3 key questions your cash flow statement helps you answer

The cash flow statement helps illustrate the quality and sufficiency of a company's earnings

Why is the cash flow statement so ridiculously important?

Any accrual accountant will tell you that net income and net margin performance over time are still king of the hill when it comes to judging management and business performance. And, the income statement and balance sheet are clearly important financial statements. But, they are also prone to manipulation. A construction company with $200,000 in cash sales from Q1 to Q3 and $800,000 in credit sales (on completion) in Q4 could end the year with $1,000,000 in sales for the year. And yet, what if those $800,000 sales are to large customers that require large amounts of up-front work (cash consuming work) and are very, very slow to pay? Things can look fairly rosy on both the income statement and the balance sheet, unless we carefully investigate each one of those invoices and complete a credit analysis on the likelihood of receiving payment. Will the company have enough cash to deliver on the services, or will they run dry first? What if the large customers fail to pay and allege improper work or defects? 

Only by examining the cash flow statements can we really develop a keen sense of the operational performance of the company in question. Companies really only do three things. They complete business operations (operating cash flows). They obtain debt or equity financing (cash flows from financing). Or, they invest in or sell long-term assets (cash flows from investing). How can a reader of a cash flow statement quickly gain some insight into what is happening with the underlying business? 

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Question 1: Are cash flows from operations negative?

Negative cash flows from operations is almost always a very negative situation. It strongly suggests that revenues are insufficient to cover fixed costs, and potentially variable costs as well. A business that can't cover its variable costs should shut down. A firm that has negative net margin due to fixed costs may potentially be able to survive, so additional review would need to happen to ascertain what the outlook is in this area.

Conclusion: stay away or be very concerned. Perhaps a major turnaround can be implemented to get the business on a firmer footing. This often requires capital, and it will be important to make sure we're not partaking in the sunk cost fallacy. Many owners are emotionally invested in their businesses and sometimes emotional biases can get in the way of good clear, objective reasoning about a businesses future potential.

Question 2: Are cash flows from operations positive, but not enough to cover investing needs? 

Most growing small businesses are in this category. There are surplus cash flows from operations, but it is not enough to meet the company's investing needs. Growing companies are cash hungry, and there are often huge opportunities to increase operating leverage with the deployment of investment capital. More stores. More equipment. Low surplus operating cash flows can signal high expense growth. Sometimes this is good expense growth - building additional capacity in staff and skills for future sales growth.

The outlook could also be cloudy. If the business is an a weak credit position and equity backers are lacking, the business may be trapped in a place where its operating results are insufficient to meet its investment needs over the long-term. Growth opportunities may fade, and the company could suffer from an inability to grow due to foregone investments (e.g. low operating leverage).

Conclusion: Could be good, could be bad. The financial statements, management and overall business need to be studied more to make a conclusion on whether the outlook is positive or negative.

Question 3: Are cash flows from operations positive and high enough to investing needs? 

Well, you have basically Apple. Apple Computer is a large cap growth company that makes so much money every day, every week, every quarter that they don't know what to do with it. Businesses in this position are cash cows. They are in the enviable position of not being able to find enough investments or Net Present Value (NPV) positive internal projects in which to deploy the firms capital. These are often mature companies, but not always. Companies like Apple are both mature AND high growth. If you're a small business owner your goal is to get your company to this stage of high growth, absurdly high cash flow performance. Apple is very much the exception however. Many cash cows are at a high risk of low or moderate growth, and may be in industries that are in decline. Financial risks may be low, but strategic risks may  lurk in the background.

Conclusion: Companies like this can throw off cash flows in the form of dividends since there is more cash than there are suitable investment opportunities (internally).