The cash flow chart is a great analytical tool that brings a real added value to the financial analysis process. This document is sometimes often poorly known by financial analysts because the individual accounts do not currently provide for it in France. It is important to know how to read and interpret this financial statement and integrate it into the overall approach of financial analysis.
The Importance of the Cash Flow Chart
The flow chart is an essential document to implement or understand the financial management of a company because it traces all the origins and uses of cash of a period.
It tracks all cash flows, cash receipts and disbursements, for a period. It explains how one passes from the balance sheet of the year N-1 to the balance sheet of the year N. For this reason, it is said that it provides a dynamic view of the balance sheet.
Cash flows are Grouped into three Families:
- Cash flow from operations (FTA) : it indicates which cash surplus was generated by the company’s own activity resulting from its turnover;
- Cash flow from investing (FTI) : it shows the disbursements resulting from the acquisition of fixed assets, net of cash received from the sale of fixed assets;
- Cash flow from financing (FTF) : it tracks all cash inflows and outflows relating to financing choices: capital contribution, payment of dividends, loans issued and repaid, amounts lent by shareholders, etc
The sum of all cash flows represents the change in cash position and results in the end-of-year cash position, the same cash position as that shown on the end of period balance sheet.
The flow table is comparable to a document that would track all household cash inflows and outflows. The balance sheet is a static and cumulative document.
The financing plan constitutes the forecast cash flow statement as part of a business plan. It is the central tool for implementing financing choices in the context of a business plan.
Financial analysts do not always have access to this document. French accounting standards relating to individual accounts are limited to the balance sheet and the income statement, here only consolidated financial statements, whether IFRS or French (Regulation 99-02), provide for this financial statement. However, the CFO is reconstituting his company’s flow chart to see more clearly how to define the balance of financial management.
Analyze Cash Flow Activity (FTA)
The cash flow of the activity represents the surplus of cash generated by the main activities of the company, i.e. its turnover, excluding investment and financing activities. This surplus reflects the creation of wealth generated by the company, it is obviously vital at the same time to repay the loans, self-finance part of the investments, pay dividends, etc
In contrast to the two following flows, the flow of activity is determined indirectly:
Cash flow from operations (FTA) = Cash flow from operations (CAF) – Change in WCR
Cash flow represents a “potential” cash surplus that does not take account of customer-supplier payment discrepancies. The change in the WCR makes it possible to move from a potential flow to a real flow, which improves the cash position.
The direct presentation that is not used in practice would consist in showing directly the receipts of exploitation (customer) and the disbursements of exploitation (suppliers, wages, taxes…)
The indirect presentation, which is the only one used in practice, is much more relevant for the analysis because it allows to see if the variation of the cash flow of the activity comes from the profitability (CAF) or in the management of the BFR (crisis of growth , poor inventory management, customers).
Analyze the Cash Flow Investment (FTI)
The FTI represents the investment effort of the period net of disposals; movements relating to this flow must necessarily give rise to a movement in fixed assets in the balance sheet. Disposals are obviously recorded for their real price of sale, i.e. the cash flow. This requires eliminating the gain or loss on disposal at the level of the self-financing capacity.
Investment Cash Flow (FTI) = – Capital Assets + Disposals
To be included in the cash flow of the investment, the movement must have as counterpart the increase or decrease of an asset on the balance sheet.
The FTI reflects the investment effort of the period. It is obviously variable according to the sectors, whether one is in a low-capitalistic service activity or in heavy industry. Investment expenditures are not always linear. A company can invest in saw tooth; make a major expense a year and few the next 4 or 5 years.
Beyond the figures, the analyst wonders about the strategy pursued in terms of investment:
- Does the company invest on an organic basis (property, plant and equipment) or does it have an entity buyback policy?
- Do investments constitute a simple renewal, an increase in production capacity, productivity investments, and diversification into new businesses?
- Does the company pursue an organic growth objective by investing primarily in property, plant and equipment or acquisitions by acquiring entities?
- He will finally question the motivation of the sale of entities: are they constrained by the need to deleverage, do they correspond to a choice of refocusing or strategic redeployment?
Analyze Cash Flow Financing (FTF)
It intervenes logically after the flows of activity and financing. This is indeed to finance net investments of self-financing.
The cash flow of the financing traces the financing choices of the company:
- Shareholder flows (capital increase and dividend payments, partners’ current accounts
- Flows with lenders: loans issued and repaid.
It appears logically in third position because the financing choices result in part at least from the flows of activity and investment:
- For example, a growing company that has to finance large hardware investments will use MLT loans unless the cash flow from the business is high enough to self-finance these investments.
- Conversely, a profitable company with little investment will be able to pay a high dividend.
Three specific flowchart ratios are used to analyze funding choices:
- The Debt Service Rate
What percentage of the CAF is absorbed by the repayment of the MLT loans?
The dynamic repayment capacity ratio standard incorporates the idea that the repayment of the capital portion of the loans must not absorb more than 50% of the CIF. Otherwise, the company would no longer have sufficient cash to invest and pay dividends.
- The Percentage of Investments Financed by MLT Loan
This ratio is only fully relevant for companies that finance themselves by backing, mainly SMEs. The latter usually only obtain financing from MLT to finance the acquisition of an asset.
One of the CFO’s missions in financial management is to ensure the sustainability of the company’s MT, in particular by ensuring high working capital. A high FR limits the excessive use of cash loans, which constitute a precarious resource that can be denounced by lenders on short notice.
- The Payout Ratio
In most cases, the company defines the dividend distribution as a percentage of the previous year’s result.
It indicates the percentage of net profit of year N-1 paid in year N in dividends. It is obviously irrelevant when the company pays an exceptional dividend representing several years of income.
Reminder of the Financial Analysis Process
Financial Analysis is a structured approach in Several Stages
- Activity : evolution of turnover
- Profitability : evolution of net income and intermediate results (interim management balances if expenses are classified by nature as is the case in French standards)
- The financial balances of the balance sheet (FR – BFR = TN) as well as the ratios relating to the financial structure, the treasury, the deadlines of the WCR, etc.
- Profitability, analyzed through the economic profitability ratios [Operating result / (Fixed assets + BFR)] and financial profitability [net income / equity]. Profitability is a synthesis between profitability and financial equilibrium.
The order in which the steps appear makes it possible to show cause-effect links between them.
For example, a strong increase in sales (activity) may have a negative impact in terms of margin if the company grants more discounts (negative squeeze effect) or will better absorb fixed costs. The growth of the business will probably require new investments and therefore a need for additional financing. The flow analysis intervenes at least twice in the financial analysis process.
- A Synthetic Vision of all the Events of a Period
Before starting the analysis process, reading the flow chart provides a synthetic view of the overall financial evolution over the period: profitability with cash flow, management of WCR, investments fixed assets, financing choices, including shareholder compensation in the form of dividend payments and, finally, cash flow.
By providing an overview, this first quick and fast reading of the flow chart can guide its analysis: how to explain this decrease in the CAF, this sharp increase in the stock, what is the impact of a loan amount high on the structure ratios, etc
- Identify Flows Related to Investment and Financing.
Investment and financing transactions obviously have an impact on the financial balance sheet balance sheet, more specifically on working capital. The balance sheet, however, gives a cumulative and static view that masks flows. It is therefore necessary to identify the cash flows of investment and financing prior to the analysis of financial balances.
Certain flows that are similar to investment or financing transactions are not included in the cash flow statement because they do not generate a cash flow even if they appear on the balance sheet:
Leasing or financial leasing transactions (finance lease under IFRS)
When the lease contract is signed, the user company receives the equipment covered by the contract. There is however no cash flow that would appear in case of acquisition: money made available by the bank and payment of the supplier. No initial flow appears in the flow table even if the asset and the corresponding loan appear in the balance sheet. Only the repayments for their share of capital will appear on the flow sheet.
Conversions of loans into shares
Some bond issues provide for a conversion option in favor of the lender. On the balance sheet, the conversion results in a decrease in the debt and an increase in equity (capital and share premium). Once again, this transaction does not translate into cash flow and therefore does not appear on the balance sheet.
The acquisition of an entity with payment by share exchange
The company that acquires an entity issues new shares and delivers them in exchange for the shares of the entity it controls. This operation will appear in the balance sheet but not in the flow table, or only for a balance possibly in cash (the balance).
The Limits of Flow Analysis
The flow analysis is not a substitute for the profitability analysis. Only a detailed analysis of the income statement can explain the evolution of the result (scissors effects and absorption of fixed charges). It does not replace the analysis of financial balances either. Only the balance sheet gives the cumulative view of fixed assets, working capital, equity, loans, etc and allows the calculation of debt ratios.