Cash Flow Analysis Example Using Cash

Flow Ratios Everyone Should Know

Dave Ahern April 16, 20200 comments
Advanced Metrics, Equity Accounting
“There is a huge difference between the business that grows and requires lots of
capital to do so and the business that grows and doesn’t require capital.”
—Warren Buffett, from Warren Buffett and the Interpretations of Financial
Statements
Cash is king, and Buffett has built quite a kingdom, with the latest balance sheet
reporting that he has $128 billion at his disposal.

The cash flow statement is one of the required reports for financial reporting for all
publicly traded companies. Still, it is probably the most misunderstood of the big
three and beyond calculating free cash flow.

There is a wealth of information contained in this statement, plus there are all kinds
of ratios we can use to unlock that information to use for our gain. We can find the
liquidity of a company, capital expenditures, and much more.

Want to find out how much a company spent on dividends or share repurchases? It
is all there on the cash flow statement.
Running a cash flow analysis and determining where the money went is a little like
we do every month, wondering where that $20 bill we had in our wallet went? The
same applies to the cash flow statement; we can work down the list and discover
some gems to help us determine the financial health of our company.

Determining where the cash went is essential, as well as for deciding what kind of
free cash flow is available to use for other opportunities for reinvestment or
purchases.

With the goings-on in the market as relates to the global pandemic, there has been a
returned focus on companies’ balance sheets, and rightfully so. But a cash flow
analysis can help you just as much, and frankly is not that difficult.

In today’s post, we will:

• Determine what a cash flow analysis entails

• Discover the difference between accrual and cash accounting

• Uncover the three different sections of the cash flow statement

• Discuss useful ratios to utilize to discover the financial strength of your

company.

What is a Cash Flow Analysis?

A statement of cash flows shows us how a company spends its cash (outflows), and
where a company receives its money (inflows). The cash flow statement includes all
the sources of cash inflows a company will receive from operations and outside
investment sources. Additionally, it will consist of all of the cash outflows that pay for
activities and reinvestments during each period.

Cash flow analysis is the examination of a cash flow statement and analyzing all the
inflows and outflows of cash from the business. A cash flow analysis will examine
inflows and outflows from operations, financing activities, and investment activities.

In plain English, it means that we are examining how a company makes money,
where the sources of cash are coming from, and what it means to the value of the
company.

Before we start diving into analyzing a cash flow statement, we need to have a word
about accounting. It won’t be boring, I promise.

Accrual vs. Cash Accounting

In accounting, there are two types of using the data to create our reports.

• Accrual accounting
 • Cash accounting

Let’s discuss accrual accounting first.

Most companies use the accrual accounting method and is the method where
revenue is reported as income when it is earned as opposed to when the company
gets paid. Expenses are recorded when they happen, even though the expense has
not been paid for yet.

For example, if we sell an iPhone, we record the income on the income statement
even though we haven’t been paid for the phone yet. From an accounting standpoint,
the company would earn a profit from the sale and pay taxes on the sale. However,
no cash has been received. Another point is that there would be cash outflows
initially because money needs to be spent on buying inventory and on making the
iPhone.

Most companies extend credit to their suppliers to pay their invoices, with the
standard terms being 30, 60, and 90 days, depending on the industry and
relationship with the supplier. And this sale would be an account receivable on the
balance sheet with zero impact on the cash until it is received.

Cash accounting is the other method of accounting. In the cash accounting method,
you account for the sales when they are received and the expenses when they are
paid.

On the income statement, a company’s profit is listed as net income; it is considered

the bottom line for all companies. However, because of utilizing accrual accounting,
not all net income means that all receivables have been received from their
customers. In other words, even though the company is listing a profit, there still may
be monies owed to them from distributors that have purchased their product but
have not paid for them yet.

From a financial accounting standpoint, the company might be profitable, but if the
receivables are not paid in time or are never collected, the company could have
financial issues. Even the best companies can struggle to manage their cash flow
adequately, which is why doing a cash flow analysis is a critical tool to have in our
toolbox when evaluating companies.

Ok, now on to the three sections of the cash flow statement.

The 3 Sections of the Cash Flow Statement

The cash flow statement has three distinct sections, which are broken out into three
particular components.

• Operations
 • Financing

• Investments

Each of these segments has a particular impact on the business. We will discuss
each section in turn.

Cash Flow from Operations (CFO) – This section records the net income from the
income statement. Items included in this section are accounts receivable, accounts
payable, and income taxes payable.
Cash flow from operations is the lifeblood of the business; it proves that positive
cash flow can sustain the company before making any long-term investments, such
as buying a new production plant.

In this section, we start with the net income and then make adjustments as cash
changes hands. For example, if a supplier pays a receivable, it would be recorded as
cash from operations. Changes in current assets and current liabilities are recorded
here in the cash flow from operations.

Click to zoom

Cash Flows from Investing Activities – In this section, cash flows from sales and
purchases of long-term assets like property, plant, and equipment or PPE, we can
include things like vehicles, buildings, land, and equipment.
Typically, when buying fixed assets like PPE requires a capital expenditure, which is
considered a cash outflow. Included in these transactions are things like buying a
new production plant and investment securities.

Cash inflows would flow from the sales of these assets such as fixed assets,
business segments, or whole businesses, and the selling of investment securities.

Of particular interest in this section is the cash outflows for capital expenditures for
maintenance, or purchasing of physical assets that support the continued success of
the business.

Basically, this section outlines any cash paid out to invest in the business.

A note about free cash flows, the item capex, or capital expenditures is found in this
section. To quickly calculate free cash flow, you can take cash flow from operations
and subtract the capex from the investing section. Of course, we can get more
granular, and we will uncover more in the upcoming section, but this is a quick and
dirty way to approximate free cash flow.

Click to zoom

Cash Flow from Financing Activities – the home of debt and equity transactions is
cash flow from financing activities. Here we will find cash outflows for dividends,
share buybacks, and purchases of bonds. We will also see cash inflows from the
sales of stock. Any monies received from taking a loan or any cash the company
used to pay down long-term debt will be recorded here.
For those of us who are dividend investors, this section is of importance because we
can see cash dividends paid, and not the net income used to pay for the dividends.
That is of concern because we want a company that can sustain its dividends from
operations of the business, as opposed to taking on more debt.

For investors, this is probably our favorite section because we can see equity being
returned to us, via dividends or buybacks and the source of those equity returns.

Click to zoom

Ok, now that we have covered the basics of the cash flow statement, let’s move onto
analyzing the cash flow of a business.

For more info on the cash flow statement, specifically on some of the more important
line items, check out this great article by Cameron Smith.

Cash Flow Ratios Everyone Should Know

Analyzing the cash flow statement is usually pushed down to the last item to do, but
let’s take a look at some ratios that can help us define the financial health of a
business.

I said earlier that cash is king, keep in mind that earnings grow from cash, not the
other way around. Wall Street focuses much of its attention on earnings and not
cash when it should be the other way around.

When we analyze the cash flow statement using ratios, it is crucial to compare
similar companies to each other, in other words, apples to apples. Using those kinds
of comparisons will give you some anchors to tell whether or not that is a good
number; in a vacuum, it is too hard to say.

Most financial experts define cash flow as the net cash with depreciation added back
in. It is better to use the net operating cash flow from operations and add back the
capex, as depreciation is a non-cash charge.

Ok, enough talk, let’s get to the ratios.

A note before we proceed, you can substitute free cash flow for any of the other cash
flows in the following ratios.

The first ratio is:

Operating Cash Flow Ratio – With this ratio, we can determine how many dollars of
cash we get from our sales. Unlike most balance sheet ratios, there is no defined
“good” number to be above or below. Typically, we want a higher ratio than a lower
one.
Operating Cash Flow Ratio = Cash Flows From Operations (CFO) / Sales
(Revenues)

Ok, let’s use Visa to continue our exploration of their cash flow statement.

To find the sales, we are going to look at the income statement from their latest 10-k.

And the net cash flow from operations.

Click to zoom

Our numbers for our ratio then:

• Sales = $22,977
 • Cash flow From Operations = $12,784

Before we go, a note that all numbers will be listed in millions unless otherwise
stated.

Back to our ratio:

Operating Cash Flow Ratio = CFO / Sales

Operating Cash Flow Ratio = $12,784 / $22,977
Operating Cash Flow Ratio = 55%
So for every dollar of sales, we produce $0.55 of operating cash flow, pretty
impressive!

Quickly, I will put together the last two years of the same ratio to give us some
context.

• 2018 CFO Ratio = $12,941 / $20,609

o 2018 CFO Ratio = 62.7%

• 2017 CFO Ratio = $9,317 / $18,358

o 2017 CFO Ratio = 50.8%

Ok, that gives us an idea of how Visa has done creating cash flow from its sales over
the last three years. Later we will compare all of these numbers to Mastercard to get
a reference point.

Asset Efficiency Ratio

Remember Return on Assets? This ratio is similar, except we use cash flow from
operations as opposed to net income. Using this ratio will tell us how a company
uses its assets to create cash flow. It is best to use this ratio over a longer time to get
a feel for the use of assets.

We already have our cash flow from operations, so now I will go to the balance sheet
for our total assets.

Asset Efficiency Ratio = Cash Flow from Operations / Total Assets

Click to zoom

2019 Asset Efficiency Rato = $12,784 / $72,574

2019 Asset Efficiency Ratio = 17.61%
Now, I will do the ratio for the last five years to give us a little historical perspective.

• 2018 18.69%

• 2017 13.71%

• 2016 8.7%

• 2015 16.72%

• 2014 18.68%

It looks like it has been pretty consistent over the six years, with one odd number in
2016.

Current Liability Coverage Ratio

Excellent ratio to test for solvency, another simple ratio, this ratio tells us about the
company’s debt management.

For this ratio, we are going to use our cash flow from operations, as before, but we
are going to subtract dividends paid to give us a more accurate picture of the
operating cash flows.

Current Liability Coverage Ratio = ( CFO – Dividends Paid ) / Current Liabilities.

So we go back to the cash flow statement to find the dividends paid under the cash
flows from financing section and then back to the balance sheet for the current
liabilities.

Click to zoom
Click to zoom

Cash for dividends paid = $2,269

Current Liabilities = $13,415

We are plugging in our numbers for our formula.

Current Liability Coverage Ratio = ( 12784 – 2269 ) / 13415

Current Liability Coverage Ratio = 78.3%
Now, I will put together the same ratio over the last four years so we can get a flavor
of their coverage ability.

• 2018 97.5%

• 2017 77.4%

• 2016 52.4%

• 2015 100.1%

The higher the number, the more we like it, if it drops below 100%, it is unable to pay
for current liabilities, and this is a more accurate indicator of the company’s ability to
pay its current liabilities than either the current or quick ratio.

We can use the same ratio with short-term debt and free cash flow. And this ratio is
a great way to analyze the short-term stability of a company; for example, this would
be an excellent ratio to deploy during this current market volatility.

Long-Term Debt Coverage Ratio

If we are going to measure short-term liabilities, we might as well look at a ratio for
the long-term debt. It is a great practice to split the two liabilities short-term and long-
term debt to get a real sense of what is owed short-term and long-term.

The higher the number, the more cash is required to pay off the debt from
operations.

Long-term Debt Coverage Ratio = ( CFO – Dividends ) / Long-term Debt

We will go back to the balance sheet for the long-term debt, the other number we
already have.
Click to zoom

Long-term Debt Coverage Ratio:

• Cash From Operations – $12,784

• Dividends Paid – $2,269

• Long-term Debt – $16,729

Long-term Debt Coverage Ratio = ( 12784 – 2269 ) / 16729

Long-term Debt Coverage Ratio = 62.8%

Interest Coverage Ratio

The ratio above will tell us the ability of the company to pay its interest payments on
its current debt. A company that is highly leveraged will have a low multiple, and a
company with a superior balance sheet will have a higher multiple. If the interest
coverage is less than one, then the company is running the risk of default.

Interest Coverage Ratio = ( Cash from Operations + Interest Paid + Taxes Paid ) /
Interest Paid

We return to the cash flow statement for all the data for this ratio.

Click to zoom
Numbers for our ratio:

• Cash flow from Operations – $12,784

• Interest Paid – $537

• Taxes Paid – $2,648

Now plugging in all the numbers:

Interest Coverage Ratio = ( $12,784 + $537 + $2,648 ) / $537

Interest Coverage Ratio = 29.7x
The above calculation tells us that Visa has 29 times the cash flow to meet its
interest payments.

Cash Generating Power Ratio

Have to love the name of this ratio, something right up Andrew’s alley.

The above ratio is designed to illustrate the company’s ability to create cash solely
from operations when compared to the total cash inflow.

The twist on this one is that we use the inflows of cash from the investing activities
and financing activities, as opposed to total cash.

I will use Visa’s cash flow statement to illustrate how this works.

Click to zoom

Cash Generating Power Ratio = Cash from Operations / ( CFO + Cash from
Investing Inflows + Cash from Finance Inflows )

Our numbers from the cash flow statement:

• Cash from Operations – $12,784

• Cash from Investing Inflows – $4,018

• Cash from Finance Inflows – $162

Cash Generating Power Ratio = $12,784 / ( $12,784 + $4,018 + $162 )

Cash Generating Power Ratio = 75.2%
Let’s look at the next four years to get a five-year snapshot of the ability of Visa to
generate cash.

• 2018 77.29%

• 2017 64.33%
 • 2016 18.28%

• 2015 72.24%

You can notice as we look at the inflows of cash into Visa that they are surviving on
their cash from operations, which is very comforting.

External Financing Index Ratio

The financing ratio tells us how dependent a company is on financing for its cash
flow.

It compares the cash flow from financing to the cash flow from operations. The
higher the number, the more dependent on financing the company is, and some of
the most reliable companies will have negative numbers; they can pay back all of
their financing from net cash, such as dividends and debt. In this case, the ratio will
be negative, which is a good thing.

External Financing Index Ratio = Cash From Financing / Cash from Operations

Click to zoom

Numbers from the cash flow statement:

• Cash from Operations – $12,784

• Cash from Financing – -$12,061

External Financing Index Ratio = -12061 / 12784

External Financing Index Ratio = -94.7%

Now that we have had a good rundown of some useful ratios for analyzing the cash
flows of a company. Let’s take a look at a comparison by using the same numbers
from Visa, and I will compare them to Mastercard to give us an idea of the strength
of either company.
Using the chart above, we can see that both Visa and Mastercard have strength in
their cash flow, and based on the analysis using our ratios, we can see that Visa has
superior operating cash flows, current liability coverage, and external financing and
the others are strengths of Mastercard.

Doing this kind of analysis is a great exercise to dig deeper into the numbers of any
company you are investigating.

Final Thoughts
The ratios that we have learned today are all somewhat straight forward and easy to
navigate. Doing this kind of cash flow analysis is another skill that we can add to our
arsenal of investigative tools when looking at each section of the financial
statements.
I would strongly encourage you to add this list of ratios to your investment checklist
as you work through a company to discover its strengths and weaknesses.

Every company will have its strong points and weak points; our job is to uncover
those in a systematic, rational way. And using a cash flow analysis is a great way to
discover the ability of a company to grow, use, and generate more cash from its
operations, financing, and investments.
Remember that cash is king, and the stronger the cash generation, the stronger the
company.

Your homework is to do five cash flow analyses of any companies you wish and
email them to me, and I will check your work.

I want to thank you for taking the time to read this article, and I hope you find some
value in it to help you with your investing journey.

If you have any questions, please don’t hesitate to reach out.

Until next time, take care and stay safe,

Dave