Cash Flow Analysis Blog #3 – cash flow determinants & significance
There are many elements to operating, investing, and financing cash flows. To identify which of the determinants of these cash flows are significant; one needs to calculate the impact of a specific cash flow item against its own group activities’ net cash. Meaning, to identify if profit (or net income) is a significant determinant to operating cash flow, we need to calculate how much of the operating cash flow is made up of profit – simply by dividing profit by net cash from operating activities. This calculation, and others that correspond to each of the entries in our example company Caterpillar’s (CAT’s) cash flow statement, can be observed in the first tab of the attached file.
In CAT’s case, the determinants are profit, depreciation and amortization, receivables and payables, inventories, capital expenditures, proceeds from assets disposals, investments in and disposals of acquisitions and securities, dividends paid, shares repurchased, and debt issuances and payments.
As a note, each financial analyst has his or her own threshold in determining “significance”, it can be 10%, 15%, or 20% impact or even higher. Some firms dictate the percentage threshold in determining “significance”. I used 10% minimum in determining significance. For a fuller, richer view of significance, each of the cash flow item should also be analyzed from the perspectives of its historical trend, volatility, and speed of change – especially against the firm’s performance, life stage, and the macro-economic conditions.
One of the most important criteria in a cash flow analysis is if the operating cash flow is positive and sufficient to cover capital expenditures – capex for short. Capex is the fund companies used to buy/upgrade long-term physical assets (property, plant, and equipment). It is important because, without these assets, companies won’t be able to reach their optimum level of financial performance. Some industries are very capital intensive, examples are manufacturing, utilities, telecom, oil and gas. Fortunately, in CAT’s case, their operating cash flow is sufficient to cover capex:
Another important criteria in a cash flow analysis is the consistency of the operating cash flow. One can use the Coefficient of Variation (CV) method to measure the volatility or variability of the operating cash flow. The benefit of this method lies in its simplicity - it is simply a calculation of the operating cash flow’s standard deviation divided by its arithmetic mean:
With a CV less than 1, CAT’s operating cash flow demonstrated low volatility – as expected from a mature company.
The next step in the analysis is “common-sizing” the cash flow statement using net sales as the common size. For this article, CAT’s common size cash flow statement can be observed in the second tab of the attached file.
Once the cash flow statement has been “common-sized”, we evaluate the depreciation expense and net capex compared to the operating cash flow. For a manufacturer like CAT, we would expect these numbers to be significantly large as the nature of the business requires large properties and a high level of equipment to assemble, store, and move the inventories of heavy machineries (bulldozers and excavators).