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How To Analyse Financial Statements: The Cash Flow Statement

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Lately, we’ve been answering a host of investing-related questions posed by our readers in our ‘Ask A Foolish Question’ series. A bunch of those we’ve received pertain to the question of how to go about analysing financial statements.

Those are great questions – and important ones as well. At the Motley Fool Singapore, we aim to be part-owners of businesses and to understand them, we need to understand their numbers. That’s where knowledge of financial statements comes into play.

Every company has three financial statements: the balance sheet, the income statement, and the cash flow statement.

We’ve previously looked at the balance sheet and the income statement, and in this final instalment of this series, we’ll finish off with the cash flow statement.

The cash flow statement

It records the flow of cash into and out of a business for a given period and like the income statement, is cumulative in nature.

The cash flow statement is often confusing for most as they are unable to discern the difference in the flow of cash as compared to the record of sales and expenses that are found on the income statement.

Thing is, a company showing a net profit of $1m does not necessarily mean that cash on its balance sheet has increased by $1m. That’s because of a difference in terms of accounting systems. An income statement follows the “accrual” system of accounting while the cash flow statement uses the cash-in/cash-out system.

If I may, I shall use a simple bubble-tea stand opened by 10 year-old John, and funded by his mother, as an example (John’s a real budding entrepreneur with supportive parents). But before you carry on further, it might be a good idea to read up on our take on the balance sheet and income statement for a better understanding of the contents in this article.

A simple example

Going back to John, this is what his balance sheet looks like on his first day of business:

Assets
Cash S$100
Inventory (consisting of syrups and starch-pearls) S$50
Simple kitchen equipment S$50
Total S$200
Liabilities and Equity
Loan from Mom (free of interest!) S$190
Equity S$10
Total S$200

Standing in his favourite play-ground in the park with his bubble-tea stand, he starts hawking his wares. Business is brisk as his tasty concoction proves a hit with thirsty joggers, cyclists and other visitors to the park. At the end of the day, he manages to sell 200 cups of the tea at S$1 each. With each cup costing him only S$0.10 to make, he manages to earn an amazing profit of S$0.90 per cup (those adorable puppy-eyes on John’s face makes it easy for the park’s visitors to shell out money for a cup of drink).

This is what his “accrual” income statement would look like:

“Accrual” Income Statement
Sales S$200
Cost of Sales S$20
Net Profit S$180

But here’s where it gets interesting. As John wanted to capture as large an addressable-market as possible for his drinks, he allowed customers without cash to pay on credit, telling them that he’ll be back in the park the next day and they could pay him then.

It was hugely successful as 90 cups of the bubble-tea were purchased by joggers who normally do not carry cash with them as they run.

So, even though John sold 200 cups of tea, the actual cash that came in was only S$100 and this is what the accounting would look like on a cash-in/cash-out basis:

“Cash-in/Cash-out” Statement
Cash Sales S$110
Cost of Sales S$20
Cash Profit S$90

As for John’s balance sheet as he packs up for the day, this is what it looks like:

Assets
Cash S$210
Inventory (consisting of syrups and starch-pearls) S$30
Simple kitchen equipment S$50
Accounts Receivable (from the customers who bought on credit) S$90
Total S$380
Liabilities and Equity
Loan from Mom (free of interest!) S$190
Equity S$190
Total S$380

Looking at the balance sheet above, we see that John’s cash account increased to S$210 from S$100 despite clocking a net profit of S$180. That’s because John collected actual cash of only S$110 from the sale of bubble-tea and so the cash on his balance sheet only went up by that amount. The other S$90 in sales that would come in later from customers who bought on credit would be converted into cash only when these customers paid John.

What this simple example can tell us is, businesses do not actually receive the same amount of cash that’s shown in its income statement for the same reporting period.

And as investors, we want to know how much cash it is actually collecting from all its reported ‘profits’ because the cash that’s used to pay out dividends, repay loans and grow the business is ultimately paid out from cash and not profits. That’s why the cash flow statement exists so that we, as investors, can determine the actual amount of cash that flows in-and-out of the business.

Back to the real deal

Now that we’ve got accrual and cash-in/cash-out accounting out of our way, let’s take a look at a real cash flow statement that’s released by publicly-listed companies here. The cash flow statement is divided into three sections: Cash flows from operating activities; Cash flows from investing activities; and Cash flows from financing activities.

The first section deals with the cash that a company either generates or consumes from its daily business operations.

The next section, its name implies, is concerned with the cash a company generates or uses when it invests. A company can use its cash to purchase investments such as debt-securities from other companies or sovereign nations or even shares of other publicly traded companies. In addition – and more importantly for shareholders – this section also records the amount of cash that a company has spent in investing into its own business, either for growth or to maintain its current competitive market position.

The last section tells us the cash inflows/outflows that result from financing activities, such as the payment of dividends, repayment/issuance of loans, proceeds from the sale of shares etc.

We can use healthcare provider Raffles Medical Group’s (SGX: R01) cash flow statement (which is partially reproduced below) for the 12 months ended Dec 2012 as a real-life example:

  In S$ m
Cash flows from Operating Activities 69.55
Cash flows from Investing Activities -10.46
Cash flows from Financing Activities -6.25
Total 52.84

From the table above, we can see that there’s a total of S$52.84m in cash that flowed into RMG in the whole of 2012.

For the cash flow statement, some important things to note would be how cash flows from operating activities changes with time. As investors and shareholders, we’ll ideally want to see it grow steadily over time.

In addition, a company should be generating the bulk of its cash needs from its operating activities and not its financing activities – that’s something investors should keep a look out for in their investments.

Foolish Bottom Line

What’ve we given here is useful in giving ourselves a head start in understanding financial statements. But truth be told, financial statement analysis itself entails a wide breadth of knowledge and is definitely not something that can be easily covered in its entirety in an article or two.

It would definitely serve an investor well to continue digging in further.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.