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Lesson 1 of 5 · 13 min
Evaluating sources and uses of cash
Read a cash flow statement in four steps: first the big picture of where cash comes from and goes, then the drivers inside operating, investing and financing activities.
In short
- Step 1: identify the major sources and uses of cash across operating, investing and financing activities. Step 2: operating drivers. Step 3: investing drivers. Step 4: financing drivers.
- For a mature company, operating activities should be the main source of cash, and CFO should cover capital expenditures.
- A growth-stage company can run negative CFO for a while as it builds inventory and receivables, but this cannot last.
- For a mature company, CFO is normally above net income because of non-cash charges. Large earnings with weak CFO can signal poor earnings quality.
- In investing and financing, ask what each line is, where the money for big investments came from, and why assets are being sold or capital raised or returned.
Step 1: the big picture
Start by summarising the three section totals and asking which activity supplied the cash and which consumed it. This tells you more about a company's position than any single line item.
Over the long run, a business has to fund itself from operating activities. If CFO were negative year after year, the company would have to keep borrowing or issuing shares to cover the gap. Lenders and shareholders expect to be paid back out of operations, so that cannot go on forever.
Cash generated by operations then has two possible uses. If the company has value-creating investment opportunities, spending the cash in investing activities is desirable. If it does not, the cash should go back to capital providers through financing activities: debt repayment, dividends or buybacks.
Finally, check whether CFO is large enough to pay for capital expenditures. When it is, the company generates free cash flow in the generic sense (CFO minus capex), which later lessons refine into FCFF and FCFE.
| Company | Operating | Investing | Financing | Reading |
|---|---|---|---|---|
| Mature, healthy | Large inflow | Outflow (capex) | Outflow (repay, pay out) | Operations fund everything; excess returned |
| Growth stage | Small or negative | Large outflow | Inflow (borrow, issue shares) | Acceptable for a while; CFO must turn positive |
| Mature, struggling | Negative | Outflow or asset sales | Inflow | Warning: capital providers fund the shortfall |
Step 2: what drives operating cash flow
Operations both use cash (holding receivables and inventory, paying staff and suppliers) and generate it (collections from customers). The changes in receivables, inventory and payables show whether the business is absorbing or releasing cash, and why.
Compare CFO with net income. Net income is reduced by non-cash charges such as depreciation and amortisation, so for a mature company CFO is expected to be higher than net income. That is a healthy sign.
When net income is high but CFO is weak, be suspicious. The company may be making aggressive accounting choices that lift profit without bringing in cash, for example booking revenue faster than customers pay. The relationship between net income and CFO is a basic indicator of earnings quality.
Also look at variability. Volatile earnings and cash flows make a company riskier and its future cash flows harder to forecast for valuation.
- What are the main determinants of CFO?
- Is CFO higher or lower than net income, and why?
- How consistent is CFO from year to year?
A rise in receivables is revenue that has been recorded but not collected. If receivables grow much faster than sales, profit is running ahead of cash.
Steps 3 and 4: investing and financing
In the investing section, go line by line. Each line is a source or a use: spending on property, plant and equipment, buying whole businesses, putting money into liquid securities, or cash raised by selling such assets.
If capital investment is large, ask where the money came from: surplus CFO or new financing. If assets are being sold, find out why and what it means for the business; selling a division to fund payouts is very different from selling surplus equipment.
In the financing section, see whether the company is raising or returning capital and in what form. Regular borrowing raises the question of when repayment falls due. Dividends and share repurchases are the two ways of returning capital to owners. In every case, ask why capital is being raised or repaid.
Formula
- Generic free cash flow
A first test of whether operations can fund investment. FCFF and FCFE refine this measure.
Worked examples
Example 1 Two years of section totals
Arcadia Outdoor Ltd (GBP millions) reports: Year 1: net income 300, CFO 420, investing −310 (capex 330, equipment sales 20), financing −90. Year 2: net income 410, CFO 380, investing +540 (capex 360, sale of a division 900), financing −1,050 (share buyback 700, dividends 200, debt repaid 150). What are the main sources and uses of cash, and what should the analyst look into?
Example 2 What is dragging CFO below profit?
Pinecrest Software Inc. (USD millions) reports net income of 260 and the following operating adjustments: depreciation and amortisation +40, increase in receivables −180, decrease in deferred revenue −30, increase in payables +10. What is CFO, and what does the pattern suggest?
Example 3 Reading the stage from the signs
Three companies report section totals (EUR millions). Alfa: CFO −40, investing −120, financing +170. Beta: CFO +500, investing −200, financing −280. Gamma: CFO −60 for the fifth year in a row, investing −10, financing +80. Interpret each.
On the exam
Expect concept items on the first step of cash flow analysis, the desirable pattern for a mature company, what CFO below net income suggests, and short interpretations of section totals.
- Treating a large investing inflow from asset sales as a sustainable source of cash.
- Reading CFO above net income as a warning; for a mature company it is the expected result of non-cash charges.
- Assuming negative CFO is always bad. For a growth-stage company it can be acceptable for a time.
- Jumping into line items before identifying the overall sources and uses of cash.
Check yourself
Q1Which pattern is most desirable for a mature company?
Q2A company reports net income of NOK 700 million, CFO of NOK 820 million and capital expenditures of NOK 560 million. CFO in excess of capital expenditures is closest to:
Q3A young, fast-growing company has negative CFO because it is building inventory and extending credit to new customers. This is best described as:
Q4A company reports strong, rising net income, but its CFO has been well below net income for several years. This most likely suggests:
Q5A mature company generates more CFO than it needs and has no value-creating investment opportunities. The surplus cash should most appropriately be:
Answer the 5 questions: +10 XP for each one you get right first time.
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