Large companies, especially those that are listed on exchanges, are required to report large amounts of financial data. These reports have two main purposes. First, they make it harder for criminals to launder money and commit fraud. Secondly, with their help, we can learn a lot about the situation inside the company. One of the most important indicators is the cash flow statement, sometimes referred to as cash flow.

Cash flow definition

Let's start with the basics as usual. Financial liquidity is a state in which the company can efficiently and on an ongoing basis pay off all its obligations, such as production outlays, salaries, subscriptions or leases . However, liquidity can vary as some companies have high turnover and the money they need reaches them in a few days, while others have to wait several weeks for the money.
When required by law, companies are required to produce cash flow statements, which are special reports on all income and expenses.

cash flow

What is the cash flow statement showing us?

Cash flow statements contain a lot of useful information because, as mentioned earlier, they allow us to estimate the company's liquidity. In addition, we can draw conclusions about the effectiveness of debt collection, such as payments for sold products and services, and we can also find out if the company is repaying debts efficiently.

Each cash flow statement contains 3 categories of business:

  • flows from operating activities, that is, from the production of goods and sale of services. It usually represents the largest proportion of all flows,
  • flows from investment activities, i.e. from the purchase and sale of fixed assets, intellectual property, long-term investments, etc.,
  • fash flow from financial activities, i.e. the result of the sale of shares, bond issue, dividend payments, loan repayments and bank commissions.

Differences between cash flow and free cash flow

Cash flow is not the only indicator of a company's cash flow. There is also FCFF, i.e. free cash flow to the company. FCFF determines the flow of funds to equity holders and creditors such as banks . In other words, FCFF is a surplus (shortage) of funds resulting from the company's operations after all expectations of capital donors have been met. Sounds complicated? We'll try to simplify it in a moment with a formula.

Free cash flow formula:

Total Sales - Operating Costs Including Depreciation - Income Tax + Depreciation - Investments - Working Capital Increase = FCFF

OK, but what do these individual elements of the equation mean?

Total Sales: is the net value of all products and services sold during the period.

Operating expenses: are all expenses that the company must cover in order to earn. These include salaries, material purchases, fuel for company cars and insurance.

Income Tax: this is quite obvious. Every company has to pay tax on its profits, although there are exceptions.

Investments: a business needs to invest in order to thrive. This may include the purchase of new technologies and patents, new machinery or new buildings.

Depreciation: is the current impairment of the company's assets.

Working capital: as the name suggests, it is capital that brings profits to the company. It is used for short term expenses.

When all these factors are combined, we get a free cash flow.

What if the cash flow is too low?

Unfortunately, there are some poorly performing companies. If the analyzed company has low liquidity, the investment may be very risky. This is because it means the business is struggling to generate income or pay off debts. This situation could turn into bankruptcy.

If you want to learn more about solving liquidity problems, this article should be helpful .

Are the statements trustworthy?

Ok, companies are required to keep reports, but you can probably trick them somehow. are this is in reality? It's quite complicated.

While frauds do occur, many are detected by auditors. Moreover, this type of behavior is not appreciated by investors and the management of companies would be exposed to very big problems. And why are some people still trying to cheat?

When you don't know what's at stake, it's money, and so it is this time. Good financial results attract investors, and this allows the company to develop spectacularly. The regulations are structured in such a way that a determined accountant will surely find a way to bend the truth a little. This is what creative accounting is all about, which you often hear about in the media.

Using the cash flow statement for investing

We have mentioned several times on our blog about the need for financial education. One example is the knowledge of financial analysis which is very good for investing in stocks. Big companies like Apple, Meta, Walmart and Asus are very meticulously vetted by the market. Each financial report has an immediate impact on the price of shares, and the market itself changes their valuation. When you become interested in smaller companies, however, you will notice that the market response time is much worse, up to several days. Therefore, you should be able to do a simple business analysis yourself that will allow you to stay ahead of the current market trend. Isn't that brilliant? See for yourself!

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