Cash flow statement analysis is crucial for understanding a company's financial health. It reveals how a business generates and uses cash, providing insights into its operational efficiency, investment strategies, and financing decisions.

By examining cash flow ratios and comparing cash flows to accrual earnings, analysts can assess a company's liquidity, solvency, and overall financial performance. This analysis helps identify potential red flags and evaluate the quality of reported earnings, essential for making informed investment decisions.

Cash Flow Statement Components

Operating, Investing, and Financing Activities

• Cash flow statement divides into three main sections providing distinct insights into company's cash management (operating activities, investing activities, financing activities)
• Operating activities involve cash flows from day-to-day business operations (cash receipts from customers, cash payments to suppliers and employees)
• Investing activities encompass cash flows from long-term asset transactions (acquisition and disposal of property, plant, and equipment, investments in securities)
• Financing activities involve cash flows related to capital management (issuing or repurchasing stock, borrowing or repaying debt, paying dividends)

Presentation Methods and Reconciliation

• Two approaches for presenting operating cash flows exist (direct method, indirect method)
• Indirect method sees more common use in practice
• Non-cash investing and financing activities disclosed separately (schedule or footnote to cash flow statement)
• Net change in cash on cash flow statement should reconcile with change in cash balance on balance sheet between two periods

Cash Flow Ratios for Analysis

Liquidity and Solvency Ratios

• Cash flow ratios provide insights into company's cash generation and financial obligation management
• Operating cash flow ratio measures short-term obligation coverage ability (operating cash flow / current liabilities)
• Cash flow coverage ratio assesses total debt repayment ability (operating cash flow / total debt)
• Cash flow to capital expenditures ratio indicates internal funding capacity for investments (operating cash flow / capital expenditures)

Performance and Valuation Ratios

• Free cash flow yield provides insight into cash generation relative to market value (free cash flow / market capitalization)
• Cash flow per share ratio allows comparison of cash generation across different-sized companies (operating cash flow / number of outstanding shares)
• Trend analysis of cash flow ratios over multiple periods reveals insights about financial health and operational efficiency

Cash Flows vs Accrual Earnings

Timing Differences and Quality Assessment

• Cash flows and accrual-based earnings often differ due to timing discrepancies between transaction recording and actual cash movements
• Earnings quality assessed by comparing net income to operating cash flow (higher ratio of operating cash flow to net income generally indicates higher quality earnings)
• Non-cash expenses create disconnect between reported earnings and cash flows (depreciation, amortization)
• Working capital account changes significantly impact earnings-cash flow relationship (accounts receivable, inventory, accounts payable)

Analysis Tools and Implications

• Accrual ratio measures earnings influence by accruals ((net income - operating cash flow) / average total assets)
• Persistent large differences between cash flows and accrual-based earnings may indicate potential earnings management or accounting irregularities
• Understanding sources of cash flow-earnings differences crucial for accurate financial analysis and company valuation

Red Flags in Cash Flow Statements

Operational and Financial Concerns

• Consistently negative operating cash flows paired with positive net income may indicate poor earnings quality or potential accounting manipulations
• Heavy reliance on external financing for operations can signal unsustainable business practices (frequent stock issuances, debt increases)
• Large persistent discrepancies between reported earnings and operating cash flows warrant further investigation into accounting practices
• Significant unexplained cash flow fluctuations between periods could indicate business volatility or potential misreporting

Accounting and Reporting Issues

• Aggressive expense capitalization reflected in high investing cash outflows relative to operating cash flows may artificially inflate reported earnings
• Unusually high accounts receivable growth compared to revenue growth could suggest revenue recognition issues or deteriorating collection practices (extended payment terms, channel stuffing)
• Consistent use of one-time gains or non-recurring items to boost operating cash flows may mask underlying operational weaknesses (asset sales, insurance proceeds)
• Misclassification of cash flows between categories can distort financial picture (operating expenses reported as investing activities)