Understanding Financial Statements Part 3: Statement of Cash Flows (Statement of Cash Flow)

In the past two weeks, Viet Hustler has introduced readers to 2 types of financial statements: including Balance Sheet and Income Statement. The 3rd article in the series Understanding Financial Statements by Viet Hustler will provide readers with a more detailed view of the Statement of Cash Flows (Cash Flow Statement), with practical analyses on Apple.

Introduction to the Statement of Cash Flows (Statement of Cash Flow)

The Statement of Cash Flows (Statement of Cash Flow) is a report that records the cash inflows and outflows of the business to provide readers with complete information related to cash circulation—including cash, bank deposits, cash in transit... over a specific period.

The Statement of Cash Flows is classified into 3 activities: Operating activities, investing activities and financing activities over a specific period.

1. Cash flows from operating activities:

• Inflows and outflows from the business's production and sales activities.

  • This is also the most important activity/cash flow. 

2. Cash flows from investing activities: 

• Inflows and outflows from financial investment activities and buying, selling, or disposing of fixed assets.

3. Cash flows from financing activities:

• Inflows and outflows from capital management activities: including raising capital from creditors and owners, repaying capital to creditors, share buybacks, interest payments to investors, dividend payments to shareholders…

Example: Apple's 2022 cash flows are illustrated in the chart below.

• Total cash generated from business operations is 122.2 billion USD:

  • Of which, net income is 99.8 billion USD — accounting for the majority of the inflows.

• Apple used this inflow for the following investments:

  • 22.4 billion USD used for investments: mainly investment in equipment and plants (10.7 billion USD) + stock investment (9.8 billion USD).

  • 110.7 billion USD payments for financial activities including: stock buyback - buyback (89 billion USD) and dividends to current shareholders (15 billion USD).

→ Net cash flow for the year was -11 billion USD (equivalent to a deficit of 11 billion USD).

• The company started the fiscal year with 36 billion USD in cash and ended the year with 25 billion USD. This difference matches the change in cash flow for the same period.

Structure of the Cash Flow Statement

(1) Cash flow from Operating Activities

To calculate cash flow from operating activities, there are 2 methods: direct and indirect

1. Direct method

Direct cash flow from operating activities consists of 2 types:

• Cash inflows:

  • Receipts from sales, service provision and other revenue forms,

  • Other receipts…

• Cash outflows: Payments to suppliers, payments to employees, depreciation, interest expense, corporate income tax, other expenses for operating activities.

• Cash inflows – cash outflows > 0: The business is operating well.

• Cash inflows – cash outflows < 0: The business will face cash shortage (also known as financial distress). If not resolved, it will lead to bankruptcy or dissolution.

2. Indirect method

To calculate cash flow from operating activities using the indirect method, we start with Net income, then add back the non-cash expenses and changes in working capital.

• Non-cash expenses: are expenses that do not involve cash transactions such as:

  • Stock-based compensation (Stock-based compensation): a benefit that allows employees the right to buy company stock at a discount or even for free. 

  • Depreciation (D&A): an expense that reflects the decrease in value of long-term assets such as buildings, equipment, or patents — when the company uses these assets.

• Changes in working capital refers to the movement of current assets and current liabilities during the period.

In the example with Apple above, using the indirect method we have:

• Cash flow from Operating Activities ((~$122.2 billion) = Net income ((~$99.8 billion) + Non-cash expenses ($21.1 billion) + Changes in working capital (~$1.2 billion).

(2) Cash Flow from Investing Activities

Cash flow from investing activities indicates the amount of money the company uses to invest in future growth, such as buying or selling long-term assets.

• This is where capital expenditures (Capex - capital expenditure) are shown.

FYI: Capital expenditures (Capex) are costs to purchase or upgrade long-term assets such as real estate, plants, and equipment (PP&E) expected to have a useful life of more than one year.

• These purchase transactions are considered investments in the company's future growth and are often financed through a combination of debt and equity.

There are two important things to look for when analyzing cash flow from investing activities:

• Purchases or sales of property, plant, and equipment (PP&E): These are long-term assets that the company uses to generate revenue. 

  • High PP&E can be a good sign, as it means the company is investing in future growth. 

  • Conversely, high proceeds from the sale of PP&E can signal a danger warning, (as the company may be in trouble and has to sell assets).

• Purchases or sales of investments: These are investments in other companies or assets that the company uses to generate additional income.

  • The example below from Apple shows that the company used a large sum of money to repurchase its own shares on the open market (purchases of marketable securities)

    • … this move may please large shareholders but does not help the future business operations of the enterprise.

(3) Cash Flow from Financing Activities

Cash flow from financing activities shows the amount of money the company raises from investors or borrows from lenders.

Some things to note when analyzing cash flow from financing activities:

• Borrowing or repaying debt: Borrowing and debt repayment activities during the period are shown on the cash flow statement.

  • From this, investors wanting to check if the company is overly indebted can refer to the balance sheet.

• Issuing or repurchasing equity: A company can issue new shares to raise cash.

  • Additionally, the company can buy back its own shares — reducing cash but also reducing the number of shares outstanding — making each share more valuable to existing shareholders.

• Dividend payments: The company can distribute a portion of its profits to shareholders in the form of cash dividends.

Financial ratios in the cash flow statement

1. Free Cash Flow = Cash Flow from Operating Activities - Capex.

   Free cash flow represents the amount of cash the company has available to pay dividends, repurchase shares, or repay debt.

2. Interest Coverage Ratio: indicates the company's ability to pay interest

3. Dividend Payout Ratio: indicates the % of free cash flow used by the company to pay dividends to shareholders

4. Debt / Free Cash Flow Ratio: indicates how many years of operation the company would need if using free cash flow to pay off all debt.

Conclusion

Thus, just by reading and analyzing the Cash Flow Statement, investors can grasp information about the cash flows in the business. From there, they can make predictions and assessments about the business's future growth potential.

A healthy business is one that always has reasonable cash inflows and outflows, with cash inflows greater than cash outflows.

To help readers learn more about knowledge related to business analysis, Việt Hustler will continue to bring more useful articles in the “Entrepreneur’s Perspective” section.