Why should investors look at cash flows of a company?

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Australian Economy, Macro Economics

You may wonder why there’s a need to gaze through cashflows when looking to make an investment in a company, as it sounds very similar to the income statement, which shows how much revenue came in and how many expenses went out.

The difference lies in a complex concept called accrual accounting. Accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. While that explanation seems simple enough, it’s a big mess in practice, and the statement of cash flows helps investors sort it out.

The cash flow is very important to investors because it shows how much actual cash a company has generated. One of the most important traits you should seek in a potential investment is the firm’s ability to generate cash. Many companies have shown profits on the income statement but stumbled later because of insufficient cash flows. A good look at the statement of cash flows for those companies generally warn investors about rocky times that may be witnessed ahead. For example: Contango Income Generator Limited (ASX: CIE) reported for cash and cash equivalents to $14,906,953 as of December 2017, up from $11,203,919 as of June 2017. On the other hand, for the month of February 2018, the underlying portfolio posted a negative return of 2.1% versus a 0.2% return generated by the All Ordinaries Index. Long term performance remains solid with the 12 months return at 10.2% since inception. Given that the group’s yield is based on stocks that have increased their performance and reported cashflows, CIE has the potential for maintaining the returns.

Because companies can generate and use cash in several different ways, the cash flows are separated into the following three sections:

Cash flows from operating activities refer to money generated by a company’s core business activities. This number highlights the firm’s ability (or inability) to make a profit, while it provides good insight into whether the firm is making money.

Cash flows from investing activities may sound like the amount of money a company generates from investments it has made, but the accountants who fill out corporate balance sheets for an example are generally not referring to the number of shares of the company being bought or the number of municipal bonds it has sold. Rather, from a corporate perspective, they are generally referring to money made or spent on long-term assets the company has purchased or sold. A negative cash flow from investing would indicate that the group is investing more in new assets for future instead of divesting the assets for profit purposes.

Cash flows from financing activities measures the flow of cash between a firm and its owners and creditors. Corporations often borrow money to fund their operations, acquire another company or make other major purchases. Timely operational expenditures, such as meeting payroll requirements, would be one reason for cash-flow financing. Companies are essentially borrowing from cash flows they expect to receive in the future by giving another company the rights to an agreed portion of their receivables. This allows companies to obtain financing today, rather than at some point in the future.


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