Cash Flow Analysis
| Cash flow analysis centers on the cash inflows and outflows within each distinct section of the cash flow statement. |
These distinct sections, as outlined in statement of cash flows purpose and format, are the cash flows from operations (CFFO), cash flows from investing activities (CFFI), and cash flows from financing activities (CFFF).
Since there are three sections with two possibilities of net inflow and net outflow, there are eight possible combinations for the cash flow statement. This is similar to computing eight possible combinations for tossing three coins with two outcomes each. Since there are also two possible outcomes for the three sections of the statement of cash flows, then the total combinations are computed as: 2 outcomes x 2 outcomes x 2 outcomes = 8.
In the case of cash flow analysis, however, the outcomes are anything but random! On the contrary, the cash flow patterns are indicative of management’s ability to generate cash and use it to lay the groundwork for future growth opportunities while controlling debt.
These cash flow analysis combinations can therefore be used to scan the main sections of the cash flow statement to assess how successfully management is generating cash from operations, and in turn using that cash inflow for future growth.
Cash Flow Analysis Patterns
| Section | Pattern #1 | Pattern #2 | Pattern #3 | Pattern #4 | Pattern #5 | Pattern #6 | Pattern #7 | Pattern #8 |
| CFFO | + | + | + | + | – | – | – | – |
| CFFI | + | + | – | – | – | – | + | + |
| CFFF | + | – | + | – | + | – | + | – |
Positive patterns in cash flow analysis first and foremost include net cash inflows from operating activities CFFO(+). When a company shows positive cash flow for CFFO, then it is generating positive cash flow from its core operations. Similar to most trends, one year is not significant, but several years with a cash flow pattern are used to gauge consistent growth.
The first four patterns show net cash inflows from operations. It is not necessarily negative, and is in fact quite common, for young businesses to show net cash outflows from operations CFFO(-). For younger companies, different ways to acquire cash are reviewed on the cash flow financing page.
The next question that should be asked in the cash flow analysis process is then: if the company is generating positive cash flow from operations, how is management using that cash?
CFFI shows whether or not a company is investing in the business in preparation of future growth. Cash outflows for investments can include investing in property, plant, and equipment, land, building, and even acquiring new companies. In this case, net cash outflows from investing CFFI(-) in combination with cash inflows from operations CFFO(+) is a positive indicator that the company is using cash to continue to prepare for future growth.
Cash Flow Analysis and Capital Expenditures
| Cash for capital expenditures varies widely by industry. Telephone and cable companies, for example, spend enormous amounts on capital to build communication networks. Auto companies and suppliers also spend large amounts on capital.
GM spent four times what it earned on capital expenditures, and Goodyear spends nine times what it earns. This pattern can only be maintained by issuing more debt, weighing down the balance sheet. While investing in capital expenditures is good for future growth, a mature company should be funding its capital expenditures with cash from operations, while also paying down debt or rewarding stockholders with dividends and stock buybacks (pattern #4). Watch out for industries and companies that finance capital expenditures with more debt (pattern # 3, and pattern #5). |
Finally, cash outflows for financing CFFF(-) is also a positive sign when it comes from cash inflow from operations (CFFO +) since it indicates the company has the wonderful problem of extra cash to a) pay down debt, b) issue dividends, or c) repurchase its own stock. The latter increases shareholder interest in the company and per share earnings, thereby adding value to outstanding shares without the tax burden of dividends.
Therefore, pattern #4 indicates a positive cash flow position that generates cash from operations, uses that cash for growth opportunities, while making payments to shareholders and lenders.
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