How to identify stocks that are able to keep on investing for growth and also to make consistent growth in dividend payments to shareholders from others that fail to do so?
The answer lies in reading a stock’s statement of cash flows. It records a stock’s actual movements in its cash balances over a stipulated period of time. I find it to be very useful to search for stocks that are cash-rich, thus, having options to either expand its businesses or to reward shareholders with cash returns. Here, I’ll provide a sample of a company’s statement of cash flows:
In this article, I’ll share 5 things to know about statement of cash flows to allow you to interpret it easily. They are as follows:
#1: Why Read Statement of Cash Flows if I’m Investing for Capital Gains?
I believe a stock’s statement of cash flows is very powerful. But, regrettably, the statement is also one of the most neglected by the investment community. This is because there is a perception that it is not relevant to people who intend and solely want to achieve capital gains from buying shares.
These people are often speculators and gamblers in the stock market.
Value investors read a stock’s statement of cash flows before investing into it. It is because:
1. Long-term stock price performances tend to follow long-term stock profits.
2. Stocks that grow profits consistently tend to have sustainable growth in stock prices for the long-term.
3. Most stocks that grow profits consistently are able to do so because they had built a system to ensure that their companies’ growth are sustainable.
4. This involves a system to raise cash consistently to invest for the long-term.
Thus, the chronology is as follows:
Cash Flows > Capital to Invest > Higher Earnings > Higher Stock Prices.
Cash Flows Leads to Capital Gains.
#2: Why Read Statement of Cash Flows if there is Statement of Profits or Loss?
What is the difference between cash flow statement and income statement? I’ll explain:
Let’s assume that I’m a retailer who runs a grocery store.
First, I secured my products (1,000 cans of Pepsi) from my supplier at total cost of $ 5,000. I was given a credit terms of 90 days to make payment. Thus, on the day that I received my products, my financial accounts would be as follows:
Then, I sold the 1,000 cans of Pepsi in 60 days, collecting $ 10,000. Thus, at the sixtieth day, my financial accounts would be:
On the ninetieth day, I settled my bills from my supplier. Thus, my financials are as follows:
As such, there is a time difference when I would record a sales and an expense from when I would record a receipt or payment in cash. That is why I would be reading both its income statement alongside with its cash flow statement.
In essence, there are three parts to a stock’s statement of cash flows which are as follows:
#3: Part 1 – Cash Flows from Operating Activities
It tells you if a stock is receiving or incurring cash flows from its businesses. This is vital because stocks which consistently brings in positive operating cash flows year after year are ones that has good customers that pay money and providing them the flexibility to finance the following:
1. Invest for Growth (Refer #4)
2. Pay Dividends Consistently (Refer #5)
3. Pay Off Long-Term Borrowings (Refer #5)
Here’s a trick to save time:
I’ll first compile the figures for net cash from operating activities, which is often the final figure for this part of the financial statement, over the past 10 years. If it is able to generate 10 out of 10 years of positive and rising cash flows, then, it is the kind of stock that I would be keeping into my watch list.
#4: Part 2 – Cash Flows from Investing Activities
This part is where I find stocks that have potential to grow in the near future. It is because it reports what and how much did a stock invest into further growth. For a start, a stock may choose to invest in the following:
1. Property, Plant & Equipment (PP&E)
It includes the purchase of new land, building, factories, motor vehicles, plants, machinery, and equipment to either replace old ones that are obsolete or grow its existing production capacity.
2. Investments into New Companies:
A stock may invest into buying a new company in order to be integrated with its existing companies to be more competitive or to diversify into a new business.
Instead of stating ‘investment into new companies’, they would be given a term based on the stock’s shareholdings in the new company. For instance, if a stock:
3. Acquisitions into Investment Properties / Plantations Assets:
A stock may generate passive income from investing into properties or to own a portfolio of plantation estates.
#5: Part 3 – Cash Flows from Financing Activities
It tells you the sources and how much capital it raises via debt or equity. Often, stocks which are capable of bringing in operating cash flows consistently do not need to rely on raising debt or equity to support themselves financially. In most cases, it would be great if stocks have lesser items in this part of the statement.
Preferably, it should contain this item: ‘Dividends Paid’.
Likewise with net cash from operating activities, I would compile this figure for the last 10 years of a stock. It is often a good thing to find a stock that has paid out consistent growth in dividends, thus, would be keeping it in my watch list.
If you add Part 1, 2 and 3, you would get the total cash movements of a stock in a stipulated period of time (12 months if it is an annual financial statement).
From it, we can compute the final cash balance figures as follows: