How to read financial reports for the novice – Part 3: Cash Flow Statement

Cash flow statement describes how cash is flowing in and out of a business for a particular reporting period; e.g., 3 months, 6 months or one year. When evaluating a company, an investor would like the company to have a profitable business; i.e., sustainable or growing profits shown on the income (profit and loss) statement.  Apart from seeing good profit shown on the income statement, an investor also would like to see the company having a healthy balance sheet, preferably showing a lot of cash and current assets and little liabilities.  In addition, the profit made by the company must translate into healthy cash flow that improves the balance sheet and increases the cash and cash equivalents and/or dividend payouts to shareholders.  Sometimes a company could show great and growing profits on the income statements for several reporting periods but the cash flow (cash flowing in and out of the company) is consistently negative and the balance sheet is deteriorating.  This could be due to a number of reasons but it is certainly a cause for concern. 

Let me give you a fictitious example to show that a business A could be showing good profit on the income (profit and loss) statement but is actually not proftable.  Business A is in a business that requires it to continue to invest in new equipment and tools.  When A bought a piece of equipment costing $1m in year X, $1m cash would be spent in year X. However, if it chose to depreciate the equipment over ten years using straight line depreciation, only $100K would be deducted from the revenue each year for the next 10 years to calculate the profit.  Assuming that business A has to continue to invest $1m in new equipment every year and use the same method of depreciation, what would appear in its financial statements? The answer is $100K would be deducted from revenue to calculate the profit in Year X and $200K would be deducted in Year X+1,... and $1m in Year X+9 onward.  Even if A is not making money, its income statement could still show good profit in the first few years because the expenses on PPE is spread out over 10 years.  If an investor were to look at its cash flow statement, he/she would be able to see that A’s cash flow is consistently negative while the value of its PPE (under fixed assets in the balance sheet) keeps increasing. 

Again, let me make use of Old Chang Kee’s FY14 financial results to explain a company’s cash flow statement.  Cash flow statement consists of three main parts; namely, cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.  As in the Old Chang Kee’s FY14 cash flow statement shown below, cash flow statement will begin with profit before tax.  Note that provision for doubtful debts, amortization of intangible assets, depreciation of property, plant and equipment (PPE), re-evaluation gain or loss in the property, and interest income and expenses have been deducted or added to the gross profit to arrive at the profit before tax.  As these are not considered operating cash flow, they have to be removed from the profit before tax to determine the operating cash flow before changes in working capital.

The working capital is essentially equal to current assets minus current liabilities.  Hence, changes in working capital is also equal to the sum of changes in individual components of current assets and current liabilities, which include inventory, trade and other receivables, amounts due from associate companies, short-term deposits, prepayments, trade and other payables, other liabilities and provision for bad debts.  An increase in the current assets such as inventory and trade receivables (i.e., money owed to the business by its customers) will reduce the cash and cash equivalents and vice versa.  On the other hand, an increase in the current liabilities of the business will increase its cash and cash equivalents.

The cash flow from operation is simply the net amount of cash that has been flown into (when the figure is positive) or out (when the figure is negative) of the business for operational activities before taxes has been taken into consideration.  Net cash flow from operating activities is the end result after taxes have been deducted or tax credits have been added. 

An investor should check the net cash flow from a number of financial reporting periods to have a better picture of the cash flow situation for a business.  A business should consistently generate strong net cash flow though occasional negative cash flows in some financial reporting periods may not a cause for concern.

Cash flow from investing activities show how cash is used to procure new PPE, invest in subsidiaries and associate companies, and how cash is generated when dividend from fixed deposits is received and subsidiaries and associate companies return cash to the parents via dividend payouts.  In some industry, says high-tech electronics industry, a business may have to constantly invest in new equipment and tools.  The money spent is considered capital expenditure.  The expenses are amortized and deducted from profit and loss via depreciation of PPE. Assume a business spent $1m to procure a piece of new equipment at the beginning of a particular year (Year 1) and depreciates the equipment over 10 years.  The $1m would flowout of the business under investment activities in Year 1 in the cash flow statement and there would not be any cash changing hand pertaining to this piece of equipment after that.  However, from Year 1 to Year 10, $100K will be charged as expenses or cost each year in the form of depreciation.  If a business has to keep buying new equipment and depreciate the equipment over 10 years, the impact each piece of equipment on the profit each year is only one-tenth of the cost. Hence, to take such capital expenditure into consideration, an investor can compute the free cash flow by subtracting capital expenditures from the operating cash flow.  In this case of Old Change Kee, its free cash flow in FY14 is $11,183K - $6,040 - $6k = $5,137K, which is only marginally lower than the net profit of $5,520 (Note that the $6K spent in purchasing intangible assets is likely to be for software purchase).  Again, it is important to compute the free cash flows over many financial reporting periods to have a better picture of a business’s free cash flow as a one-off capital expenditure could skew the free cash flow for a particular reporting period.  For businesses that have to continue to invest in equipment and tools to sustain its existing business, the free cash flow will be much lower than its net profit.

Cash flow from financing activities report inflow and outflow of cash through such activities money received via issuing new shares and exercising warrants and options, business taking up new loans or repaying existing loans and financial leases, interests paid to banks and dividends paid to shareholders.  Normally an investor would like to see the business repaying its loans to reduce the debt level. The cash flow and dividend paid would also give an indication of whether the business is generating enough cash flow and free cash flow to sustain the dividend level.