Cash Flow Analysis Blog #1 – what is cash flow & why should we care?
“Cash is king.”
Cash flow management is in the heart of every business. It is what keeps the lights on. A failing business may or may not practice good positive cash flow management, but a business who practices poor negative cash flow management is most certainly doomed to fail. This series of five cash flow analysis blogs is meant for investors, and it might be helpful to business owners and other types of business persons as well.
Now that we have established why you should continue reading this article, you can expect the rest of this article to elaborate what cash flow is, the proper way to analyze it, how the results of the analysis should be interpreted, special considerations, dilemmas around cash flow analysis, as well as cautionary pitfalls around cash flow analysis.
So, what is cash flow? Simply, it is the movement of cash into and out of a company. The cash one receives from customers, lenders, and investors; and the checks the company write to pay employees, suppliers, and creditors. Smart business owners and companies’ management know that analyzing historical cash flow pinpoint patterns of cash sources and uses. Patterns that help them in developing a capital strategy to manage daily and long-term cash needed to run the business. Lenders perform cash flow analysis, among other types of financial analysis, before providing business loans to companies. Investors perform the same type of analysis, among other types of financial analysis, before investing their (or others) money in businesses.
To properly analyze a company’s cash flow, one needs access to the company’s cash flow statement. Of course, this access is harder to obtain with private companies. Unless one is a part of the company, a current or prospective lender or investor, it is virtually impossible to get a copy of a private company’s cash flow statement. Furthermore, it would be ideal to perform a cash flow analysis with 5-years (or more) period of historical data – three years at the very minimum. For these reasons, we will be using a public company’s cash flow statement – namely Caterpillar’s – for the remainder of this article. Caterpillar (ticker symbol CAT) is a US-based manufacturer of heavy machineries often used in the construction industry around the world, with financial statements that adhere to US GAAP (Generally Accepted Accounting Principles).
A cash flow statement has 3 major components: operating, investing, and financing. Operating cash flow is the cash flow generated from business operations (the sales of products or services generally within the company’s control). Investing cash flow is the cash flow generated from investment in plant, property, equipment, and other fixed assets; as well as non-recurring gains or losses. Financing cash flow is the cash flow generated from external sources (lenders, investors, and shareholders) in activities such as obtaining new loans and repaying old ones, the issuance and repurchase of stocks, and the payment of dividends. Below is CAT’s cash flow, summarized by these three major components:
As we can see, in CAT’s case, the operating cash flow is a major source of cash, the investing cash flow is a major use of cash, and the financing cash flow can be either one. It was a major source of cash in 2011 and 2012, reversing to become a major use of cash in the period 2013 through 2015. This Operating-Investing-Financing (O-I-F) pattern of + - - cash flows suggests that CAT is a mature firm. We will dive deeper into cash flow patterns in the next blog post.