It is relatively easy to master the basics of cash-flow statement analysis. Take the following steps:
1. Begin with a cursory review of the cash-flow statements. Look at the line titled "Net increase (decrease) in cash and cash equivalents," which usually appears toward the bottom of the report. A net increase indicates the customer has positive cash flow; a net decrease indicates the opposite. Be concerned about:
- Whether the company has positive or negative cash flow.
- If the company has a negative cash flow, how large the deficit is.
- Whether the company's negative cash flow is a one-time event or an ongoing problem. This is done through comparative analysis.
2. Do not overreact to bad news in the cash-flow statements. For example, a net decrease in cash and cash equivalents does not mean the corporation is about to file for bankruptcy protection. Remember that companies experience negative cash flow because of a variety of factors, including a decision to retire outstanding debts, to make an acquisition, or to purchase assets. All of these activities use cash, but might be favorable from a long-term standpoint. And the company may have access to other sources of cash--such as a line of credit with its bank.
3. Always review the company's prior periods' cash-flow statements. If a company reports a decrease in cash in the current period, it is important to review the statement for the prior period to see if this is a trend, or an isolated incident.
4. Recognize that cash flow from operations (from operating activities) is the most important metric. Operating activities are normally the primary source of cash for a company. Therefore, you want to see positive cash flow in this area. If a company has negative cash flow from operating activities, it is a red flag and a cause for additional concern.
5. Recognize that a company's ability to raise cash from sources other than operations is limited. For a while, companies may be able to compensate for negative operating cash flow through additional bank borrowing or by selling certain assets, but this is not a long-term solution to negative operating cash flow.
For example, the more a company needs to borrow to meet its current cash requirements, the higher the costs and interest rates it must pay. If the borrowing continues, sooner or later the bank will become concerned about the cash drain. At that point, it will become harder and more expensive for the company to borrow any more money.
Similarly, if a company is selling assets to offset negative operating cash flow, eventually it will run out of assets to sell. Selling off assets is not a long-term fix.
6. If the company under review has a decrease in cash and cash equivalents, or a negative operating cash flow, you should review the statement of cash flows to try to determine the underlying cause. For example, it is possible for a debtor company to record a profit but have negative cash flow from operations. How? By failing to manage and monitor items such as inventories and accounts receivable.
Key Point: Since new companies rarely generate positive cash flow right away, you need a different way of looking at these companies. The rate at which a new company uses up its venture capital to finance overhead before generating positive cash flow from operations is referred to as its burn rate--the rate of negative cash flow. For credit analysis, the question is whether revenue will begin to flow in sufficient amounts before the invested capital plus revenue is used up.
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