Cash Flows Made Simple

In Warren Buffett's letter to his shareholders in 2018, he said something about how a company's money might not always be what it seems. 

You see, his company Berkshire Hathaway made a lot of money, like $24.8 billion dollars in operating profit, but when they showed their earnings, it was only $4 billion. 

This is largely due to a loss in unrealized capital gains, which happened because some of their investments in the stock market lost value.

This is just one example of how a company's net income number can be a little tricky on their income statement.

That's why lots of smart investors like to look at the cash flow statement instead of just the net income.

It helps to know if a company is really making money or if they're just using some accounting tricks to make it look that way.

So, let's talk about cash flow statements, why cash is king.

What Is A Cash Flow

Cash flow is like keeping track of the real money a company gets and spends. 

It's the actual money that goes in and out of their bank account. 

You'd think that this cash flow would match perfectly with the money they say they earn and spend on their income statement, but that's not usually the case. 

See, sometimes the numbers on the income statement are like promises, not real money. 

Here's an example: let's say a company gets a big bill to pay next year. 

They write it down right away as an expense on their income statement, even if they haven't paid it yet. 

But on the cash flow statement, it only counts when the money goes out of their bank account. 

So, cash flow is simpler because it's only about real money coming and going. 

If the company actually paid or received money, it shows up in cash flow. 

If not, it doesn't. 

Some smart people who look at company numbers care more about cash flow than the money the company says they made. 

Take Amazon in 2014, for example. 

On the income statement, they looked like they were losing money. 

But in the real world, they were making lots of actual cash - like, 5.9 billion dollars - and putting it in their piggy bank. 

But remember, it's crucial to know where this cash is coming from, either from selling more stuff or taking out a loan from a bank.

Cash From Operating Activities

For this reason, the cash flow statement splits its cash movements into three main groups. 

The first one is the cash a company gets from its regular operations, and it's the most critical part. 

This shows us how much money the business actually made from its day-to-day work. 

Often, when folks talk about a company's cash flow, they're talking about this part, known as CFO. 

CFO includes the cash they got from selling stuff minus the cash they gave to suppliers and workers. 

It also considers things like interest paid on loans and the taxes they handed over to the government. 

So, in simple terms, it tells us how well the company's main money-making operations are doing. 

Think of it like the profit you make from your lemonade stand. 

If that number is big and growing, it usually means your lemonade business is getting bigger and better. 

But if it's getting smaller, that's a sign that your lemonade business isn't doing so well. 

And if it's negative, that's like saying you're losing money with each glass of lemonade. 

If things don't get better, your lemonade stand might have to close down.

Cash From Investing Activities

The second group is cash from investing activities. 

This is where all the cash that's used for things like buying or selling long-term assets, like buildings, equipment, and such, is counted. 

It's essentially any money spent on growing the business, taking care of the company's current stuff, buying other businesses, or investing in different securities. 

For instance, if we look at Vanilla Investor Co., the cash flow in this group would include spending on things like buying a new delivery van, purchasing another business, and getting some money market investments. 

Now, usually, this type of cash flow is negative. 

That's because it often means a company is putting its money into expanding or just maintaining what it's got. 

But once in a while, it can be positive, especially if a company is getting cash back from its investments or selling off some of its assets.

Cash From Financing Activities

The last category is cash from financing activities. 

Here, you'll see the amount of money a company has either brought in or spent on things like selling shares, issuing bonds, or using various forms of borrowing. 

So, if a company takes a loan, the cash they got from it would be listed here as a positive cash flow. 

This is also where you'd subtract things like buying back shares, paying dividends to shareholders, and the company's repayments on its debt. 

Now, a positive cash flow in this category means that a business is gathering money, likely to help it expand. 

On the other hand, a negative cash flow shows that a business is shelling out cash, either to its investors via share buybacks and dividends, or to its lenders to pay down its debt. 

This will lower the company's debt level.

Free Cash Flow

So, these are the three main types of cash flows, and when you add them up, you get the company's overall change in cash, which tells you how much the firm's cash balance has shifted during a specific year. 

Now, there's also a fourth member in the cash flow family known as free cash flow, or FCF, and this is particularly adored by value investors. 

Free cash flow is quite simple. 

It's the company's operating cash flow minus the capital expenditures, which is the money from CFI used for things like company vehicles or buildings. 

This number is super important because it basically reveals how much money a company has once it's covered all its obligations. 

This is money that's free from any commitments. 

A company can use this to pay dividends, buy back shares, pay off debt, or go after new acquisitions. 

It's a profitability measure that grabs a lot of attention from analysts. 

When a company has strong cash flows, it usually can fund its own growth initiatives without needing to take on extra debt. 

But a company with consistently negative free cash flow is probably spending more money than it's bringing in, and sooner or later, it will need to find additional funding.

Why Are Cash Flows Important

So, that's a brief overview of cash flows. 

But you might wonder why analysts place such importance on this measure. 

After all, aren't the confusing rules and assumptions in net income meant to reflect a company's financial situation? 

Well, the income statement is helpful to some extent, but cash flows give us a more comprehensive view and can offer valuable insights into the quality and sustainability of a company's earnings. 

Let's take an example to understand this better. 

Imagine we have two ice cream companies, Vanilla Investor Co and Charlie’s Chocolate. 

Suppose both companies have identical balance sheets, and in 2022, they both report earnings of $10 million dollars on their income statements. At first glance, you might think these companies are equally financially strong. 

However, when we delve into their cash flow statements, we see a different story. 

For instance, looking at Vanilla Investor Co’s cash flow statement, you notice that the company has a high CFO (cash from operating activities), which can support its CFI (cash from investing activities) and even allows it to give money back to its stakeholders and creditors through its CFF (cash from financing activities). 

On the flip side, Charlie’s Chocolate has a lower CFO and significant CFI, meaning they're spending way more money than they're making from their operations. 

To cover this, they're taking on debt, as shown in their CFF.

Key Takeaway

Now, even though both companies have the same earnings figure, Vanilla Investor Co seems to be in a better financial position. 

This example highlights why it's crucial to grasp not only a company's profitability but also its cash flows. 

Companies with healthier cash flows typically have more reliable business models and fewer difficulties when it comes to funding their operations. 

Cash flows also provide insights into a firm's earnings quality. 

If a business reports substantial profits but has low or negative operating cash flow, like Charlie’s Chocolate, they might be inflating their financial performance. 

Now, the nature of a company's cash flows can significantly differ depending on the industry they are in, and specific factors like interest and lease payments have different rules. 

However, even with this basic understanding, you can gain valuable insights into a firm's financial health by examining their overall cash flows. 

So, the next time you're evaluating a company, take a good look at their cash flow statements to see how the three key components - cash flows from operations, investing, and financing - have changed over time. 

Also, compare a company's cash flow to their earnings. 

If these numbers are close to each other or if CFO is higher than net income, it likely means the company has higher earnings quality. 

Analyzing free cash flow will additionally indicate whether a company has extra money to spare or if they are spending more than they're making from their business.

While net income can provide a quick summary of a company's performance in a given year, for the complete picture, it's better to follow the cash flow.

- Ivan