Step Three: Make Money in Stocks by Using the Cash Flow Statement

Introduction

In an effort to make money in the stock market, you cannot simply buy stocks at random. You do not want to buy the stock of a company, only to have it go bankrupt after you bought it. Thus, you need to first understand the financial condition of the business that the stock represents.

Net Change in Cash

One of the most important figures on this statement is Net Change in Cash. Below this line you will see another two line items: Net Cash – Beginning Balance and Net Cash – Ending Balance. These three numbers show you exactly, for a specified time frame, usually one year, how much cash came into the business and how much cash flowed out of the business. Net Change in Cash shows the final amount of money that was involved in coming in, going out, in total.

In addition, there are three categories that are analyzed in the Cash Flow Statement: Cash Flow from Operations, Cash Flow from Investing, and Cash Flow from Financing. These three categories, plus any foreign exchange effects, must add together to equal the Net Change in Cash.

Cash Flow From Operations

This category shows the cash that is being generated from the core operations from the business. This builds off the net income of the business. If a company receives money from accounts receivable (people who owe the company money), that is a function of operating cash flow.

If a company buys inventory, that is an operating cash flow. If a company pays off their accounts payable (money the company owes), that is a function of operating cash flow. If a company’s cash is coming from the normal operations of the business, that is a positive sign. This means that the company’s money is directly related back to the normal running of the day to day operations of the business. This is an indication that the company is providing a service, or making a product, that the market wants and is willing to purchase. A stock such as this would warrant further research.

As an aside, regarding Cash Flow from Operations, there are two methods of analysis: the Direct Method and the Indirect Method. As more fully explained in the website, wallstreetmojo.com, the main difference between the Direct and Indirect method of analyzing cash flow from operations, is from where the analysis starts. The Direct cash flow method starts with cash transactions, such as cash received and cash paid, and ignores non-cash transactions.

The Indirect cash flow method starts with net income as a base and makes adjustments as needed. The Indirect cash flow method includes such non-cash transactions as depreciation and amortization, receivables and payables. These do not reflect cash flowing through the business, but are adjusted from net income. These are two different methods and both are acceptable and will get you to the same result.

Cash Flow From Investing

Cash Flow from Investing Activities is all about the company investing in long term assets. For example if a hair salon adds new salon chairs, sinks, and mirrors, those are long term assets that are improvements to the salon. That is an investing activity. If the salon buys the property where the salon is located, that is an investing activity. Additionally, if the business invests in other businesses, that is considered an investment activity. In 2021, Tesla purchased Bitcoin; that is classic cash flow from investing.

Cash Flow From Financing

The final category is cash flow from financing; this concerns the long term funding of the business. (Short term funding, if less than one year, is considered a current liability, and is found on the Balance Sheet.)

As set forth more fully in Investopedia, Cash Flow from Financing refers to the liabilities incurred in financing the business. This includes borrowing from the bank. Incurring debt, in order to fund the business, warrants a cautionary stance; businesses that have too much debt can be wiped out if the business hits a rough patch. If the business is being funded by loans rather than the sales of products or services, this can indicate that there is low market demand for the company’s product or services.

Cash Flow from Financing also includes the issuance of stock, as a means of funding the business. This shows how a firm raises capital and returns the capital back to investors through paying cash dividends to the shareholders. Cash flow from financing can also show repurchase of shares by the company. It can include the exercise by employees of stock options. It can include the receipt of cash though the purchase of hybrid securities, such as convertible debt instruments.

The financing activity from the cash flow statement focuses on how a firm raises capital and pays it back to investors through capital markets. These activities also include paying cash dividends, adding or changing loans, or issuing and selling more stock. If a company is relying too much on raising capital through the issuance of debt or through stock issuance, it can run into trouble if there is market turmoil such that no further money can be raised. This can happen due to investor fear sentiment, serious market disruption from a cataclysmic event such as war, or industry collapse. Repeated issuance of new stock, or high debt, reveals a cautionary sign in analyzing whether to buy a company’s stock.

Summary

The Cash Flow Statement tells an investor how a company is being funded — either through the normal course of business of the sale of goods or services or through financing. Ideally, the investor should buy stocks where the business is increasing profits year after year through the normal course of its business of providing goods or services. If the Cash Flow Statement reveals that the business is really being funded by debt or by the repeated issuance of stock, the investor should take that as a warning sign, and continue research on other stocks.

The Cash Flow Statement shows the investor how the money enters the business and how the money leaves the business. The Cash Flow Statement shows how much cash the business has, which is a solid indicator of the solvency of the company. This is also a key indicator of the competency of the the management. The Cash Flow Statement is considered one of the three most important financial reports for these reasons and the savvy investor will ferret out such information.