Cash is King

I keep reading the words that make the title and wanted to learn how to identify whether organizations where I have invested posses the  needed cash to survive. Cash statements as stand alone cannot give complete picture. But it is better that cash statement of these organizations is sync with the industry average. So started learning the approach to identify and writing it down for future reference,

What is cash flow statement?
The cash flow statement records a company’s cash receipts and payments during a year. It makes an entry only when some cash is received. Similarly, cash payment is reflected only when it is actually paid. To understand better, if you pay by credit card there is no flow of cash for you and if you pay cash, there is outflow of cash.

How does it work?

To evaluate the cash earned during a year, one needs to understand the three sections of a company’s cash statement—operating, investing and financing activities

When we look at operations, we are always interested in net profit when markets are at boom. But net profit does not represent cash.

Operating activity represents a company’s main line of business.. The cash generated from operations minus all the cash expenditures incurred is called the net cash flow from operations (CFO). The net profit (as given in the income account) is not the actual CFO. You have Money Receivables, which represents the services and goods sold on credit. This is not cash and hence deduct this from net profit. You also have  Money Payables and depreciation. Payables are money  that is still to be paid by the company for goods and services bought on credit and depreciation is deducted in the income account to reach the net profit. hence add net payables and depreciation to net profit.

The company can also generate cash by selling existing asset like land or building or bonds and equities of other companies. The company can also destroy cash by buying a new asset like airplanes. The difference between the inflow and outflow from the financing and investing activities along with the net CFO is the cash income during a year.

Some indications of caution

  • If cash growth does not correspond in pace with sales growth, it means that the company Could face a liquidity crunch in the future.
  • Companies should pay dividends out of the cash from their operations. Dividends from borrowed money can’t be sustained in the long run.
  • Avoid companies that generate a negative cash flow from their operations the long term. they may not be able to fund growth
  • high cash levels may indicate its inefficient utilization by the company.
  • if a company generates excess cash through loans or by selling assets, it may not be good for its health. Similarly, outflows like capital expenditure and paying off liabilities are not bad.
  • A growing company might sell goods and services on credit to gain competitive advantage in the short term. It will need a higher CFO in the long term to maintain its credit profile.