This article is the last in a series showing beginner investors how to analyze a company’s financial statements. We’ve already covered the Income Statement and Balance Sheet. Now it’s time to take a closer look at the Cash Flow Statement.
The Cash Flow Statement is typically the last of the 3 financial statements I review. But it may just be the most important. In practice, I review all 3 financial statements in conjunction with one another and recommend you do the same.
In this article, I’ll review a common sense approach to analyzing the Cash Flow Statement to determine if a stock warrants additional attention. If it passes the test, it’s then time to dig even deeper.
What is a Cash Flow Statement?
A Cash Flow Statement summarizes the movement of cash into and out of a company over a period of time. It’s comprised of 3 sections:
- Cash from operating activities
- Cash from investing activities
- Cash from financing activities
Let’s take a brief look at each.
Cash from operating activities
In my opinion, this is the most important section because it shows all cash generated by (or used in) the operating activities of the company. Put another way, it answers the question of whether the company is generating or losing cash from its operations (i.e. from the goods or services it sells).
Cash from investing activities
This section summarizes the cash flow from a company’s investments. Investments may include the purchase or sale of assets (capital equipment), loans made to vendors or merger & acquisition costs. Of particular importance is capital expenditures, which is a component of the free cash flow (FCF) calculation (more on this later).
Cash from financing activities
Lastly, is cash from financing activities. This section includes cash paid to shareholders via dividends or share repurchases. And cash paid to lenders (i.e. banks) such as principal repayment of a loan.
Analyzing the Cash Flow Statement
I’m a big proponent of keeping it simple, so I don’t scrutinize every component of the Cash Flow Statement in detail. I focus on what I find most important, and ask a few basic questions:
- Is the company generating positive cash flow and able to sustain its operations?
- Is the company cash flow positive even after backing out Stock Based Compensation (SBC)?
- Can the company pay off its long-term debt within 3 years using operating cash flow?
- Is the company generating FCF?
- Is the company excessively diluting shareholders via SBC or secondary offerings?
It might seem like a lot, but you should be able to answer these questions within 5 minutes of reviewing the Cash Flow Statement.
Let’s practice analyzing the Cash Flow Statement using Nike (NKE) as an example.
Step 1: Review cash flow from operations
It comes as no surprise that Nike is cash flow positive. In 2022, Nike generated $5.2 billion in operating cash flow. Not bad. And the company is cash flow positive even after backing out SBC ($5.2 billion – $638 million = $4.6 billion).
I have no doubt Nike can continue to support its operations. So we’ve already answered questions #1 and #2 above. But can Nike pay off all its long-term debt within 3 years? For this, we need to look at the Balance Sheet.
In 2022, Nike had $8.9 billion in long-term debt on the Balance Sheet. And for the past 5 years, Nike has averaged around $5 billion per year in operating cash flow. So Nike could easily pay off all long-term debt within 3 years using operating cash flow ($8.9 billion / $5 billion = 1.8 years).
The answer to question #3 is yes.
Step 2: Review cash flow from investing
Famed investor Warren Buffett believes the intrinsic value of a business is the sum of all future earnings (he calls it Owner’s earnings) of the business discounted back to today’s value. You may know it as Discounted Cash Flow (DCF).
Free cash flow is a good proxy for Mr. Buffett’s “Owner’s earnings” and is easily calculated from the Cash Flow Statement.
Free Cash Flow = Operating Cash Flow - Capital Expenditures
Investopedia defines FCF as the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Basically, it’d be your profit as the sole owner of the business.
In 2022, Nike generated $4.4 billion in FCF ($5.2 billion – $758 million). And over the past 5 years, they’ve averaged around $2-3 billion in FCF per year.
Nike is generating billions in FCF each year, so the answer to question #4 is yes. This leaves no doubt Nike is a profitable company generating positive cash returns.
Step 3: Review cash flow from financing
This section of the Cash Flow Statement is where you can determine if a company is friendly toward shareholders. A company that’s friendly toward shareholders will do one or more of the following:
- Pay a dividend
- Maintain or reduce total number of shares outstanding
- Manage debt
Let’s take a look at Nike to see if it’s shareholder friendly.
Net issuance of common stock represents the net amount (value) of stock issued by Nike during the period. In 2022, Nike removed $4 billion in stock from total number of shares outstanding. This means Nike repurchased more stock than it issued. This is a good thing. The answer to question #5 is no.
In 2020, Nike issued $6.1 billion in debt. This could’ve been a bond, bank loan or other source of funding. Net issuance of debt is basically flat for all other years shown. We’ve already established Nike is generating enough cash to service its debt, so $6.1 billion isn’t cause for concern.
In 2022, Nike paid out $1.8 billion in dividends to shareholders and has been steadily increasing that amount over the years.
Nike checks all the boxes for shareholder friendliness: it pays a dividend, is retiring more stock than it’s issuing and effectively manages its debt.
Bottom Line
Is the company generating or burning through cash? This can only be answered by analyzing the Cash Flow Statement.
The steps outlined in this article are just one way to quickly analyze the Cash Flow Statement. But you may prefer one aspect over another, so be sure to make it your own.
And don’t forget to analyze the Cash Flow Statement in conjunction with the Income Statement and Balance Sheet. Analyzing any one without the other is sure to leave a gap in the story.
