Cash flow statement – Investing Class

Lets take a look at a sample cash flow statement to go through this discussion. I am choosing a company familiar to almost everyone reading this article: Coca-Cola

(all numbers in USD mm, source: Morningstar.com)

Some observations from Coca Cola’s 5-yr cash flow statement:

Operating cash flow: As you can see, the cash from operating activities has been around $10bn for the last 5 years even though the Net income in the range of $6bn-$9bn. The difference comes from the change in working capital (Current assets – current liabilities) and non-cash expenses like depreciation recognised in income statement.

Investing cash flow: In earlier chapters, I said that Depreciation is a real cost even though it is considered as a non-cash expense. This can be seen in the Net cash from Investing activities. The first 2 lines showing Investments in property, plant and equipment demonstrate the ongoing yearly cash outflow by the company to either maintain the properties or upgrade the plant so that they can continue to operate at current output level. This also shows that Depreciation of assets on the Balance sheet (recognized at initial cost) is not able to capture the real cost of upgrading/replacing assets, as the actual cash outflow in the Investments in property, plant and equipment has been consistently higher than the depreciation number used in Income statement. Hence, the cash flow statement provides a better view of requirements for running the business. It is can also be useful to see the trend of percentage of investment in plant, property and equipment to the net income over the years. This gives us an idea of total capital expenditure requirements for the company.

From the other investing activities of Coca Cola (Purchase of Investments and Sales/maturities of investments), we can infer that most of those movements correspond to cash equivalents on Coca Cola’s balance sheet recognized as liquid investments.

Financing cash flow: Coca Cola has been issuing more debt than the maturing debt. Since it is a company with strong earning power (seen from the operating cash flows), it seems to be leveraging the business over the years, adding $2bn-$5bn of debt every year. On top of this, it has been paying out hefty dividends to the shareholders along with net stock buybacks, both activities loved by the shareholders. Even though it does seem like the company is being shareholder friendly, increasing amount of debt can be painful if the interest coverage falls with decline in operating cash flow. Before investing in the company, I would go back to balance sheet to see the amount of leverage (Debt/Equity) and to income statement to check Interest coverage ratio (EBIT/Interest expense). Finally, whether the Return on Capital is more than the cost of debt (ROIC).

Questions to ask from any cash flow statement:

Are the operating cash flows able to fund the investing activities for the business? What proportion of net income is spent in investment in property, plant and equipment every year?
What is the disparity between depreciation and actual expenses to maintain the business?
Is the company issuing more capital via equity or debt? Is it good for shareholders?

Chapter 20 – Valuation concept (P/E ratio)

Chapter 18 – Cash flow statement (1)

Coming to the final financial statement that we look at while analysing a company – Cash flow statement. This statement shows the actual cash inflow and outflow for the period under study. We can visualize it as the sources and uses of cash for a business. It is categorised under 3 main headings:

Cash from Operating activities: This section shows the actual cash generated by the business from its operating activities, i.e. main business operations. For the hot dog owner, that would be total cash generated from selling hot dogs minus his cash outflow for ingredients, advertising, rent, salaries of staff etc.
Cash from Investing activities: This section primarily shows the cash used/received from investing in/liquidating assets of the business and upgradation of machinery or infrastructure. For the hot dog owner, this could mean buying more stalls, more kitchenware, more tables, buying a new shop and so on.
Cash from Financing activities: This section shows the total change in cash from payment of dividends, raising more capital (by issuing more stock or debt), buying back stock from market (resulting in Treasury stock), paying off debt etc. Effectively, this section involves the change in cash position due to financing from banks and capital markets.

We are concerned mainly about the cash from operating activities and cash from investing activities. The reason is – for a stable or a healthy business, normal operations should be able to generate enough cash for existing business as well to fund the expansion activities. If not, then the business would dip into Financing activities involving banks and capital markets which can result in dilution in stake of existing shareholders or taking on more debt. Also, to have access to capital markets for more capital (debt or equity), the business would need to show a good underlying business opportunity, else who would be really interested in investing? It does not mean that a company with troubled underlying business is not able to raise capital – it just comes at a higher price!

Why is cash flow statement different from the income statement?

Good question. Two major reasons:

Revenues: In accounting, the company can record revenues when the sale contract is signed. But the cash from this contract may not come until next year. So even though we see increase in revenues, we will not see the corresponding cash to hit the bank account. Remember the cash cycle we discussed in Chapter 10 where a part of revenues is captured as Receivables on the Balance sheet. Those receivables become cash when the customers pay up for the sale of products.
Investments: As a business invests in new assets, only a portion of the cash flow is recognised in Income statement using Depreciation (as discussed in Chapter 4). The cash flow statement helps us to understand the actual cash outflow for new investments in plants or property recognized at 100% of cash outflow.

A Cash Flow Statement can be constructed using a Balance Sheet and Income Statement together. We are not going to have that discussion here, as it would be a part of an accounting discussion rather than an investing discussion. But we will talk about some sanity checks or potential red flags when looking at a cash flow statement in the next Chapter.

Chapter 19 – Cash flow statement (2)

Chapter 17 – Key ratios