In recent posts on the blog we sketched a scenario in which you’re sitting with a client and he or she has just given you the latest set of financial statements for the business and you have to say something quickly. In those posts we talked about the first five figures to look at in an income statement and the balance sheet.
Today we’re going to think about the first five figures to look at in a cash flow statement or, as some of you will now know it, a statement of cash flows.
A cash flow statement is not an easy document to read, especially when you’re trying to do it quickly. We think it’s best to focus on three main points to keep it simple so that you can quickly get an idea of what happened to the cash in the business during the period…. which is really what we want to know for our assessment;
- how much cash was left at the end of the period – which is usually a year
- what was the change in the amount of cash left at the end of the period – was the change positive or negative from the previous year
- what happened to the cash in each of the three sections of the cash flow statement; operating, investing and financing.
The first figure to look at is right at the bottom of the cash flow statement and it is the “cash at the end of the year” figure and the first thing we want to know is; has the figure gone up from the previous year or gone down? In other words, did the business have more or less cash at the end of the period than at the end of the previous year? Then we’re keen to know from management whether the trend is likely to continue in the current year
In asking this question what we want to know from the management of the business is; do they expect the cash flow to improve or to deteriorate this current year and why?
The second figure that we should look at is the “net change in cash” and this will be just above their “cash at the end of year” figure. The “net change in cash” is a summary of what happened to the cash flow during the year from those three sections that make up the cash flow statement; operating, investing and financing and it disregards the amount of cash that the business started the year with. Again the first question to ask is; has the figure gone up from the previous year or gone down? We’re looking to see whether the year’s cash flow was more positive or was more negative than the previous year.
The second question to ask about the “net change in cash” figure is which of the three sections of the cash flow statement contributed most to the change.
So, following on from that we turn our attention to each of the three sections of the cash flow statement.
The third figure that we’d look at is “net cash flow from financing activities” and under that heading we’re especially interested in the borrowings of the business. As usual, the question that we would ask is; has the figure gone up or gone down from the previous year? In effect, what we are asking is whether the business increased its debt or whether it repaid some of its debt during the period.
We’ll also see in this section how the change in liabilities has affected the business’ short-term and long-term liabilities. The second question then is; did the change in short term liabilities generate cash? That would be an indicator of increased risk since that would imply that short-term liabilities have been increased or did it utilise cash which would mean less risk because that implies that some or all of the short-term liabilities have been repaid.
The third question that we would want to ask about this section of the cash flow statement is; are increases in long-term liabilities matched by increases in non-current assets, which you’ll find in the cash from investing activities section? Remember that long term liabilities should be used to finance non-current assets.
The fourth figure to look at is the “net cash flow from investing activities” and here we normally see whether the business has invested in non-current assets, such as fixed assets, or sold some off, or has it invested in other businesses or sold off its investments in other businesses? Of course, the first question is; has the figure gone up or gone down from the previous year?
This answers the question; has the business made more investments in non-current assets, especially fixed assets, or have non-current assets been disposed of? Our main concern here is, if fixed assets were disposed of to generate cash, were they productive assets?
Sometimes the business will sell off assets that it actually needs simply to generate cash to pay debt or, possibly, operating expenses. In that case, the future sustainability of the business may be in question if productive assets have been reduced or are no longer there.
The third question to ask in this section is; are any new investments productive; that is, if the business has acquired interests in other businesses or purchased non-current assets are they productive assets in the sense that they will contribute to the business’ profitability or is the new asset a nice car for the director?
The fifth figure to look at is “net cash flow from operating activities”. Operating activities relate to the day-to-day running of the business including its working capital management and in many ways this operating activities section is the most important section on the cash flow statement because businesses must generate positive cash flow from their operations otherwise they will be in trouble when their cash reserves run out.
You won’t be surprised to hear that the first question to ask is; has the figure gone up or gone down from the previous year? What we really want to know is; is the business generating more or less cash from its operations than the previous year?
The second question to ask is; is the cash flow from operations positive and, if not, will it be reversed in the current year?
It’s not unusual for a business to have negative cash flow from operations in one year but the situation can’t be allowed to continue indefinitely unless the business has planned it that way and has significant cash resources to carry it through to a time when cash flow from operations will turn positive.
The third question to ask is; how did changes in working capital, (that’s inventory, accounts receivable and accounts payable) affect cash flow? One of the biggest drivers of cash flow is working capital so the ability of management to manage working capital effectively is a key indicator of their abilities and whether they are able to optimise the cash flow to avoid running into cash flow problems.