Finance

Financial Terms every Beginner Investor should understand- Part 2

Welcome! Today we will be going through basic financial terms on Affordability!

If it’s your first time here, this is actually Part 2 of a two-part mini blog series where I expand on:

  • Profitability ie. Income Statement [Part 1]
  • Affordability ie. Cash Flow Statement

The reason why I’ve decided to expand on these terms is not only tell you what it means, but why is it important. One of the first steps to being an investor, is to hone the ability to read financial statements and understand the significance of financial terms. After all, numbers are resultant of a business story and numbers don’t lie. Hence, it’s always a great place to start.

As mentioned in the previous post, the key takeaway is to always compare it :

  • Over a period of time (ie. Company’s past performance)
  • With its competitors

Financial statements are all interlinked so if you haven’t checked out Part 1, you can check it out here because the points will be connected.

As we all know – CASH IS KING. We have heard this over and over again. It doesn’t matter how profitable you are on paper, more importantly, it’s about how much cash is actually coming into your pocket over a period of time. That’s why these terms are so important.

Before I start explaining the terms, would just like to explain on :

A. The Difference between an Income statement vs Cash Flow statement

One word – timing.

Okay this may sound a bit technical but bear with me – in the accounting world, these two statements differ in preparation basis:

  • Income statement is prepared on Accrual basis – transactions are recorded as and when they are INCURRED/EARNED
  • Cash Flow statement is prepared on a Cash basis. – transactions are recorded as and when they are PAID/RECEIVED

Example: Imagine you washed a car for your friend in exchange for $50. The moment you finished washing that car you have earned $50 regardless of when that $50 is actually paid to you. That is accrual basis. Cash basis would mean you record that transaction in maybe your lil notepad, only as and when you receive it.

Why is this important?

  • Accrual basis is important to accurately reflect the performance for a period for more effective decision making. Almost all Income statements are prepared on an accrual basis. Think back of when you owed your friend cash, when was the last time you paid it in a day? chances are you probably took your time and eventually realise oh crap I still owe you – sorry.
  • Cash basis is important because it indicates actual collectability. You may have earned that right to the cash, but it doesn’t matter if no one is actually paying you. And if you have no tangible cash, you can’t run a business.

So both of them are important, just for different reasons.

B. How a cash flow statement is read

It’s essentially a statement that shows how the changes/movement in cash during the financial year. In a nutshell:

Opening Cash balance + Changes in Cash Flow = Closing balance

& these Changes in cash flow are categorised into 3 large categories as shown below:

  • Net Cash Flow from Operating Activities (CFFO)
  • Net Cash Flow from Investing Activities (CFFI)
  • Net Cash Flow from Financing Activities (CFFF)

Now let’s jump into it.

1. Cash Flow from Operating Activities [CFFO]

Net Cash Flow from Operating Activities is the net cash you actually receive from doing what you do (ie. your business operational activities). Mathematically:

CFFO = Cash receipts from customers – Cash payments to suppliers

In a perfect world, the revenue and the operating costs the business has recorded for the year, should translate into CFFO. However in the real world, this is subjected to credit terms. Depending on the nature of the business, more often than not, sales and expenses are made on credit (ie. Buy now, pay later), and this dictates the timing of business’ outflows and inflows of cash. Ideally of course every business would want the credit terms for its sales to be shorter than that of its supplier’s.

Eg. Let’s imagine your business has a 30 day credit term for sales to customers and 45 day credit term for its purchase of inventory from the supplier. Assume you sold a product and bought inventory TODAY. 30 days from now you can expect to receive cash from your customer and 45 days from now you have to pay your supplier. Isn’t this great! You literally have a 15 day gap from the moment money enters your bank to the time it has to leave your bank.

Why is this important?

  • CFFO indicates the operational efficiency of a business – being able to continue to generate cash (ie. grow the revenue AND collect its revenue) and is indicative of the health of its core business. It could also shed light on the liquidity management of the business as a drastic increase in revenue but much lower CFFO could be an indicator that much of the cash has yet to be collected.
  • The growth of CFFO is indicative of how much money will be made available for reinvesting in the business for future expansion and distribution to shareholders [think: Grow the pie]

2. Cash Flow from Investing Activities [CFFI]

Net Cash Flow from Investing Activities is the net cash you invest into your business to grow it – this is primarily expenditure on capital expenditures which are purchase of assets that can help you generate more money in the future.

Example – you have a little cleaning business. If you decide to purchase a new vacuum which can boost your productivity by 2x, and bring in more customers – that act of purchasing a new vacuum is in itself an investment in the business. Hence it would be recorded as an outflow under Cash Flow from Investing Activities.

Why is this important?

  • It’s a gauge of the business’s efforts to future proof itself (ie. to reinvest in itself for future growth) – a business that is constantly reinvesting in itself, is likely to be be building a competitive advantage, or future proofing itself from change in customer trends and the industry. Like in the example of that cleaning business – I’m sure you would be more keen to invest in a business who is constantly investing in better equipment to boost productivity, than those that stick to the same old method. [think long term]
  • It’s an indication of minimum level of CFFO required – capital driven businesses (ie. businesses that require large amounts of money to generate more revenue) are bound to have much higher cash outflows of investing activities. Eg. In the oil and gas industry, large amounts of money are constantly being reinvested to upgrade machinery to ensure that oil production can continue at a high rate. Thus, it’s important for an investor to assess how much investing activities is typically spent on a year to year basis – because chances are the business needs to generate CFFO that is well above it, to to sustain the long-term growth of the business.

3. Free Cash Flow [FCF]

Free Cash Flow is as literal as it sounds. It means the amount of Cash Flow that is FREEEE.

Mathematically, Free Cash Flow = CFFO – CFFI

And free in this context means, it’s up to management what they would like to do with this excess cash; which in the business sense has two options. You either:

  • Pay this out as dividends to shareholders
  • Repay existing debts
  • Keep it as cash, for the use of the business

Why is this important?

  • The trend of FCF over time is Indicative of effectiveness of business strategy – a growing FCF means the business is growing at a healthy rate; without the constant need to reinvest in itself. What’s the point of earning CFFO of $100mil, just to have it all go to investing activities. There is practically nothing leftover for shareholders

4. Cash Flow from Financing Activities [CFFF]

Financing activities here indicate the sources of funds to the business, apart from its business’ operating cash inflows. These are primarily Debt or Equity.

Debt: Borrowing money from banks, in exchange for interest payments. [Fixed repayments]

Equity: Selling a stake of a business to potential investors in exchange for money. [Discretionary payments]

So, Cash flow from Financing Activities are the net in/outflows of a business for servicing debt/distributing a % of profits to shareholders.

Why is this important?

  • This is also the one that us as investors are very interested in, because we can assess how much of the company’s earnings are being paid out as dividends to us!
  • This gives insight to the company’s capital management strategy – this could be one of the most challenging questions for the business – balancing the interest of creditors (borrowers) and their shareholders.

Eg of considerations on the Outflow of Financing activities:

  • Should a company pay off its debt, and therefore lower its interest expense? But this could mean foregoing investing activities that could benefit the company on a longer term or shareholders that are waiting for a reward.
  • Or should they keep shareholders happy by prioritising dividend payments, so as to give them an incentive to buy the stock.

Eg of considerations on the Inflow of Financing activities:

  • Should the company take on more debt to fund future growth strategies? Will the revenue generated in the future be sufficient to repay this debt and cover interest payments? After all debt repayments are mandatory..
  • Should the company issue more shares, and take on more equity? Even though dividends and share buy backs are discretionary, issuance of too many shares may dilute more shareholders and risk a sell off (ie. fall in stock prices).

5. Closing Cash Balance

This is the final cash balance that a business has at the end of a period. After all is said and done, it’s important to see how much is leftover. Just like too much of a good thing could be a bad thing. Closing cash balances are best kept in moderation. Too little of it compared to its historical records, could be a sign that businesses are not generating sustaining levels of cash flow; but too much of it could be a sign of idle cash and wasted potential.

Why is this important?

  • It could be indicative of how ‘cheap’/’expensive’ the stock price is.

Imagine if a company has 1000 shares; and each share is worth $20. Let’s say the company has a closing cash balance of $5,000. So, for every unit of share ($5000/1000 shares), $5 is actually cash. So when you buy the company’s share price, the differential between $20 – $5 = $15 is the value you impute on the company’s future growth prospects and management alone. So clearly in this scenario, it helps when the company is cash rich. And this will help you gauge if the current stock price is worth the buy-in.

And that wraps up my two-part series! Hope this can give you a little more insight to to the signficance of the numbers on the Income statement and Cashflow statement and eventually help you in your investing journey 🙂

For more financial tips, check out the other articles under the ‘Lets Talk Money’ blog series.

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