Learn how to analyse the financial statements of public U.S. companies, item by item.
The Cash Flow Statement
The purpose of the cash flow statement (CFS) is to detail a business’s in- and outflows of cash and reconcile these with net income. Let’s look at Coca-Cola’s cash flow statement for the fiscal year ending December 31st, 2020.
We can divide the CFS into three distinct segments: cash flow from Operating Activities, Investing Activities and Financing Activities. Unlike the income statement, the CFS does not employ accrual accounting, so only those cash flows which have actually materialised are reported. Typically, the CFS begins with net income, details a variety of items that are either added or subtracted, and finally produces a cash figure for that year, which mirrors any increase/decrease in cash on the balance sheet during the same reporting period. The CFS is therefore linked to both the income statement via net income and the balance sheet via changes in the cash balance between periods. Furthermore, it is important to know that unlike the income statement and balance sheet, the CFS includes both positive and negative numbers which represent cash inflows and outflows, respectively.
Cash flow from Operating Activities describes any cash inflows and outflows related to the company’s core business operations – i.e., the sale of its products/services. The first line of the cash flow statement is Net Income, which is taken from the income statement. Non-cash charges, such as Depreciation/Amortisation and Stock based Compensation Expense are added back to net income because they do not represent actual cash outflows. Indeed, Depreciation and Amortization represents theoretical accounting expenses which serve the purpose of spreading out the purchase price of tangible (depreciation) and intangible (amortization) assets over their useful lifetime. Similarly, Stock-based Compensation Expense describes the theoretical cost to shareholders of company employees exercising their stock options, which would dilute their claim to profits. Therefore, both are cash inflows, so they are added to Net Income. Deferred Income Taxes, which are essentially tax savings for the reporting period, are also added back to Net Income as cash inflows.
Equity (Income) Loss – Net of Dividends represents any share of income/loss the company in question is theoretically entitled to from its investments in other companies – after any cash dividends received from these entities have been deducted. The item is designated as a cash outflow because it does not constitute hard cash, so it is deducted from Net Income. Foreign Currency Adjustments are made by parent companies to translate the financial results of their foreign subsidiaries into the domestic/main currency, which for Coca-Cola is the U.S. Dollar (as it is a U.S. based company). This process results in gains and losses through fluctuations in foreign exchange rates between the dates that transactions are recorded by the subsidiaries and the date that the translation occurs. The item Foreign Currency Adjustments has produced a loss in this case and is deducted from Net Income as a cash outflow. This particular CFS also contains more ambiguous items: Significant (Gains) Losses – Net is a cash outflow as it has not brought any new cash into the business for this reporting period whereas Other Operating Charges and Other Items represent cash inflows.
Net Change in Operating Assets and Liabilities is also known as the ‘Change in Non-Cash Working Capital’ from one reporting period to the next. Here is how it is calculated:
Non-Cash Working Capital = (Current Assets – Cash) – (Current Liabilities – Current Debt)
An increase in Non-Cash Working Capital, which could be brought about by retaining more inventory or having more accounts receivable, has the effect of reducing operating cash flow because such items tie up cash. Conversely, a decrease in Non-Cash Working Capital would increase operating cash flow. In this case, we can see that Coca-Cola’s Non-Cash Working Capital has decreased, since the item is framed as a cash inflow (it is added to Net Income). If Non-Cash Working Capital had decreased year-over-year, we would have deducted it as a cash outflow and the item would have been shown in brackets. Net Cash Provided by Operating Activities summarises all of the adjustments made above and indicates the cash that Coca-Cola’s core business operations produced in the fiscal year of 2020.
Let’s move on to the Investing Activities section, which makes further adjustments to the Net Cash Provided by Operating Activities figure and is far more intuitive in terms of the items it contains. Purchases of Investments such as highly liquid U.S. treasury bills or certificates of deposit are designated as cash outflows and Proceeds from Disposals of Investments (gains from the sale of such investments) are cash inflows, which warrants no further explanation. Acquisitions of Businesses, Equity Method Investments and Non-Marketable Securities, a cash outflow, denotes any purchases of a controlling stake in other companies (>51%), a significant but non-controlling stake (20-50%), in addition to the purchase of illiquid assets which could include shares in private companies, savings bonds, or complex derivative products, respectively. Proceeds from Disposals of Businesses, Equity Method Investments, and Non-Marketable Securities simply envelops the gains from selling any of the above investments – a cash inflow. Purchases of Property, Plant and Equipment are a cash outflow, whereas the Proceeds from Disposals of Property, Plant and Equipment are, unsurprisingly, a cash inflow. Other Investing Activities, a miscellaneous item, is a cash inflow for this year.
The third section of the CFS is Financing Activities and it begins with Net Cash Provided by Investing Activities. Issuances of Debt describes any new debt that the Coca-Cola company has taken on in this reporting period – a cash inflow. Payments of Debt, on the other hand, details any debt repayments that the company has made – a cash outflow. Issuances of Stock is a cash inflow that represents equity financing i.e., the creation and sale of new shares to the public in order to raise capital. Purchases of Stock for Treasury, a cash outflow, denotes share buybacks which involve a company buying its own shares in the open market in order to return capital to shareholders indirectly. This process reduces the number of shares in circulation, decreasing the supply, which raises demand and artificially increases the share price. Dividends are also a cash outflow and they are a way of returning capital to shareholders directly – a proportion of the Coca-Cola company’s earnings are paid directly to shareholders. Other Financing Activities describes a cash inflow and is the final adjustment for this section. Net Cash Provided by Financing Activities, which stands at approximately $8 billion, incorporates all of the cash in- and outflows throughout the CFS’s sections.
However, before arriving at the ‘bottom line’ of the CFS, which highlights the change in cash year-over-year, a few adjustments are still made for the Effect of Foreign Exchange Rates and Restricted Cash and Cash Equivalents. The former refers to the impact of forex fluctuations during the reporting period, whereas the latter describes cash that is reserved for a specific purpose (such as collateral for a loan) and therefore unavailable. Making these adjustments finally presents us with the increase in unrestricted cash year-over-year (2020 vs. 2019) – $315 million, which matches the difference between the cash & cash equivalents listed on the balance sheet in 2020 and 2019 as you can see below:
To conclude, the cash flow statement is incredibly important despite traditionally receiving less attention than the income statement and balance sheet. Through shedding light on how much cash is moving in and out of the business and for what reason, investors can gauge how solvent/liquid a company is, analyse income and expenses in more detail, and judge the extent to which the business is a ‘cash cow’. Cold, hard cash is the most liquid asset and is therefore incredibly valuable – it can be used to pay off debts, make spontaneous investments, or be used to reward shareholders via buybacks or dividends. Unambiguous cash flows, through excluding ‘paper earnings’, are also more difficult to manipulate than net income – this is another reason why the CFS appeals to investors. For all of the above reasons, many investors today actually utilise free cash flow in place of net income, to get the best possible idea of how much cash a company is producing so it can be valued more accurately.
Johan Lunau – 23/06/21