"The fact is that one of the earliest lessons I learned in business was that balance sheets and income statements are fiction, cash flow is reality." – Chris Chocola.
Businessman, lawyer, and former politician Chris Chocola mentioning one of the most important lessons he learned. Balance sheets and income statements are the outcome of assumptions and timings.
On their own they can be irrelevant. Cash flow movement are cold hard facts.
Thus, two different auditors can sign-off as 'true and fair' the financial results of an organisation depending on the management assumptions and opinions that they find palatable.
But as for cash, you either have the ringgit value or do not – it has nothing to do with any assumption or opinion.
Cash flow is a critical factor when evaluating the health and potential of an investment in stocks. It provides a clear and tangible insight into a company's financial health, operational efficiency, and future growth potential.
Unlike earnings, which can be manipulated through accounting practices, cash flow presents a more accurate picture of a company's financial situation.
Profits and losses are opinions; cash flow is fact. Thus, cash flow is an essential metric for investors aiming to make informed decisions. Informed investment decision- making remains the perpetual mantra for all successful investors.
Cash flow refers to the net amount of cash and cash equivalents moving into and out of a business. It is categorised into three main types:
Operating Cash Flow (OCF): This is the cash generated from a company's regular business operations. It reflects the company's ability to generate sufficient revenue to maintain and grow its operations.
Investing Cash Flow (ICF): This represents the cash used for investing in assets and
acquisitions. It can include purchases of equipment or investments in other companies.
Financing Cash Flow (FCF): This is the cash flow between the company and its owners and
creditors. It includes issuing and repurchasing of stocks, dividend payments, and borrowing
and repayment of debt.
Importance of Cash Flow in Stock Investment
True Indicator of Financial Health.
Cash flow provides a real-time snapshot of a company's financial health. Unlike net income, which can be influenced by non-cash items such as depreciation and amortisation, cash flow shows the actual liquidity position.
A company with strong cash flow can meet its obligations, invest in growth opportunities, and return capital to shareholders through dividends and buybacks.
Predicts Future Performance
A consistent positive cash flow indicates a company's ability to generate revenue and profit sustainably. Investors use cash flow projections to assess whether a company can continue to grow and provide returns.
Companies with strong cash flow are typically better positioned to weather economic downturns, invest in new projects, and capitalize on market opportunities.
Assessment of Operational Efficiency
Operating cash flow highlights the efficiency of a company's core business activities. High OCF suggests that the company's operations are generating enough cash to cover operating expenses and investment needs.
Conversely, low or negative OCF can indicate underlying problems, such as poor management or declining sales.
Liquidity and Solvency
Liquidity refers to a company's ability to meet its short-term obligations, while solvency refers to its ability to meet long-term debts.
Positive cash flow ensures that a company has the liquidity to pay off its immediate liabilities and the solvency to sustain its operations over the long term.
This is particularly crucial for investors, as companies facing liquidity or solvency issues are at a higher risk of default or bankruptcy.
Capital Allocation and Growth Opportunities
Companies with strong cash flow have the flexibility to reinvest in their business, pursue new growth opportunities, and make strategic acquisitions.
This reinvestment can lead to higher future earnings and an increase in stock value.
Investors often look for companies with solid cash flow as they are more likely to deliver long-term growth and returns.
Dividend Sustainability
For income-focused investors, the sustainability of dividends is a key concern.
Dividends are paid out of cash, not earnings. A company with strong and consistent cash flow is more likely to maintain and grow its dividend payments, providing a reliable income stream to shareholders.
In summary, cash flow is an indispensable metric for stock investors. It provides a clear and accurate picture of a company's financial health, operational efficiency, and future growth prospects.
By focusing on cash flow, investors can make more informed decisions, reduce investment risks, and identify companies with the potential for sustainable growth and returns.
While other financial metrics are also important, cash flow offers the most comprehensive insight into a company's true financial position, making it the cornerstone of sound investment analysis.
*The writer is a former chief executive officer of Minority Shareholders Watch Group and has over two decades of experience in the Malaysian capital market.