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.



Cash flow from operating activities




Explanatory notes
Net profit




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




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




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




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



Change in operating assets and liabilities
– Trade and other receivables




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




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




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



Income tax paid




Actual income tax paid to the Inland Revenue Authority
Interest received




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



Cash flows from investing activities



Purchases of property, plant and equipment




Payment for PPE
Net cash used in investing activities



Cash flows from financing activities



Bank loan paid


Repayment of bank load due during the financial year
Dividend paid




Dividend paid to shareholders
Net cash used in financing activities



Net movement in cash and cash equivalent (CCE)



CCE at beginning of financial year




CCE at end of financial year




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.

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.

What Are The Important Financial Ratios To Look At? (Part 1)

Return On Assets – ROA

This indicates how the company is using its assets to generate income. It is calculated by dividing its net income against total assets. For example,

Net Income = $1,000,000
Value of total assets = $3,500,000
ROA → $1,000,000 / $3,500,000 * 100 = 28.57%

The higher the ROA, the better it is. If you are to do a comparison between companies within the same industry.

Company A Company B
Net Income $1,000,000 $1,000,000
Value of total assets $3,500,000 $7,000,000
ROA 28.57% 14.29%

It will be a better choice to consider invest with Company A, because it is generating more income with lesser assets.

Return On Equity – ROE

This indicates how the company is using its shareholders’ money to generate income. It is calculated by dividing its net income against shareholder’s equity.

Shareholders’ equity is calculated by deducting total liabilities from total assets.

For example,

Total Liabilities (Debt) = $1,000,000
Total Assets = $2,500,000
Net Income = $200,000
Shareholders’ equity –> $2,500,000 – $1,000,000 = $1,500,000
ROE → $200,000 / $1,500,000 * 100 = 13.33%

The higher the ROE, the better it is. 

How To Valuate If A Company Share Price Is Overvalue Or Undervalue (Part 3)

Industry P/E Ratio Comparison

Although it might not be a an accurate way to use P/E Ratio to valuate a company. It does has its own advantage. This is done by using it to do a quick comparison of the company against other companies within the same industry.

For example, let’s do a comparison below:

Company Share Price P/E Ratio Market Capitalization
Company A 20 21 1.5 Billion
Company B 30 14 2 Billion
Company C 10 18 1 Billion
Company D 5 99 100 Millions
Company E 23 200 1.3 Billion

From the table, it looks like Company E is overvalued. Its market capitalization is comparable to the rest of its peers, yet its P/E ratio is almost as 10 times higher to its peers. I probably would not be interested in looking at Company E.

Company D looks overvalue, but its market capitalization is almost 10 times smaller. I would research more into Company D as it could have higher potential growth.

Price to Book Ratio

If the company is to go bankrupt and liquidated, investors/shareholders will be paid with the proceed from the liquidation. The proceed is known as book value.

By comparing the company’s stock price to its book value, we are able to gauge if the company is undervalue.

If the ratio is more than 1, it is not necessary that it is overvalue, because the company could have good growth and intangible assets such as special patents or technology.

If the ratio is less than 1, it is an indication that the company is undervalue.

However, this can also mean that this is a distressed company. You should find out more in depth about what has happened to the company.

You have to ask yourself, if it is going to cost you a lot lesser to buy out all the outstanding shares than the physical assets. You might as well buy over all the physical assets and sell it for profit. Why should you still bother to invest with the company?

How To Valuate If A Company Share Price Is Overvalue Or Undervalue (Part 2)

So How Do We Determine The Growth Rate?

Growth rate can be calculated by using the difference of current year EPS and previous year EPS.

For example,
Company ABC’s Previous Year EPS – $1.50
Company ABC’s Current Year EPS – $1.73

The growth rate → ($1.73 – $1.50) / $1.50 * 100 = 15.33 %
A better way to look at growth rate would be averaging the past 5 years growth rate known as EPS – 5 Years Growth Rate. The reason behind this is that some years the company might be doing exceptionally well, some years exceptionally bad. In that sense, getting a average would be more accurate.

For example,
Year 1 growth rate → 15.33 %
Year 2 growth rate → 25 %
Year 3 growth rate → 10.5 %
Year 4 growth rate → 29.4 %
Year 5 growth rate → 18.6 %
EPS – 5 Years Growth Rate → (15.33 + 25 + 10.5 + 29.4 + 18.6) / 5= 19.77%

PEG Ratio

Once the growth rate is determined, we can divide P/E ratio to the growth rate, and determine if the company is overvalue or undervalue.

For example,
Current Company ABC’s P/E ratio = 33.33
PEG Ratio → 33.33 / 19.77 = 1.6 (Overvalue)

The Bigger The Company, The Lower The Growth Rate

It makes sense that the bigger the company, the lower the growth rate it will achieve. Very often large company find themselves difficult to grow as they are just too big to be managed, in terms of growing the revenue and reducing the cost.

How We Know The Size Of A Company?

Size of company is measured by market capitalization. This can be calculated by multiplying the number of outstanding share and its current share price.

For example,

Current Share Price of Company ABC = $20
Number of outstanding shares = 7,000,000,000 (700 Millions)
Market Capitalization → $20 * 7,000,000,000 = $140,000,000,000 ($14 Billions)

That is to say, if someone wants to buy over the company, it will cost him/her $14 Billion!

The Disadvantages Of PEG Ratio

Although PEG ratio is a more accurate way to valuate a company’s share price. It has its pit fall. Why?

Because the earnings of the company can potentially be manipulated. Some years the company could have exceptionally high earning due to reason, such as disposing off assets (Selling off existing properties). On the income statement it will be reported as profit. However this profit does not come from regular business activity as the company is not able to replicate the event every year.

How To Valuate If A Company Share Price Is Overvalue Or Undervalue (Part 1)

Price to Earnings (P/E) Ratio

This is the most commonly method used to valuate if the company share price is overvalue or undervalue.

The formula → Current Share Price divided by Annual Earnings Per Share (EPS)

For example,

Current Share price of Company ABC = $20
Earnings Per Share over the last 4 quarters = $1.50
P/E Ratio –> $20/1.50 = 13.33

In another words, for every $1.50 that was invested, it will take about 13 years for the company to earn back the $20.

The higher the P/E ratio, the longer period it will take the company to earn back the investor’s money which was previously spend for growth and expansion.

So, It may look like the higher the P/E Ratio, the more overvalue of the company, since it is taking longer to earn back the invested capital. But, that’s not necessary the case.

If a good company is expected to grow its earning at the rate of 30 percent every year. Then it means that the company is able to earn back the money at a faster rate! The P/E ratio itself does not tell the full picture of the growth rate!

For example,
Current Share price of Company XYZ = $50
Earnings Per Share over the last 4 quarters = $1.50
P/E Ratio –> $50/1.50 = 33.33 (Looks overvalue)

Let’s assume the growth rate is 30% every year and the stock price did not change after 5 years.

EPS after year 1 → $1.50 + ($1.50 * 30/100) = $1.95
EPS after year 2 → $1.95 + ($1.95 * 30/100) = $2.54
EPS after year 3 → $2.54 + ($2.54 * 30/100) = $3.30
EPS after year 4 → $3.30 + ($3.30 * 30/100) = $4.29
EPS after year 5 → $4.29 + ($4.29 * 30/100) = $5.58

Now let’s look at the new P/E Ratio → $50 / $5.58 = 8.96 (undervalue)

So as you see can see, by simply looking at P/E ratio, it does not tell you the full picture. It all depends on the growth rate of the company. Remember, companies went public for the sole purpose of growing bigger and bigger.

What Determine The Share Price Of A Stock?

Before a private company goes public, it will go through a process known as Initial Public Offering (IPO). Where the share price of the stock will be determined by the business owner depending on the amount of money it wish to raise. Once the stock is listed on the stock market exchange, investor will be able to start buying and selling the stock, it is through the activity of buying and selling that affect the subsequent price of the stock.

How Does Buying And Selling Affect The Stock Price?

The process is known as Bid – Ask Spread. For example:
If Investor ABC already own one share of a stock, and he is selling it $21, this is the ask price.

On the other hand, Investor XYZ wanted to buy one share of the stock and he is only willing to pay $20, this is the bid price.

If Investor XYZ wanted to buy the stock badly and he wishes to close the deal at $21, he will then have to adjust his order and close the deal by submitting a bid at $21.

Once the deal is closed, Investor XYZ will want to sell the stock at a asking price of $22 to make a $1 dollar profit. Now the value of the share price is increased by $1 should other investor is willing to close the deal by submitting a bid at $22.

How Does The Supply And Demand Of The Stock Affect The Share Price?

Continue the above example,

Let’s say now the asking price by Investor XYZ is $22. Suddenly, Investor ABC who previously own 10 shares of the stock, submit an ask price of $19. Now in the market there are extra 10 shares of the stock which worth $19, $3 dollar cheaper than the 1 share offer by Investor XYZ.

Other investor who are willing to close the deal, submit a bid at $19 and close the deal. Now the value of the stock has plunged by $3. Investor XYZ is now suffering a paper loss. He can either hold on to the stock until the price bounce back, or he can sell it for an actual loss if he thinks the ask price is getting lower and lower for whatever reason.