Even investor needs to understand financial parameters to understand the companies they invest in. After all, you can't put your money into a company blindly.
Here is one such financial parameter you should know about - cash flow:
You get a monthly salary credited to your account. You use this money to buy goods and services every now and then. So, the money exchanges hands. Similarly, a company gets cash for the goods it sells and pays money for the raw materials and other expenses. This continuous exchange of money is called cash flow. This cash flow can be of three types - for operations, investments or financing needs. All these details are published in a separate report called the 'cash flow statement'.
Sometimes, you pay money upfront, while some other times, you use a credit card. In case of the latter, you can delay your actual payment by a month or so. In the same way, companies do not always pay or get money upfront - a lot of the business activities are on credit. This means, at any point in time, someone owes money to the company, which in turn has to pay money to someone else. However, the profit and loss account would not reflect this short-term liability. So, while a company may be profitable, it may be short in cash. This would increase its risk as well as financial stress. It may also cause the company to borrow more in short-term, driving up its costs. All this cannot be read in the profit and loss statement. You can understand if the company is using its cash effectively by reading the cash flow statement. It will help you get a better idea of the company's risks.
A company can generate cash through three sources - its core operations, borrowings from external sources as well as profits made from prior investments. Of these three, the operating cash flow is the most important. This is the liquid money the company uses to buy raw materials, produce goods and then sell. When the company generates more cash from its sales than required for expenses, it can re-invest this money into the company. This reduces its need for external borrowing. So, the operating cash flow helps you understand how much cash a company is able to generate through its core operations. Greater the operating cash flows, better is the company's liquidity.
Financing and investing cash flows deal with the flow of money in and out through borrowings and investments. This helps understand how much a company depends on borrowings and investments for its cash needs. Higher the financing cash flow, greater is the dependence on borrowing. This may not be profitable in the long run as it exposes the company to debt - related risks. A high financial cash flow and low operating cash flow indicates the company is unable to generate enough cash on time and thus has liquidity issues. It could also mean the company has a lower capability to withstand adverse financial conditions. A high investing cash flow, meanwhile, could mean the company has not planned a lot of expansion or new projects. Otherwise, its net investing cash flow would be negative.
FCF helps you understand how much cash a company has after it pays for its day-to-day operations as well as expansion-related expenses. It is calculated by subtracting operating cash flow by capital expenditure - the amount a company invests for expansion and new projects. A positive free cash flow is another sign of the company's profitability. However, remember, a negative free cash flow is not a bad sign. It could simply mean the company has invested a lot more than its operations earn by borrowing from the market. For example, often you hear companies announcing investments worth crores of rupees, much more than its annual profits. Similarly, a positive free cash flow could mean companies have halted expansion or new projects.
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