Interpretation of Cash Flow Statement (CFS)

The sole purpose of CFS is to provide ease of understanding cash movement of a Company. Easier said than done, understanding the story behind it turn out to be the opposite.

Format of CFS

Data from the CFS is extracted from both the Income Statement (IS) and Balance Sheet (BS). Despite the inter-connected relationship, CFS is distinct from the IS and BS, as shown below:-

CFS – Measures ‘real’ cash movements

IS and BS – Measurement based on accrual accounting

CFS allows investors to see cash movements by the major categories, namely; Operating, Investing and Financing activities. Under each category is details of cash flow movement during the financial period.

Operating Activities

Measures cash movement from core business operations, reflecting cash generated from sales of company’s products or services and cash paid from purchase of inventories. Examples of accounts affected by company’s business operations are; cash, receivables, inventory, payables, inventory.

Investing Activities

Measures cash movement from investment in property, plant and equipment. Due to the nature of investing activities, cash movements are usually cash outflows. Cash inflow will only occur when the company sells of an asset.

Financing Activities

Measures cash movement from debt, loans and dividends. Loans received from bank or new capital raised through bond issue are considered as cash inflows, while dividend payments and loan repayments are considered cash outflows.

Analyzing a CFS

Let us examine the categories and accounts of a CFS and how we can interpret the movement at our advantage.

2012

2011

Cash flow from operating activities

$’000

$’000

Source

Explanatory notes
Net profit

29,500

21,200

IS

Obtained from the IS, showing positive profit from operating activities
Adjustments for:
– Depreciation

2,500

2,150

IS

Non-cash item are added back, only considered as cash when sold
– Income tax

5,150

11,800

IS

Non-cash item are added back, only considered as cash when paid
– Interest income

(500)

(450)

IS

Non-cash item are added back, only considered as cash when received
Operating cash flow before working capital changes

36,650

34,700

Change in operating assets and liabilities
– Trade and other receivables

30,850

28,510

BS

Positive amount here represents lower receivables from customers versus prior year
– Inventories

(17,670)

6,750

BS

Negative inventory here represents higher inventory held on hand versus prior year
– Trade and other payables

9,160

(30,720)

BS

Positive amount here represents higher payables outstanding to suppliers versus prior year
Cash generated from operations

58,990

39,240

Income tax paid

(10,990)

(19,220)

BS

Actual income tax paid to the Inland Revenue Authority
Interest received

400

200

BS

Actual interest income received from bank deposits
Net cash provided by operating activities

48,400

20,220

Cash flows from investing activities

 

 

Purchases of property, plant and equipment

(13,500)

(140)

BS

Payment for PPE
Net cash used in investing activities

(13,500)

(140)

Cash flows from financing activities

 

 

Bank loan paid

(5,000)

Repayment of bank load due during the financial year
Dividend paid

(50,000)

(8,000)

BS

Dividend paid to shareholders
Net cash used in financing activities

(55,000)

(8,000)

Net movement in cash and cash equivalent (CCE)

(20,100)

12,080

CCE at beginning of financial year

240,760

252,840

BS

CCE at end of financial year

220,660

240,760

BS

From the above CFS, we can see a drop in CCE from $240,760k in 2011 to $220,660k in 2012. Changes in CCE can be seen from the self-explanatory CFS, which is mainly caused by dividends paid ($50,000k) and purchases of PPE ($13,500k). This is a very good explanation for the current financial year, so let us look at how we can interpret and forecast what is going to happen next year.

As mentioned, operating activities are real cash movement from the company’s core business activities. The majority of the company’s positive cash inflow are coming from this area, with an increase of $28,180k (2012: $48,400k vs. 2011: $20,220k). This is good news and it means that the core operations are generating favorable cash inflow. This also allows the company to invest in new equipment ($13,500k) and purchase more inventory ($17,670k) for growth and capturing of new market share. It is not an obligation for the company to distribute dividends, but the directors had agreed to share the company’s earnings with all shareholders, in hope of securing trust of current shareholders and getting more investments in future.

The amount of cash surplus available to the company should ease investors’ concern on future loan repayments and hope of more dividends payout next year.

Ultimate Weapon When All Else Fail – Fiscal stimulus

During severe economic recessions, increasing money supply through monetary policy (cut down interest rate) has failed to stimulate growth and reduce unemployment level. There is one last resort that the government can do to revive the economy, by running budget deficit.

The concept of budget deficit is to spend more than the taxes that have been collected. This is like an individual spend more on credit card than his/her personal income. To get that extra money to spend, government will have to issue more bonds.

Central bank will massively create new money to buy government bond, this process is known as Quantitative Easing (US). In a way the central bank is printing more money that will be used to buy government bond. Also, other countries can also fund the government by buying more of those bonds.

In running budget deficit, government will increase their spending to do more projects, such as public infrastructure upgrade; building new roads and freeways; expand rail network; public healthcare upgrade; build more schools and etc. All this activities and projects will encourage investment from companies, employment level will also start going up. And ultimately spur the economy into growth.

Risk of deficit

Inflation
In case you are wondering, yes the central bank can print money at will. However, massive printing of money will depreciate the value of the currency and create high inflation. If the central bank fails to manage it, high inflation will damage the economy.

Tax Increase
Running deficit might force the government to raise tax in future. Nobody likes tax increase. This will increase public dislikes against the government.

Unrealized Loss From Other Foreign Bond Holders
By having massive money supply, it will greatly depreciate the value of the currency. If foreign countries bond holders were to sell back those bonds or wait until maturity, they might suffer losses the moment they convert the money back to their own currency.

Undercut Private Investment

In the bond market, companies will have to compete with the government in selling bonds. Companies, to make their bonds more attractive to investors, will have to drive up the interest rate of those bonds. In the end, companies might find that it is not worth to sell those bonds with such high interest.

As a result, companies will not have enough funding, and started cutting down on investment on new projects.

Possible Unexpected Scenarios When Increase/Reduce Money Supply.

Although the main objective to control money supply is to either stimulate or cool down the economy. Sometimes things do not work as it supposed to be. Let’s explore various scenarios.

Scenario 1 – Country In Recession

With the country slipping into recession, central bank decided to reduce interest rate to stimulate the economy to encourage spending and investment. However, disaster strike, like a major earthquake; terrorist attack; or banks going into default for whatever reason. The public went into panic mode, rush to banks and do a massive withdrawal of money for emergency use.

In this case, the demand of money far outweighs the supply; the commercial banks will have to raise the interest rate to curb withdrawal. Despite the effort from the central bank, interest rate went up instead of down. In short term, prices of different classes of assets will likely reflect as below:

Asset Class Expected Reaction Likely Actual Reaction
Stock Market & Real Estate Up Down
Bond Prices Up Up
Bond Yield Down Down
Gold Up Down
Interest Rate (Federal Fund Rate) Down Up
Currency Down Up

In this scenario, increase of money supply by reducing the interest rate has failed to stimulate the economy.

Scenario 2 – Country with Loose Monetary Policy and Form Asset Bubble

With the economy is already doing very well, commercial banks are still able to lend out money at low interest rate, assets such as housing prices and stocks will appreciate to an unsustainable level and form asset bubble. The economy is overheating.

At the same time, inflation is creeping up. When the public begin to feel the pain of inflation, cut down spending and save money, and stop buying assets because they are too expensive. That’s when the bubble burst. Assets prices will start to fall as investors will start bidding down the prices to obtain cash.

Companies will start doing badly as business demand is slowing since everybody is saving cash due to inflation. Unemployment will start rising as companies begin to cut their expenses.

Commercial banks are making losses because people who took up the loan are not able to pay back the balance loan even after selling the assets, because the prices of asset have fallen. More and more people are getting bankrupt. Because of this, commercial banks will also curb lending as they are afraid of bad loans.

By then, there is little that central bank can do because monetary policy was already loose (low interest rate).

It gets worse, to improve business, companies will start to bring down prices on products and services, and economy will begin to experience deflation. With deflation, companies will have to do more job cuts to improve earnings. This brings unemployment rate even higher, bringing the economy into a downward spiral.

Scenario 3 – Sudden Increase of High Interest Rate and Slam the Overheat Economy

Let’s assume central bank realize the economy is overheating, and decide to cool it down. However, instead of increasing the interest rate slowly, the central bank hikes the interest rate at a rate that is so high that took everyone by surprise. This is like putting a jam brake on a sports car speeding on highway; the sports car can lose its control, flip and crash. Same things can happen to the economy.

When the money supply is reduced at such level which took everyone by surprise:

Business lending will drop dramatically due to high interest rate, and this slows down business investment. Less business investment mean lesser projects, and companies provide goods and services will begin to experience loses.

Currency will appreciate as there is lesser supply with the increase of interest rate. As the currency is appreciating, goods and services will appear to be more expensive to foreign countries; this will impact the export businesses of the country.

Unemployment will start rising as companies begin to cut spending to avoid losses.

Ultimately the jam brake brought down the economy to its knees.

How Central Bank Control Money Supply To Stimulate Or Cool Down The Economy?

I have talked about how high inflation will damage the economy of a country. Now let’s talk about what the central bank can do to control inflation. In the context of US central bank (Federal Reserve), there are three primary tools:

Deposit Banks’ Reserve Requirement

The central bank has the power to instruct banks to keep a certain threshold of money in the reserve, and it must not be lent out. This will force banks not to get into excessive lending.

By maintaining the reserve, the banks will have lesser money to lent out and circulate.

Discount Window (Discount Rate)

Commercial banks are able to borrow money directly from the central bank, at an interest date which is known as discount rate. Commercial banks will then lend out the borrowed money at an even higher interest rate to make profit.

In times of high inflation, central bank might bring up the discount rate, and commercial banks will tend not to borrow the money since it is more expensive.

So with lesser money lent out to the public, less money will be in circulation and money supply can potentially be reduced and slow down inflation.

Open Market Operations

Lastly, the leading mechanism used by the central bank to control the most widely talk about interest rate (you always see this in the news) – Federal Funds Rate, which is how commercial banks based on to charge one another for overnight lending.

Why would commercial banks want to lend to one another? Very often commercial banks have insufficient money to make new investment or lending, and they will have to resort to borrow money from other commercial banks.

Central bank cannot force all the banks to stick to the same interest rate, as this would make the banking sector very non-productive and banks will not develop competitiveness to one another. What it does is by setting a target interest rate, and then influences every bank to adopt the interest rate by buying financial assets such as government bonds, foreign currency, gold and etc.

Let say when central bank announced that it will target to bring down the interest rate. It buys government bonds from the bond market and brings up the prices of government bonds, and brings down the interest rate on bonds. Commercial banks will find the yield on government bonds unattractive, and started cashing out the money.

Commercial banks will start lending out the money at a cheaper interest rate since there is more supply after selling out the government bonds.

So, when the central bank wants to bring up the interest rate, it will start selling the government bonds, bring down the prices of bonds, and bring up the interest rate of bonds. Commercial banks will find that the yield on bonds is now more attractive to invest, and start to bring up interest rate to curb lending, and put more of their money into government bonds.

Impact Of High Inflation Caused By Massive Money Supply Or Oil Shock

I used to wonder why is it that all the central banks in the world are so afraid of high inflation, and why must they pay so much attention to it. Here’s why:

For a country to be prosperous, its real GDP must be growing consistently. As the country is growing, it will expect inflation, because there will be more demand for goods and services, as everybody has more money to spend. More spending and buying will lead to prices getting higher and higher. It should not be a worrying sign if inflation is controlled at a rate which is lower than the growth of GDP.

However, sometimes due to loose monetary policy, where there is a huge circulation of money supply, such as over lending by the banks, ultra low interest rate; or sudden increase of oil prices due to whatever reasons. The country will experience high inflation, which is a worrying sign.

Lose of Competitive Edge 

Imagine Country A and Country B are both achieving steady economic growth with double-digit GDP growth. However Country A is experiencing inflation at 5 percent, and 10 percent for Country B. Goods and services will appear to be cheaper from Country A as it is experiencing lower inflation.

Assuming that Country B is selling similar goods and services as Country A. Companies in Country B will start to lose their business, and begin job cuts. Ultimately it will leave Country B with high unemployment. Its GDP will contract and embroil in recession.

Country A Country B
Inflation → 5% Inflation → 10%
Goods and Services look cheap Goods and Services seem expensive
Country A is a happy man because it is able to sell more goods and services. Country B is in pain because companies are losing business.

Reduce Household Spending Power

Normally the wages of employees do not always rise as fast as inflation. Because all companies and bosses will definitely want to keep more cash as profit. Imagine if the economy is experiencing an annual inflation of 10 percent, where the annual average employee’s wage rises at a rate of 5 percent.

Household will have less spending power and start to save more money in the banks. Less spending will erode companies’ earnings that are selling goods and services, and eventually lead to high unemployment, and contract the GDP.

Things You Should Never Do As an Investor

Never Listen to Friends’ “Insider News”

As an investor, you should never follow your advice from your friends who claim to have “Insider News”. Why?

Firstly, you do not know how accurate his information is. He could have been misguided by another friend of his who also claims to have “Insider News”. It would not have been “Insider News” when you and your friend have nothing to do with the business.

Secondly, there are no such things as “insider news”, because it is against the law for the management of the company to divulge any non-public information.

Thirdly, as a professional investor, you should NOT invest based on rumour. Knowledge is wealth, ignorant is poverty.

Never Listen to “Experts or Gurus”

Those so called experts are just like us, they can be wrong. In fact, they are wrong most of the time. But if they are the real experts, they would know what to react if things go the other way round, and still make profit out of it (Hedging). But the experts would not openly admit their mistakes and say they are wrong. If you follow their advice and got hit badly, then who is to blame?

Don’t Believe What You Read In The News

News are created for the sole purpose of keeping the readers entertain. Journalist will always think of creative headlines to attract the readers, and they will make the fact & figures sound either very bullish or bearish. How many times have you read things like:

  • The market reached X months high.
  • A Major Pullback Is Expected
  • Economy Is Slowing Down Due to……..
  • ….. Signal Recession

By then you react to the news, you are already on the other side of the trade.

Never Put All Your Money Into One Stock

Putting all your money into one basket is like taking a bet, what if you are wrong and the share price go the other way, and you lost almost all your money?

Remember, no one can predict the market.

Never Buy Low And Think You Can Sell High Without Doing Thorough Research

There is always a good reason why the stock price is getting lower and lower. Buying lower, it might get even lower. By the time it gone up, you would have lost all your confidence and want to get out as soon as possible. So after spending months or even years constipating with the stock, you did not even make any money!

Always do your research and follow your rules. If you are confident with the company, set a target buy price, set a cut loss target, set a target sell price. Don’t be greedy when it is making money, don’t be stubborn when you are losing money and not cutting your losses.

What Are The Important Financial Ratios To Look At? (Part 2)

Current Ratio

This ratio indicates whether the company possessed more current assets than its current short term liabilities. It is calculated by dividing Total Current Assets against Current Liabilities.

Any value less that 1 is a bad sign.

For example,

Company A Company B
Current Assets $2,000,000 $2,000,000
Current Liabilities $1,000,000 $3,000,000
Current Ratio 2 0.67

Imagine if you can only sell your car now for $10,000, while you owe the bank $20,000. How would you feel?

Debt to Equity Ratio

This ratio measure how much debt the company has borrowed in proportion to shareholders’ equity. It is calculated by dividing total liability against total equity (total assets – total liabilities).

Imagine if you own a house worth $300,000, have a mortgage loan of $200,000. So effectively you have $100,000 equity. But at the same time, you also took up additional personal loan of $60,000.

So your debt to equity ratio is equivalent to $60,000 / ($300,000 – $200,000) = 0.6

Value less than 1 makes you feel safer because should you go jobless, you can still sell off your house to pay off the loan. And return the remaining $40,000 to your parents if you happen to borrow it from them.

However, having higher debt to equity ratio might not be a bad thing. It really depends on the business nature. Imagine if you can borrow $60,000 from your parents for 1 per cent interest, and then lent that money to your friend for 5 per cent interest. In between, you earn 4 per cent!

In that sense, financial companies will tend to have high debt to equity ratio.

Gross Margin

Formula for Gross margin = (Revenue – Cost of Goods Sold) / Revenue x 100

For example,

Revenue $100,000
Cost of Goods Sold $60,000
Gross margin 40%

Imagine you bought 10 books for the price of $200, and then you sold all of them for $1000.

The gross profit will be $800, and the gross margin will be 80%.

It is important to look at gross margin rather than looking at gross profit itself. Because as a public company, a gross profit of $2 Million might look like a lot, but it may only reflect a 10% gross margin, if the cost of goods sold is way too high.

In the end, a 10% gross margin might put the company at a loss after deducting expenses like salary of workers and etc.