Now that we've looked at a sample cash flow statement and how to prepare one, let's look at how to read one. Other than the obvious ingesting of numbers, we need to understand what those numbers tell us, and how to apply them to business plans, projected revenue, and profit and loss.
In the area of "operating activities" there are some numbers that will give you an indication of the daily operations of the business, and if the business is profitable. The bottom line in this section titled "net cash from operating activities" includes some information from the statement of earnings such as:
- Net earnings, or the company's profit or loss
- Depreciation expense
This line also includes information that is calculated on the statement of owner's equity such as:
- Changes in inventory
- Changes in accounts receivable
- Changes in accounts payable.
A number here that seems particularly out of line with the industry norm would be a red flag to investigate further. The figure might be the result of increased profitability, in which case the general prognosis would be a healthy company. But what if the number is a result of excess obsolete inventory, or extremely high accounts payable figures, or negative net earnings? Any of these reasons would indicate problems, and if you're reviewing the cash flows to purchase the business, this would be a tip off to investigate and delve deeper.
The area titled "net cash from investing activities" is a compilation of information as it applies to business investments. Purchasing property, renovating plant equipment, selling stocks, or purchasing new equipment are examples of investing activities. Extreme changes here might indicate problems with cash flow and the need to sell off some assets, or it might indicate capital investment upgrades of plant and equipment in order to increase productivity.
The last area, known as ‘net cash from financing activities" is a key indicator for overall operational and investment activity health. Extreme changes here usually indicate problems in the first two areas, even if that isn't directly detectable from examination. Any time a business must borrow large sums of money, unless they happen to be start-up businesses, there is generally more than meets the eye. If the change is due to selling stocks or bonds, maybe the business is raising money for expansion. Straightforward borrowing is sometimes indicative of expansion; however this method generally is more expensive to the business.
As you can see, examining this document alone will not provide you with a clear overall picture. What it will do, however, is give you a heads up that something should be further investigated.
If you're in management and responsible for planning directives and providing profit and loss projections, you need access to compiled information, because it provides a picture that day-to-day figures do not.
If you're examining a business in order to make a purchase proposal, financial problems either create a situation you do not want to be a part of, or it puts the business at a disadvantage; one that you could possibly profit from.
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.