The fundamental concept of cash flow from operating activities

French | Spanish | Portuguese | Italian | German | Japanese | Chinese | Korean | Russian | Arabic

A dynamic analysis of the company’s financing

The fundamental concept of cash flow from operating activities

The cash flow statement is designed to separate operating activities from investing and financing activities. Accordingly, it shows cash flows from operating and investing activities and investments on the one hand and from financing activities on the other hand. This breakdown will also be very useful to you in valuing the company and in examining investment decisions. The concept of cash flow from operating activities, as shown by the cash flow statement, is of utmost importance. It depends on three fundamental parameters:

• the rate of growth in the company’s business;
• the amount and nature of operating margins;
• the amount and nature of working capital.

An analysis of the cash flow statement is therefore the logical extension of the analysis of the company’s margins and the changes in working capital. Several problems can be dealt with using the concept of cash flow. By dissociating industrial and financial policy, the cash flow statement emphasises the cash flow from operating activities.

Cash flow from operating activities constitutes a fundamental aspect of the company’s profitability, especially in an economy where the value of assets on the balance sheet is low. There is no way round the following basic truth: to be profitable, a company must sooner or later generate cash in excess of what it spends. In other words, it must generate a net positive cash flow from operating activities.

Analysing the cash flow statement means analysing the profitability of the company from the point of view of its operating dynamics, rather than the value of its assets.

We once analysed a fast-growing company with a high working capital. Its cash flow from operating activities was insufficient, but its inventories increased in value every year. We found that the company was turning a handsome net income, but its return on capital employed was poor, as most of its profit was made on capital gains on the value of its inventories. Because of this, the company was very vulnerable to any recession in its sector. In this case, we analysed the cash flow statement and were able to show that the company’s trade activity was not profitable and that the capital gains just barely covered its operating losses. It also became apparent that the company’s growth process led to huge borrowings, making the company even more vulnerable in the event of a recession.

How is the company financed?

As an analyst, you must understand how the company finances its growth over the period in question. New equity capital? New debt? Reinvesting cash flow from operating activities? Asset disposals can contribute additional financial resources. The cash flow statement will enable you to understand the origin of the company’s financial resources over the period. Did the company issue new equity capital during the period, and, if so, for what purpose? To pay down debt or to finance a large investment programme? As we will see, the company’s dividend policy is also an important aspect of its financial policy. It is a valuable piece of information when evaluating the company’s strategy during periods of growth or recession:

. Is the company’s dividend policy out of step with its growth strategy?

. Is the company’s cash flow reinvestment policy in line with its capital expenditure programme?

You must compare the amount of dividends with the investments and cash flows from operating activities of the period. For a family-owned company, we would also advise increasing dividends by repayment of shareholders loans, and any other unusual operating costs or payments that could be substitutes for dividend payments. You could also look at the company’s payout ratio (see p. 541). Analysing the net increase or decrease in the company’s debt burden is a question of financial structure:

• If the company is paying down debt, is it doing so in order to improve its financial structure? Has it run out of growth opportunities? Is it to pay back loans that were contracted when interest rates were high?
• If the company is increasing its debt burden, is it taking advantage of unutilised debt capacity? Or, is it financing a huge investment project or reducing its shareholders’ equity and upsetting its financial equilibrium in the process? In conclusion, it is imperative that you analyse the cash flow statement to understand the dynamics of the company’s cash flows.

We will examine the more complex reasoning processes that go into determining investment and financing strategies. For the moment, keep in mind that analysis of the financial statements alone can only result in elementary, common sense rules.

As you will see later, we stand firmly against the following ‘‘principles’’:

• the amount of capital expenditure must be limited to the cash flow from operating activities. No! You will understand that the company should continue to invest in new projects until their marginal profitability is equal to the required rate of return. If it invests less, it is underinvesting; if it invests more, it is overinvesting, even if it has the cash to do so;
• the company can achieve equilibrium by having the ‘‘cash cow’’ divisions finance the ‘‘glamour’’ divisions. No! With the development of financial markets, every division whose profitability is commensurate with its risk must be able to finance itself. A ‘‘cash cow’’ division should pay the cash flow it generates over to its providers of capital.

Studying the equilibrium between the company’s various cash flows in order to set rules is tantamount to considering the company as a world unto itself. This approach is diametrically opposed to financial theory. It goes without saying, however, that you must determine the investment cycle that the company’s financing cycle can support. In particular, debt repayment ability remains paramount.