Course: Financial Analysis Compounding Quality

Course: Financial Analysis

🔍 How to analyze a 10-K .................................................................................................. 2
🔍 How to analyze a balance sheet .................................................................................... 8
🔍 How to analyze an income statement ......................................................................... 14
🔍 How to analyze a Statement of Cash Flows ................................................................. 23
🥇 More from Compounding Quality ................................................................................ 34

About Compounding Quality

Hi! My name is Compounding Quality.

Professionally, I am working as a Professional Investor managing a worldwide equity fund

with more than $150 million in Assets Under Management.

I am passionate about the stock market and spend more than 60 hours per week researching
stocks and have probably read over 500 investment books.

As a kid, I always wanted to become a teacher. It’s the reason why I love to teach people
about investing via this course and my Substack (https://qualitycompounding.substack.com/).

I write 2 articles per week:

• Every Tuesday: teaching you 5 things about the stock market in less than 5 minutes
• Every Thursday: A deeper, longer article full of investment wisdom
o Examples: How to think about free cash flow, investment lessons from
Warren Buffett, …

If you want to join more than 50.000 other members in our Compounding Quality Family,
you can start your journey here: My Quality Investment Philosophy.

Course: Financial Analysis Compounding Quality 1

Course: Financial Analysis Compounding Quality

🔍 How to analyze a 10-K

It’s always crucial to understand the companies you invest in.

A 10-K tells you everything you need to know about a stock.

In this article, you’ll learn how to read a 10-K like a professional.

The importance of a 10-K

According to Jim Rogers, 98% (!) of people on Wall Street don’t read the annual report. As a
Fund Manager, I can confirm that most professional investors don’t read the 10-K before they
invest in a company.

This means that you can create a BIG advantage for yourself if you read 10-Ks.

Successful investing is hard work. The best way to outperform the market is by becoming a
learning machine.

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Course: Financial Analysis Compounding Quality

What is a 10-K?
Every year, companies must publish their 10-K. It’s the most important document a company
publishes. The better you know how to read an annual report, the better you’ll be able
to understand the companies you invest in.

But what is a 10-K?

A 10-K is an official document that contains a lot of information about the company. The
SEC requires US listed companies to publish this report to inform (potential) investors about
their financial conditions. You’ll learn about the company’s history, it’s organizational
structure, financial statements, executive compensation and so on.

Structure of a 10-K
The beautiful thing about a 10-K is that they all have the same structure.

This means that the more 10-Ks you read, the faster and the better you’ll get at it.

The structure of a 10-K looks as follows:

1. Business: an overview of the company’s main operations including its products and
services. This section shows you how the company makes money
2. Risk factors: shows the major risks of the company. The risks are typically listed in
order of importance
3. Financial statements: specific financial information about the business
4. Management discussions and analysis (MD&A): Management's view on the
business results of the past fiscal year

We’ll now dig into each section using Visa as an example. You can find Visa’s 10-K on the
Investor Relations section of their website.

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Course: Financial Analysis Compounding Quality

1. Business

This section describes the company’s main products and services.

It's a good place to start as it tells you how a company makes money.

It’s very important to always invest within your circle of competence. If you don’t
understand the business model, you can skip the company right away.

The business segment can usually be found at the beginning of the 10-K.

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Course: Financial Analysis Compounding Quality

2. Risk factors

This section shows the risks a company faces, usually listed in order of importance.

Going through this section is very important. As Benjamin Graham once said:

“The essence of investment management is the management of risks, not the management of
returns."

When a company has a lot of goodwill on its balance sheet, generates a significant percentage
of its revenue from a few clients, has low margins, or is active in a highly competitive
market, it increases the risk for you as an investor.

3. Financial statements

As an investor you want to buy financially healthy companies with high margins and
plenty of reinvestment opportunities.

That’s why the Financial Statements are one of the most important sections of a 10-K.

There are 3 Financial Statements in a 10-K:

• Balance Sheet: gives you an overview of a company's main assets and liabilities. You
want to invest in companies which don't have too much debt
• Income Statement: shows the company's revenues and expenses over a certain
period. You want to invest in profitable companies which can grow their revenue
organically at an attractive rate

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Course: Financial Analysis Compounding Quality

• Cash Flow Statement: gives an overview about how much cash goes in and out a
company over a certain period. You want to invest in companies that are cash flow
positive

We’ll dive deeper in every financial statement in our next articles.

4. Management discussions and analysis (MD&A)

This section shows the view of management on the business results of the past fiscal year.

It’s always important to look at the qualitative factors behind the numbers. That’s why
it’s important that management can tell its story in its own words.

Is the increasing revenue structural? Or is it because of a one-off event?

You want to invest in companies with an integer management with skin in the game.
Management should always give you a reliable view about the performance of the company.

Avoid companies that do not give an honest representation of their results.

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Course: Financial Analysis Compounding Quality

Conclusion
• If you read the 10-K of a company you’ll learn a lot and create a BIG advantage over
other investors
• A 10-K is an official document that is published every year
• The 10-K can usually be found under the Investor Relations section of a company’s
website
• Every 10-K consists of 4 parts: business, risk factors, financial statements and
management discussions & analysis (MD&A)

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Course: Financial Analysis Compounding Quality

🔍 How to analyze a balance

sheet
Knowing how to analyze a balance sheet is a must to make good investment decisions.

You want to invest in companies that are in good financial shape.

Learn everything you need to know about a balance sheet this article.

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Course: Financial Analysis Compounding Quality

What is a balance sheet?

A balance sheet is a financial statement that shows you 3 things of a company at a specific
point in time:

1. Assets
2. Liabilities
3. Shareholders equity

In child language, a balance sheet shows you what a company owns and owes.

Balance sheet = snapshot

It is very important to understand that a balance sheet is a SNAPSHOT of a company’s
financial health at a certain point in time.

This is a fundamental difference compared to an income statement and cash flow statement as
these statements are measured OVER a period of time.

Balance sheet = snapshot —> at a certain point in time

Income statement and cash flow statement = video —> measured over a period of time

This also means that a management with bad intentions could try to fine tune their balance
sheet to look more healthy. That’s why I prefer to invest in companies with an integer
management and skin in the game.

Assets
The assets of a company show you everything the company owns.

A distinction can be made between current assets and non-current assets.

• Current assets: assets that can be converted into cash within 1 year
o Examples of current assets: cash and cash equivalents, short-term
investments, accounts receivable and inventories
• Non-current assets: assets that are harder to convert into cash
o Examples of non-current assets: buildings, stores, goodwill (premium paid
to make an acquisition) and patents

A company’s assets are always ranked from most liquid to least liquid:

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Course: Financial Analysis Compounding Quality

Questions to ask yourself about a company’s assets

1. How much cash and cash equivalents does the company have (the more, the better)?
2. How much goodwill does the company have (the less, the better)?
3. Does the company have a lot of intangible assets?

Liabilities
The liabilities of a company show you how much the company owes.

A distinction can be made between short-term liabilities and long-term liabilities.

• Short-term liabilities: a financial obligation that has to be paid within 1 year

o Examples of short-term liabilities: short-term debt and accounts payable
• Long-term liabilities: debt that has to be paid > 1 year
o Examples of long-term liabilities: long-term debt and pension plans

It goes without saying that you don’t want to invest in companies which have too much
debt.

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Course: Financial Analysis Compounding Quality

Just like a company’s assets, liabilities are also ranked from most liquid to least liquid:

Questions to ask yourself about the company's liabilities:

• Does the company have more short-term than long-term liabilities (bad sign)?
• Does the company have more cash than short-term debt (good sign)?
• Are total liabilities increasing or decreasing? And why?

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Course: Financial Analysis Compounding Quality

Shareholders equity
The shareholders equity shows you how much money the owners (shareholders) have
invested in the company.

You can calculate the shareholders equity of a company yourself very easily:

Shareholders equity = Total assets - Total liabilities

In general, there are 3 categories of shareholders equity:

• Contributed capital: the amount shareholders have invested in the company to buy
their stake
• Retained earnings: profits a company has reserved to reinvest in the business
• Treasury stock: cash the company uses to buy back its own shares

Questions to ask yourself about the company's shareholders equity:

• Does the company have a lot of retained earnings (good sign)?

• Are there a lot of preferred stocks (bad sign)?
• Does the company buy back shares (good sign)?

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Course: Financial Analysis Compounding Quality

Great ratios to analyze a company’s

balance sheet
You’ve now learned that you should invest in companies which are in good financial share.

Just like Terry Smith, I like to look at 2 ratios to determine the healthiness of a balance
sheet:

1. Interest coverage
2. Net debt / free cash flow

Interest coverage

This ratio shows you how easily a company can pay back the interests on its outstanding
debt.

You can calculate it as follows:

Interest coverage = (EBIT / Interest payments)

The higher this ratio, the better. I prefer to invest in company’s with an interest coverage
of at least 10x.

Net Debt / Free Cash Flow

This ratio shows you how many years it would take the company to pay down all its debt
when it would use all available free cash flow.

The formula for this ratio is very obvious:

Net Debt / Free Cash Flow = (Net Debt / Free Cash Flow)

The lower this ratio, the better. Personally I prefer companies with a Net Debt / Free Cash
Flow lower than 4.

Conclusion
That’s it for this article. Here’s what you should remember:

• A balance sheet tells you what a company owns and owes

• The balance sheet consists of 3 parts: assets, liabilities and shareholders equity
• The interest coverage and net debt / free cash flow are 2 great ratios to analyze a
balance sheet

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Course: Financial Analysis Compounding Quality

🔍 How to analyze an income

statement
Knowing how to analyze an income statement is a must to make good investment
decisions.

As an investor, you want to buy profitable companies which make money for you while
you sleep.

Learn everything you need to know about Income Statements in this article.

What is an income statement?

An income statement is also called a profit and loss account.

It shows the company's revenue and expenses over a certain period.

The income statement provides you with a lot of insights as it tells you how much revenue is
translated into net income, the efficiency of management, and much more.

An income statement always has the same format:

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Course: Financial Analysis Compounding Quality

I will show you step by step how you can go from revenue to net income.

Revenue
For a company, it all starts with its revenue or sales.

Revenue is the money a company receives from selling its products and/or services.

Let’s say that a fictional company Drink Inc sells 2,179,050 drinks at a price of $2 per drink.

In this example, the company’s revenue is equal to $4,358,100 ($2 * 2,179,050 drinks).

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Course: Financial Analysis Compounding Quality

Cost Of Goods Sold (COGS)

The section cost of sales or costs of goods sold (COGS) shows you all the costs a company
makes to produce its products and/or services.

When Drink Inc. would need $1.25684 to produce a drink, its COGS would be equal to
$2,738,714 million (2,179,050 million drinks * $1.25684 per drink).

• Revenue Drink Inc. : $4,358,100

• COGS Drink Inc: : $2,738,714

Gross profit
After you know the revenue and COGS of a company, you can calculate the company’s gross
profit:

Gross profit = Revenue - COGS

Gross profit Drink Inc. = $4,358,100 - $2,738,714 = $1,619,386

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Course: Financial Analysis Compounding Quality

Gross margin
Now you know the gross profit, you can also calculate the gross margin:

Gross margin = Gross profit / Revenue

Gross margin Drink. Inc = $1,619,386 / $4,358,100 = 37.2%

A gross margin of 37.2% means that a company needs $0.628 to produce its products while it
can sell them for $1.

The higher the gross margin, the better.

When a company has a very stable and high gross margin, it is often an indication that the
company has pricing power.

Operating expenses (OPEX)

The operating expenses or OPEX show you all the expenses a company makes to run its
daily operations.

Operating expenses consist out of 4 pillars:

• Sales & Marketing

• Depreciation & Amortization
• Research & Development (R&D)
• General & Administrative expenses

In our example Drink Inc. has $560,430 in selling and operating expenses and has $293,729
in general and administrative expenses. As a result, OPEX is equal to $854,159.

Operating income
Now you’ve taken a look at the operating expenses, you can calculate the operating income
or EBIT of a company.

The operating income shows you how much money a company earns from its normal
business activities.

You can calculate it as follows:

Operating income = Gross profit - Operating expenses

Operating income Drink Inc = $1,619,386 - $854,159 = $765,227

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Course: Financial Analysis Compounding Quality

Non-operating income and expenses

Income and expenses that aren’t related to the normal business activities of the company are
classified under non-operating income and expenses.

Non-operating income and expenses consist of 4 parts:

• Other income
• Gain (loss) on financial instruments
• Gain (loss) on foreign currency
• Interest expenses

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Course: Financial Analysis Compounding Quality

Drink Inc. gained $5,513 from financial instruments as well as $960 from the sale of a fixed
asset (other income). Drink Inc. also made a loss on foreign currency of $12,649 and has
interest expenses of $18,177. This mean non-operating expenses are equal to $24,353 ($5,513
+ $960 - $18,177 - $12,649).

Income before taxes

The income before taxes or earnings before taxes (EBT) shows you how much profit the
company has made before taxes.

All other costs have now already been taken into account .

Income before taxes = Operating income - Non-operating income and expenses

Income before taxes Drink. Inc = $765,227 - $24,353 = $740,874

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Course: Financial Analysis Compounding Quality

Income tax expense

It goes without saying that every company needs to pay taxes.

These taxes are paid to federal, state and local governments.

Drink Inc. needs to pay 34,7754% in taxes (rounded). With an income before taxes of
$740,874, this is equal to $257,642.

Net income
The bottom line or net income of an income statement shows you how much money the
company has made after subtracting all costs and taxes.

Net income is also known as ‘earnings’ or ‘profit’.

You want this number to be positive as this means the company is making money.
Furthermore, the company should be able to grow its earnings at an attractive rate.

Net income = Income before taxes - Taxes

Net income Drink Inc. = $740,874 - $257,642 = $483,232

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Course: Financial Analysis Compounding Quality

Profit margin
You can now also calculate the company’s profit margin:

Profit margin = Net income / Revenue

Profit margin Drink Inc. = $483,232 / $4,358,100 = 11,1%

The higher the profit margin, the better.

Why? Because you want to invest in companies that manage to translate most sales into
earnings.

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Course: Financial Analysis Compounding Quality

Earnings per share

For shareholders, it is very handy to take a look at the earnings per share of a company.

Let’s say that Drink Inc. has 100,000 shares outstanding.

Earnings per share = Earnings / Outstanding shares

Earnings per share Drink Inc = $483,232/ 100,000 = $4.83

Looking at the earnings per share of a company is handy as it allows you to take a look
a the valuation by comparing the stock price with its earnings per share.

Let’s say that in our example Drink Inc. has a stock price of $90.

P/E ratio = Stock price / earnings per share

P/E ratio Drink Inc = $90 / $4.83 = 18.6

The lower, the P/E ratio, the cheaper the stock.

Learn more about valuation here: everything you need to know about valuation.

Questions to ask yourself

While looking at an income statement, the following questions can help you to determine
whether a company might be interesting:

• Are revenues and net income predictable and robust?

• Are revenues steadily increasing over time?
• Does the company have a high gross margin?
• Is the company structurally profitable?
• How much revenue is translated into net income?

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Course: Financial Analysis Compounding Quality

🔍 How to analyze a
Statement of Cash Flows
EBITDA is an opinion, cash flow is a fact.

The Cash Flow Statement is one of the most important statements in a 10-K.

In this article, I’ll teach you how to analyze a Statement of Cash Flows in a few minutes.

What is a Cash Flow statement?

A cash flow statement shows you how much cash goes in and out a company over a
certain period.

The purpose of this statement is to track how much cash is moving through a business.

You want to invest in companies that generate cash and manage their cash position very
well.

Every cash flow statement consists of 3 parts:

• Cash Flow from Operating Activities

• Cash Flow from Investing Activities
• Cash Flow from Financing Activities

In this article, we’ll use an example to make everything clear:

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Course: Financial Analysis Compounding Quality

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Course: Financial Analysis Compounding Quality

Difference with an income statement and

balance sheet
There is an important difference between a cash flow statement and an income statement and
balance sheet.

A balance sheet and income statement use ACCRUAL ACCOUNTING. This is a method
where revenue and expenses are recorded when an accounting transaction occurs.

A cash flow statement uses CASH ACCOUNTING. As a result, the cash flow statement
only records transactions when money effectively enters or exits the company.

This a very important difference.

Balance sheet and income statement = Accrual accounting

Cash flow statement = Cash accounting

Now you know the difference between accrual accounting and cash accounting, we’ll dig into
each section of the Cash Flow Statement.

Cash Flow from Operating Activities

This section shows all cash the company generated from its normal business activities.

In other words: it shows you all the cash a company earned from selling its normal
products and/or services.

When a beer company generates $2 per beer in operating cash flow and sold 2 million beers
in a certain year, its cash flow from operating activities would be equal to $4 million.

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Course: Financial Analysis Compounding Quality

The cash flow from operating activities is comparable to net income, but it filters out a
few income and expense posts that didn’t cause actual cash to enter or exit the
company.

You can calculate the cash flow from operating activities as follows:

Cash Flow from operating activities = net income + non-cash charges +/- changes in
working capital

Non-cash charges

A non-cash charge is a write down or accounting expense that does not involve a cash
payment.

A few examples of non-cash items:

• Depreciation and amortization

• Asset impairment
• Deferred income tax
• Write-downs of goodwill
• Stock-based compensation

Working capital

Working capital is the money a company has available to meet its current, short-term
obligations.

Working capital = Accounts receivable + Inventory - Accounts payable

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Course: Financial Analysis Compounding Quality

As can be seen in the formula, working capital consists of 3 parts:

• Accounts receivable: the money customers owe the company

• Accounts payable: the money the company owes its suppliers
• Inventory: the value of the goods that the company hasn’t sold yet

The less working capital a company needs, the better.

Why? Because it means that a company doesn’t need much cash to fund its ongoing
business activities.

A few companies even have a negative working capital. This means that its clients are
funding the ongoing business activities of the company as the accounts payable are larger
than the accounts receivable + inventories.

Changes in working capital

Remember that from going to net income to operating cash flow, you only needed to take the
changes in working capital into account.

Let’s show the formula again to refresh your mind:

Net cash provided by operating activities = net income + non-cash charges +/- changes in
working capital

Why do you only need to take the changes in working capital into account? Because when a
company needed $5 million to fund its operations last year and it also needs $5 million to
fund its operations this year, there were no cash changes.

Changes in working capital:

• Accounts receivable: negative if it increases.

o Why? Because clients not paying you immediately can be seen as giving a
small loan to your customers for a short period
• Inventory: negative if it increases
o Why? Because you aren’t earning money on products in your inventory
• Accounts payable: positive if it increases
o Why? Because if you don’t pay your suppliers immediately, your suppliers are
giving a ‘free loan’ to you

Example Cash Flow from Operating Activities

You don’t understand everything completely yet? No worries.

An example will make everything a lot more clear. Let’s use these numbers:

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Course: Financial Analysis Compounding Quality

Net cash provided by operating activities = net income + non-cash charges +/- changes in
working capital

Net cash provided by operating activities = $37,037 + ($6,757 + $1,141 + $2,253) + (-

$2,172 - $973 + $223 + $1,080 + $2,340 + $1,459 + $4,521) = $53,666

Cash Flow from Investing Activities

The Cash Flow from Investing Activities gives you an overview about the company’s
investment related income and expenditures.

The Cash Flow from Investing Activities consists of 3 major parts:

• Capital expenditures (CAPEX)

o The cash a company spends to buy, maintain or improve its fixed assets
(buildings, vehicles, equipment, land, …)
• Mergers & Acquisitions
• Purchase/Sale of marketable securities
o Marketable securities are assets that can be liquidated to cash quickly. These
securities can be bought and sold on a public stock exchange

You can calculate the cash flow from investing activities as follows:

Cash flow from investing activities = Sale of marketable securities + divestments - CAPEX
- Mergers & Acquisitions - purchase of marketable securities

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Course: Financial Analysis Compounding Quality

Example Cash Flow from Investing Activities

Now let’s make everything concrete again with our example:

Cash flow from Investing Activities = Sale of marketable securities + divestments - CAPEX
- Mergers & Acquisitions - purchase of marketable securities +/- other

Cash flow from investing activities = ($104,130 + $20,317) + $0 - $0 - ($496 + $8,165 +

$911) - $148,489 - $160 = -$33,774

Free cash flow

After you’ve taken a look at a company’s cash flow from operations and cash flow from
investing activities, you can calculate the free cash flow.

Free cash flow = operating cash flow - CAPEX

The free cash flow of a company is one of the most important financial metrics.

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Course: Financial Analysis Compounding Quality

If you want to learn more about free cash flow, take a look at this article: What you need to
know about free cash flow.

Cash Flow from Financing Activities

Last but not least, the Cash Flow from Financing Activities measures the cash movements
between a company and its owners (shareholders) and its debtors (bondholders).

This section gives you an insight about how the company is financing its business
activities.

The Cash Flow from Financing Activities consists of 3 major parts:

• Borrowing and repaying debt

• Issuance of stocks and share buybacks
• Dividends

You can calculate the cash flow from financing activities as follows:

Cash Flow from financing activities = Debt issuance + issuance of new stocks - dividends -
debt repayments - share buybacks

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Course: Financial Analysis Compounding Quality

Example of Cash Flow from Financing Activities

Now you know the formula to calculate the Cash Flow from Financing Activities, we can
calculate it for our example:

Cash Flow from financing activities = Debt issuance + issuance of new stocks - dividends -
debt repayments - share buybacks +/- other

Cash flow from financing activities = $16,896 + $0 - $10,564 - $0 - $22,860 + $149 = -

$16,379

Changes in cash balance

Finally, you can calculate the total changes in the cash balance:

Cash at the end of the year = Cash at the beginning of the year + CF from operating
activities + CF from investing activities + CF from financing activities

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Course: Financial Analysis Compounding Quality

In our example:

Cash at the end of the year = cash at the beginning of the year + operating cash flow +
investing cash flow + investing cash flow

Cash at the end of the year = $10,746 + $53,666 - $33,774 - $16,379 = $14,259

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Course: Financial Analysis Compounding Quality

It is a good sign when the cash at the end of the year is higher than the cash at the
beginning of the year.

Why? Because it means that there is a positive difference between the cash that has
entered the company and the cash that has left the company over a certain period.

Conclusion
That’s it for today. Here’s what you should remember:

• The cash flow statement shows how much cash goes in and out a company over a
certain period.
• It consists of 3 parts: Cash Flow from Operating Activities, Investing Activities
and Financing Activities
• Cash Flow from Operating Activities: cash that enters and leaves the company from
its normal business activities (selling its products and services)
• Cash Flow from Investing Activities: cash the company needs to (dis)invest to
maintain its normal business activities
• Cash Flow from Financing Activities: cash movements between a company and its
owners (shareholders) and its debtors (bondholders)

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Course: Financial Analysis Compounding Quality

🥇More from Compounding

Quality
If you liked this free course, you’ll love our website.

Every week, we write 2 articles to help you become a better investor.

• Every Tuesday: teaching you 5 things about the stock market in less than 5 minutes
• Every Thursday: A deeper, longer article full of investment wisdom
o Examples: How to think about free cash flow, investment lessons from
Warren Buffett, …

Start your journey here: My Quality Investment Philosophy.

Course: Financial Analysis Compounding Quality 34