Cash Flows: A Measure to Understand a Company’s Present Financial Health!

Cash flows

Understand how to analyse the cash flows of a company by looking at its operating cash flows, free cash flows and free cash flow yield.

Every business spends cash on purchasing raw materials and turns them into finished goods, which are sold in the market for cash. This is a cycle that every company follows. Be it a local tea seller or a multinational company. No matter what, every company needs cash to ensure the smooth running of its business.

If a business faces a cash crunch, it would disrupt the functioning of the business and will face difficulties in funding for future growth initiatives. Hence, every company focuses on selling its manufactured products on time to recover costs and earn revenues. 

The revenues are later invested as CAPEX.

But, as an investor, how would you know if the company is efficient enough in generating cash, and how is it spending cash to generate future profitability for the company? Simply, by taking into account the cash flow statement and, specifically, Operating Cash Flow (OCF), Cash From Investing and Financing Activities and Free Cash Flow Yield.

Firstly, What is a Cash Flow Statement?

A cash flow statement includes the cash inflow and outflow records. It helps us understand where the cash is coming from and where the company is spending it. 

The cash flow statement consists of three parts:

  • Cash flow from operations 
  • Cash flow from investing activities
  • Cash flow from financing activities

What is Operating Cash Flow?

Operating cash flow includes all the cash the company earns through selling its products and services and the variable expenses that the company does, like employee salaries, cost of production, etc. 

It also considers the non-cash items like depreciation and goodwill amortisation, which basically do not go out of the company in the form of cash but still remain in the picture. 

Analysing cash flow from operations is relatively simple. If the company has a negative operating cash flow, then it does not have sufficient funds to keep its business going. On the other hand, a consistent increase in cash flow from operations is a good sign. 

Cash Flow from Investing Activities

Now, if the company invests or sells assets like land, acquisition, and receives interest on investments, all of this becomes a part of the cash flow from investing activity. 

In the investing activity section, it is called capital expenditure or CAPEX, when a company invests its funds to purchase long-term assets, upgrading or maintaining its existing assets like plants, property, etc.  

When we deduct CAPEX from the net operating cash flows, we get an important metric that every company aims to achieve: Free Cash Flow (FCF). 

What is Free Cash Flow, and Why is it an Important Metric to Analyse a Company?

Free Cash Flow (FCF) reflects the amount of cash a company generates after accounting for capital expenditures. Every company wishes to earn as much free cash flow as possible as it is the excess money that can be used for future investment opportunities, debt repayment, or distribution of dividends to shareholders.

FCF is considered an important indicator of a company’s present financial health rather than earnings, as it provides a more comprehensive picture of its cash flow situation.

Analysing Free Cash Flow

  • A positive FCF is a good sign. Moreover, the higher the FCF, the better. A higher FCF will also give a boost to the market value of the company because the value of any business is the discounted value of cash flows which will be generated over a period. 
  • A negative FCF is a red flag.
  • While analysing a company, we look at its Free Cash Flow Yield. It is calculated by dividing the free cash flow by the company’s market value. 

Analysing Industries Using FCF Yield

Here we must understand that not every industry can be analysed using FCF yield. That’s because companies in a few industries have to invest a massive amount of capital in CAPEX to ensure the smooth functioning of their business. To some extent, such industries are cement, metals, petrochemicals, pharmaceuticals and FMCG. As these industries have a high CAPEX, analysing them based on free cash flow yield will not give you a proper analysis. 

Conversely, industries with low CAPEX requirements are where you can use FCF yield to analyse better. These industries are IT, healthcare services, e-commerce, etc. 

Moreover, while analysing, check for consistency and growth in operating cash flows, free cash flows and free cash flow yield. Looking at cash flow yield is not the only metric you must use to analyse a company. There can also be a situation where the company may not invest funds towards CAPEX, leading to high free cash flows, again a red flag as continuous use of plants & machinery causes wear & tear, which has to be repaired continuously.  

To conclude, while analysing a company, it is also essential to look at other financial metrics to comprehensively understand its financial health. However, banks & lenders to most companies these days take into account the free cash flows to ascertain the required working capital limits of a company.

Note: This article was originally written by Teji Mandi for ET Markets.

Read the article here. 

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