow = Cash Flow from Operations – Capital
Expenditures
Free Cash Flow is Cash Flow from Operations less capital
expenditures. It is the cash available to debt and equity holders after the
expenses and taxes are paid and capital expenditures have been deducted.
The difference between Owner’s Cash Profits and Free Cash
Flow is Free Cash Flow would deduct all capital expenditure, including any
extraordinary expenditures used to grow the company. Owners’ Earnings and
Owners’ Cash Profits only subtract the average capital expenditures or those
needed to sustain the company.
A positive free cash flow means the company has enough cash
inflows to maintain operations and meet its capital expenditure plans. A
negative free cash flow means the company needs to use cash reserves, or raise
cash through the sale of assets, stock or debt. In the long run, a company
cannot have negative free cash flow and remain a going concern.
Net
Free Cash Flow (NFCF)
Net Free Cash Flow is Free Cash Flow less the current
portion (amount to be paid over the next year) of capital expenditures, long
term debt, and dividends).
Net Free Cash Flow = Free Cash Flow – current capital
expenses – current portions of long term debt – current portion of future
dividends
This is a more conservative version of Free Cash Flow. A
positive net free cash flow means the company has enough cash inflows to meet
ALL the plans (operations, investments, and financing) of the company during
the following year. A negative net free cash flow means the company needs to
use cash reserves, raise cash from outside sources, or cut planned cash
outflows.
Summary
Cash Flow is one of the most important investment concepts
to understand. For the value investor it is more important than accounting
profits because it paints an untainted or truer picture of the company and its
finances.
Each one of the different cash flow metrics gives pertinent insight into the health of an entity. By using the different types of cash flow for investment analysis you will be greatly improving your ability to analyze and compare investment opportunities.
