So… You’ve figured out how to read an income statement and a company’s balance sheet. If you’re reading this article now, well… good for you! You’re that much closer to understanding how to go about investing in a company.
In this third part of the series of ‘How To Analyse A Stock‘, we’ll show you the basics of the cash flow statement.
Disclaimer: we’re not experts but we just want to share the little that we know in hopes that it’ll help you to take the first steps in your investing journey and maybe even spark conversation in our Seedly Q&A!
An Analysis Of Seedly Chicken Rice Limited
For this exercise, I’ll be using a fictitious chicken rice company, Seedly Chicken Rice Limited – that has been in the chicken rice business for the past 10 years – again, to explain the basics of how to evaluate a company in simple, bite-sized terms.
We’ve covered the company’s Income Statement and Balance Sheet previously. So now, let’s look at the company’s Cash Flow Statement.
Why Look At The Company’s Cash Flows?
Ever heard of the term, “Cash is King”? You know that cash is good for you. It allows you to purchase your necessities, and also allow you to quickly go into investments when opportunities arise. Similarly, for a company, it is important to have cash on hand for many reasons:
- Pay off expenses
- Capital expenditure
The statement of cash flows or cash flow statement tells you about the cash that is entering and leaving the company.
Basically, it shows you how the company is spending and utilising their cash, and also where all that cash is coming from. The amount of cash a company has shows you how liquid a company is, which is the ability of the company to meet short-term obligations.
Without positive cash flows, the company may be in a dire position and may even go bankrupt. And that’s NOT something we’re looking for when looking for a company to invest in.
The statement of cash flows is divided into 3 parts:
- Operating Activities
- Investing Activities
- Financing Activities
Let’s take a look at Seedly Chicken Rice Limited’s cash flows statement for the year ended 31 December 2019.
1) Operating Activities
This refers to the cash flows from operations. Operations here would mean the revenue-generating activities that the company is engaged in. For Seedly Chicken Rice Limited, it would be:
Profit Before Taxation
Remember what we talked about in the first article about Income Statement? This is the profit which the owners of Seedly Chicken Rice Limited can pocket.
Depreciation Of Property, Plant, And Equipment (PPE)
Depreciation of their kitchen equipment due to use.
Net Gain On Disposal Of PPE
One day, the boss of Seedly Chicken Rice Limited realised that the stoves are taking too long to cook the chickens. The slow cooking led to customer orders being delayed and that delay eventually led to a loss in customers as they got impatient waiting for their food.
Convinced that he needed new and better stoves, he upgraded the stoves and sold off the old ones. Lucky for him, he managed to sell them at a gain.
Gain = Sale price – Net book value (where Net book value = Cost price – Accumulated depreciation)
Impairment of Receivables
Impairment occurs when for example, Seedly Chicken Rice Limited caters their chicken rice to Company X for their company gala event. Unfortunately, Company X goes bankrupt after their celebration and is unable to repay its debt.
Interest Expense and Interest Income
More will be explained below.
Write-Off Of Intangible Assets
Intangible assets (for example, Seedly Chicken Rice Limited’s brand reputation) are tested for impairment (the process of writing off) at least once a year or whenever there is an indication of impairment, whichever comes first.
Impairment occurs when the fair value (the market or recoverable value) is lower than the book value (what is stated in the financial statements).
For example, you bought a Huawei smartphone that is worth $1,000 and you’re supposed to use it for 5 years. The annual depreciation of the Huawei smartphone would be $200.
But because their reputation suffered recently, the fair value of the smartphone got affected.
So if you wish to sell your phone after the first year, the book value of the smartphone is $1,000 – $200 = $800 (what it’s supposed to be worth). BUT because the whole Google-Huawei fiasco, the second-hand phone shop offered to buy your phone at only $300. Essentially, that means that there is a $500 impairment (loss in value) to the value of the phone.
Write-Off Of Inventories
Over the year, they sometimes overestimated their sales and ordered too many chickens in advance. Their unsold chickens turned bad and the amounts have to be written off since these chickens are “obsolete” and cannot be sold.
Changes To Working Capital
Working Capital = Current Assets – Current Liabilities
Changes to Net Working Capital = Working Capital (Current Year) – Working Capital (Previous Year)
You’ll notice that any increases this year to assets will be reflected as a negative number. Conversely, the reverse applies for liabilities. You’re probably wondering, “Why is an increase in inventory indicated as a negative number? Isn’t it a good thing?”
This is because there is a decrease in cash.
The cash outflow you experience when you gain other assets is because you have to pay for your purchase of inventory. However, this only applies to Operating Activities only.
2) Investing Activities
Like the name suggests, this portion shows the cash flows from investments.
Investing activities can be in capital expenditure such as the purchase of property, plant, and equipment (PPE), investments in subsidiaries (if any) and/or investments in financial markets. In this case, let’s assume that Seedly Chicken Rice Limited only has capital expenditure.
Purchase Of PPE
This refers to the upgrade of new stoves, and also the purchase of new PPE when they opened a new chicken rice store! When they purchased new PPE, their revenue and profit increased.
This shows that capital expenditure is utilised wisely as it is put to good use.
Proceeds From Disposal Of PPE
This refers to proceeds from selling off old equipment.
Interest Income Received
Interest received on the cash they put in the bank, etc.
Given the $50,000 cash they have (as in the Balance Sheet), and they put it all in a savings bank account for 0.4% interest per annum. That would give an interest income of $200. (You may think that’s very low… maybe they should look to put their cash in a better savings account instead!)
3) Financing Activities
This portion talks about cash flows from different methods of financing, for example, the issuing of shares or taking up of loans.
Being shareholders, you are definitely interested in this, right? The good news is, Seedly Chicken Rice is a publicly listed company which pays dividends.
Some points to take note:
- Not all companies pay dividends.
- If they do, check whether the dividends paid is consistent with the previous year, or even better, if they increased from the previous year.
- Check also whether the dividend payout ratio is sustainable. If the payout ratio is close to 100%, that is a red flag because it means the company it means they are not retaining their earnings and that is not sustainable! (Note that for REITs, this is an exception, as they have to distribute at least 90% of their taxable income by requirement.)
Proceeds From Long Term Loans
They borrowed $30,000 from the bank.
The interest paid on their loans.
Referring back to their balance sheet, they have a loan (long-term borrowing) of $30,000. Assuming they are paying an interest of 2% (technically too good to be true! But assuming somehow they did…), their interest paid would be $600 per year.
If you’ve followed through this far, congrats! You have finished learning the basics of the 3 Financial Statements. You may be asking…
But… What do these numbers actually mean?! Fret not.
In the next part of the series, we will be putting meaning to these numbers by explaining the different financial ratios and metrics. Stay tuned for it!