Key Elements of the Statement of Cash Flows for Investment Bankers - dummies

Key Elements of the Statement of Cash Flows for Investment Bankers

By Matt Krantz, Robert R. Johnson

Most individual investors dwell on the income statement and, to a lesser degree, the balance sheet. But investment bankers know the power of a third, often overlooked financial statement: the statement of cash flows. The statement of cash flows is the place where the company tells investors where the dollars are coming and going in the business.

Cash flow is very different from net income. A company may book a sale as revenue, but that cash isn’t received yet. The statement of cash flow concerns itself with cold, hard dollars that find their way into the company.

Follow the money! That’s the advice often given to detectives and investigators. And the same can be said to investment bankers. Tracing the movement of cash through a company can tell the investment banker a great deal about the company and its economic feasibility. The cash flow statement is a powerful document that shows investment bankers how the business is a cash-using (or cash-burning) machine.

The statement of cash flows is broken into three distinct areas. Each areas reveals specific information about the type of cash flow.

Cash flows provided from (used by) operating activities

If you want to know how much cash it brought from the business itself, this section is the one for you. Here, you find how much of the company’s profit came from conducting business in cash.

Calculating cash flows provided from operating activities starts with net income, taken right from the income statement. Uses of cash are then deducted from net income, and sources of cash are added back. The most important adjustments to cash flow in the eyes of investment bankers include

  • Adding back depreciation and amortization: Net income takes a big hit from an expense that doesn’t cost the company any cash: depreciation. Accountants require companies to deduct from their reported profit the estimated monetary value of wear and tear on equipment. But that wear and tear may never actually cost real cash. Depreciation is added back to net income to come up with net cash flow from operations.

  • Stock-based compensation: A big part of a company’s overhead is the money paid to executives. But much of the payment to CEOs and the other executives at the top of the firm is never paid in cash, but in stock-based rewards. Because this pay isn’t in cash, it’s added back to net income.

  • Change in accounts receivable: When a company sells goods and services, it often doesn’t collect right away. That sale may be good enough to count as net income, but it’s not enough for cash flow from operations. Accounts receivables are subtracted from net income as a result.

Cash flows provided from (used by) investing activities

You have to use cash to make cash. Companies can often borrow money to make improvements to their facilities, but many times a company taps its cash hoard to add capacity, expand facilities, or build new computer systems.

The starting point for calculating cash flows provided from investing activities is cash flows provided from operating activities. From there, a number of adjustments are made to show investors how much cash is used or generated not just from the company’s operations, but also its investments. Sources of cash are added back, while uses of cash are subtracted, as follows:

  • Capital additions: Periodically, the time comes for companies to put money into assets to make them better or make them last longer. These investments are called capital additions. When such improvements to assets are made using cash, the amount must be subtracted from cash flow.

  • Proceeds from sales of property, plant, and equipment: Companies sometimes find that they’re sitting on assets they don’t need or want anymore. When these assets are sold, they’re a boost to cash. In this section, investors adjust their cash flow to reflect the influx of cash from divestitures.

  • Business acquisitions: Companies buy other companies for a variety of reasons. Whatever the reason for the deal, if the buyout is done using cash, that must be reflected as a use of cash in the cash flow statement.

Cash flows provided from (used by) financing activities

Even the simplest companies typically use cash that’s brought in from outside investors or lenders. Even a 5-year-old opening her first lemonade stand likely got started using a loan to buy lemons and sugar from her parents.

This section of the cash flow statement attempts to help investors see the inputs and outflows of different forms of financing, be it from debt or stock. Digging into this area of the cash flow statement gives investment bankers a clear view of where the company is getting and using cash to pay for its operations. This section includes the following:

  • Increases in debt: When companies borrow, it’s an addition to cash from financing and added to cash flow. Investment bankers can keep an eye on whether companies have been adding to debt if they see increases on this line item in the statement of cash flows.

    Companies often distinguish when they add short-term versus long-term debt. Often, when companies restructure, they try to exchange costly debt that matures in a few years, called short-term debt, with longer-term debt that matures in five or more years. This common maneuver, which often taps the resources of investment bankers, is designed to save on current interest expense.

  • Repayment of long-term debt: When companies pay down debt, they’re using cash. This can be a good move for companies looking to reduce their debt and interest expense.

  • Cash dividends paid: Increasingly, investors have urged companies to use their excess cash to pay a periodic cash payment, or dividend. Dividends can be suspended by companies if they hit hard times (unlike interest payments that must be made), but they’re still significant uses of cash.