Understanding a company is similar to understanding your own personal finances. In fact, if you look at a company's financial statements, you will find that they are similar to our own "personal" financial statements. However, for most of these, there is a different basis for how items are reported. Table 1 provides a simple analogy.
|TABLE 1. Financial Statements: Corporate and Personal Similarities|
|Corporate Statement||Personal Statement|
|Balance Sheet||Mortgage Application|
|Cash Flow Statement||Checking Account Statement|
|Income Statement||Personal Tax Return|
|Footnotes to Financials||How you explain your finances to an investment advisor or IRS auditor|
If you were to analyze your own finances, you typically would start by looking at how much money you have in your checking account and at the transactions posted to your account. This usually represents "the truth" about how you really spent all of your money.
This is very much how analysts look at corporate financial statements—starting with the cash flow statement—to get at "the truth."
This article outlines four basic cash flow analysis steps you can use to better understand a company's financial position.
The process starts with an understanding of the cash flow statement.
Imagine how a bank investigates you when you're applying for a mortgage to buy your first home. The bank wants to know everything about your income tax filings, bank statements, pay stubs, debt payments and credit score before approving you for a loan. They are looking at your "cash flows" to see how you've really managed your personal cash flows or business.
You should begin looking at a company with the same approach, using the cash flow statement to provide you with a greater sense of how the business model really works—where does cash come from (source of cash) and where does it go (use of cash)?
The cash flow statement has three parts, although the components may vary depending on the type of business the company engages in:
Each of the line items in the cash flow statement indicates whether cash was spent or received. For example, if accounts receivable increased by $100,000, this tells you that there was a use of cash, which will be depicted as -$100,000 (the negative sign indicating that product went out the door). An accounts receivable item indicates that a customer was given credit to pay the bill later, even if the sale has already been made. But cash has not been received and, hence, if accounts receivable increases, it means that more bills have not been collected and the cash has been "used."
You might also see cash flow from the issuance of stock of, for example, +$1,000,000, which indicates that stock was issued and was a source of cash (the positive sign showing that cash came into the company).
You should view the cash flow statement as a time series in a spreadsheet. A time series looks at the cash flow statement on a yearly and a quarterly basis. Here's what you will be looking for:
Where do you find the company's strategy?
Most of the time you can find this within the company's 10-K report under the following sections: business overview, management strategy and competition, and management discussion and analysis (MD&A). This is important because you need to see whether management is putting its money where its mouth is.
Industry and Economic Trends
These help you understand why the company is implementing its current strategy (or what strategy it should be implementing).
The worst possible scenario is when you see industries consolidate, margins shrink, cash flows from operations decline and a management that is dependent on a high share price and acquisitions to keep growth rates high per expectations and perceptions. Aggressive accounting becomes almost inevitable.
As you look at the time series of cash flows, you start to understand how the business really works, and you might even be able to get a sense of what vulnerabilities the company is susceptible to.
The next step is to compare cash flow with other financial statement line items. This separates how the company says it grew and how it actually grew, via the use of the time series of cash flows.
Doing these calculations will compel you to ask questions about the results and encourage you to look deeper into the line-items that made the most impact.
One key caveat: Make sure that you compare growth rates year-over-year to eliminate seasonality. Growth rates are highly volatile within the year and between quarters. Example: Comparing second quarter with first quarter doesn't compute. Compare this year's second quarter with last year's second quarter.
Last but not least, make sure to read the footnotes. Do not read these first because you will not know about the company's business model, usually found in the business overview section of the 10-K report.
Reading the footnotes takes time, but they're the best guide about how the items on the financial statements are being measured and reported. In particular, read the following sections:
As a general rule: The longer the discussion of a particular footnote, the more this footnote may become the central issue of your analysis.
Cash flow analysis can be a complicated process. However, as an initial four steps, the process outlined here will give you a much better understanding of the true financial position of any company that may be of interest.
Jay Taparia, CFA, is principal, Sanskar Investments, Inc.; director of education, Investment Analysts Society of Chicago; and professor/lecturer at the University of Illinois at Chicago.
This article originally appeared in the March/April/May 2003 issue of The Financial Journalist, published by the Association for Investment Management and Research (www.aimr.org), headquartered in Charlottesville, Va. AIMR is a non-profit professional association of 60,000 financial analysts, portfolio managers and other investment professionals.