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)