A company can show positive cash flow but still be in serious financial trouble. Positive cash flow alone does not guarantee a healthy financial position. Investors, managers, and analysts must look deeper into the cash flow statement to spot potential dangers. Understanding how to read cash flow statements correctly can prevent serious financial mistakes.
The Structure of a Cash Flow Statement
A cash flow statement is divided into three parts:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
Analysing these sections helps identify the real source of positive cash flows.
Cash Flow from Operating Activities
This section covers cash generated from everyday business activities, such as:
- Revenue from sales
- Collection of customer debts (Accounts Receivable)
- Payments made to suppliers (Accounts Payable)
- Inventory management
Healthy businesses typically have a strong positive cash flow in this section. Problems arise if this area shows figures like non GamStop casinos.
Cash Flow from Investing Activities
Cash flow from investing activities involves cash used or gained from investments, such as:
- Buying or selling equipment
- Acquiring or disposing of property
- Investing in other businesses
Regular negative cash flow here might mean the company is investing heavily in growth. However, positive cash flow could also mean the business is selling valuable assets to survive.
Cash Flow from Financing Activities
This section shows cash related to financing, such as:
- Borrowing money
- Issuing shares
- Paying dividends
- Repaying loans
Positive cash flow here often means the company is raising money through debt or issuing shares, which can mask operational weaknesses.
How to Spot Warning Signs
Even with positive cash flow, certain warning signs indicate financial trouble.
Negative Operating Cash Flow
Positive total cash flow with negative operating cash flow indicates serious issues. A healthy business must generate positive cash flow from its core operations. Negative operational cash flows may force a company to sell assets or borrow money to survive.
Selling Assets to Raise Cash
Companies might sell equipment, property, or other assets to show positive cash flows. If this happens frequently, it suggests the business is struggling. Selling assets provides immediate cash but reduces the company’s ability to earn profits in future.
Increasing Borrowing or Debt Levels
A company may have positive cash flow because it borrowed money. Continuously relying on loans creates high debt and can cause long-term trouble. High interest payments eventually drain cash, making it harder to invest in future growth.
Practical Example of Identifying Problems in a Cash Flow Statement
Let’s examine a simplified cash flow statement for a fictional business, Crabcake Ltd.
Crabcake Ltd Cash Flow Statement (Year Ending 31 December 2020)
| Activity | Cash (£) |
| Operating Activities | |
| Net Income | 1,000,000 |
| Add: Depreciation | 100,000 |
| Increase in Accounts Receivable | (300,000) |
| Decrease in Inventory | 200,000 |
| Increase in Accounts Payable | 150,000 |
| Net Cash from Operating Activities | 1,150,000 |
| Investing Activities | |
| Purchase of Equipment | (500,000) |
| Sale of Property | 1,000,000 |
| Net Cash from Investing Activities | 500,000 |
| Financing Activities | |
| Issuance of New Shares | 700,000 |
| Repayment of Long-term Debt | (200,000) |
| Net Cash from Financing Activities | 500,000 |
| Net Increase in Cash | 2,150,000 |
Analysing the Example
At first glance, Crabcake Ltd has positive cash flows. However, some worrying points appear when examined closely:
- The company reported increased Accounts Receivable (£300,000 negative impact). This suggests problems collecting payments from customers.
- Positive investing cash flow (£500,000) largely came from selling property, not investment growth.
- Positive financing cash flow (£500,000) resulted from new shares issued, meaning shareholders’ stakes were diluted.
Despite positive net cash flows, Crabcake Ltd faces operational difficulties.
Key Ratios to Identify Hidden Problems
Several financial ratios help spot hidden cash flow issues:
Operating Cash Flow Ratio
This measures a company’s ability to cover its short-term debts from its operating cash.
Operating Cash Flow Ratio=Operating Cash FlowCurrent Liabilities\text{Operating Cash Flow Ratio} = \frac{\text{Operating Cash Flow}}{\text{Current Liabilities}}Operating Cash Flow Ratio=Current LiabilitiesOperating Cash Flow
- A ratio below 1 signals that operational cash is insufficient to meet short-term obligations.
Debt to Cash Flow Ratio
This ratio shows how long it would take a company to pay off its debts using only operating cash flows.
Debt to Cash Flow Ratio=Total DebtOperating Cash Flow\text{Debt to Cash Flow Ratio} = \frac{\text{Total Debt}}{\text{Operating Cash Flow}}Debt to Cash Flow Ratio=Operating Cash FlowTotal Debt
- A higher ratio suggests heavy reliance on borrowing, which can lead to problems if operating cash flow declines.
Free Cash Flow
Free cash flow is the cash available after funding business operations and capital investments.
Free Cash Flow=Operating Cash Flow−Capital Expenditures\text{Free Cash Flow} = \text{Operating Cash Flow} – \text{Capital Expenditures}Free Cash Flow=Operating Cash Flow−Capital Expenditures
- Negative free cash flow indicates the company isn’t generating enough money to support growth or repay debt comfortably.
Common Mistakes When Reading a Positive Cash Flow Statement
- Ignoring Operating Cash Flow: Investors often look at total cash flow without reviewing operating cash. Always check this first.
- Overlooking Asset Sales: Asset sales inflate positive cash flows but may signal trouble. Frequent asset sales weaken the company’s earning power.
- Misinterpreting Debt Increases: Increased borrowing boosts cash flow, but also increases future financial burdens.
What Healthy Cash Flow Looks Like
A healthy cash flow statement should typically include:
- Positive cash flows from operating activities.
- Investing activities showing investment in growth (negative cash flow is normal here).
- Balanced financing activities without excessive borrowing or continuous share issuance.
Example of a Healthy Cash Flow Statement
| Activity | Cash (£) |
| Operating Activities | |
| Net Income | 800,000 |
| Add: Depreciation | 100,000 |
| Decrease in Accounts Receivable | 50,000 |
| Decrease in Inventory | 100,000 |
| Increase in Accounts Payable | 30,000 |
| Net Cash from Operating Activities | 1,080,000 |
| Investing Activities | |
| Purchase of Equipment | (400,000) |
| Net Cash from Investing Activities | (400,000) |
| Financing Activities | |
| Repayment of Debt | (200,000) |
| Payment of Dividends | (100,000) |
| Net Cash from Financing Activities | (300,000) |
| Net Increase in Cash | 380,000 |
This indicates a stable business growing organically without depending heavily on external sources.
Conclusion
A positive cash flow statement does not always mean financial stability. Analysts must focus on cash from operating activities, observe asset sales closely, and consider debt levels carefully. By properly examining these aspects, it becomes easier to identify hidden dangers in a company’s financial health.