Financial Reports: How to Read the Statement of Cash Flows for Financing Activities
Companies can't always raise all the cash they need from their day-to-day operations. Financing activities listed on financial reports are another means of generating cash. Any cash raised through activities that don't include day-to-day operations appears in the financing section of the statement of cash flows.
When a company first sells its shares of stock, it shows the money it raises in the financing section of the statement of cash flows. The first time a company sells shares of stock to the general public, this sale is called an initial public offering. Whenever a company decides to sell additional shares to raise capital, all additional sales of stock are called secondary public offerings.
Usually, when companies decide to do a secondary public offering, they do so to raise cash for a specific project or group of projects that they can't fund by ongoing operations.
The financial department must determine whether it wants to raise funds for these new projects by borrowing money (new debt) or by issuing stock (new equity). If the company already has a great deal of debt and finds that borrowing more is difficult, it may try to sell additional shares to cover the shortfall.
Buying back stock
Sometimes you see a line item in the financing section indicating that a company has bought back its stock. Most often, companies that announce a stock buyback are trying to accomplish one of two goals:
Increase the market price of their stock. (If companies buy back their stock, fewer shares remain on the market, thus raising the value of shares still available for purchase.)
Meet internal obligations regarding employee stock options, which guarantee employees the opportunity to buy shares of stock at a price that's usually below the price outsiders must pay for the stock.
Sometimes a company buys back stock with the intention of going private. In this case, company executives and the board of directors decide that they no longer want to operate under the watchful eyes of investors and the government. Instead, they prefer to operate under a veil of privacy and not to have to worry about satisfying so many company outsiders.
For many firms, an announcement that they're buying back stock is an indication that they're doing well financially and that the executives believe in their company's growth prospects for the future. Because buybacks reduce the number of outstanding shares, a company can make its per-share numbers look better even though a fundamental change hasn't occurred in the business's operations.
If you see a big jump in earnings per share, look for an indication of stock buyback in the financing activities section of the statement of cash flows.
Whenever a company pays dividends, it shows the amount paid to shareholders in the financing activities section. Companies aren't required to pay dividends each year, but they rarely stop paying dividends after the shareholders have gotten used to their dividend checks.
If a company retrenches on its decision to pay dividends, the market price of the stock is sure to tumble. The company's decision not to pay dividends after paying them in the previous quarter or previous year usually indicates that it's having problems, and it raises a huge red flag on Wall Street.
When a company borrows money for the long term, this new debt also appears in the financing activities section. This type of new debt includes the issuance of bonds, notes, or other forms of long-term financing, such as a mortgage on a building.
When you read the statement of cash flows and see that the company has taken on new debt, be sure to look for explanations in the management's discussion and analysis and the notes to the financial statements about how the company is using this debt.
Paying off debt
Debt payoff is usually a good sign, often indicating that the company is doing well. However, it may also be an indication that the company is simply rolling over existing debt into another type of debt instrument.
If you see that the company paid off one debt and took on another debt that costs about the same amount of money, it likely indicates that the firm simply refinanced the original debt. Ideally, that refinancing involves lowering the company's interest expenses. Look for a full explanation of the debt payoff in the notes to the financial statements.