Introduction

Continuing with the statement of cash flows, looking at the Company’s operating, investing, and financing activities can tell you a lot about the health of a company. Starting with operating activities, you can see whether the Company can generate cash with its core operations. Investing activities shows how the Company uses their cash float to grow their business. Financing activities showcase the Company’s dependence on external sources of cash to fund the Company’s objectives. Individually, the movements in one activity do not necessarily indicate a good or bad situation. Evaluate these activities in the aggregate (i.e., operating, investing, and financing) to determine whether a company is doing well or trying to stay afloat. In today’s blog, let’s go over each component of the statement of cash flows at a high level to describe how these activities influence one another. 

What does the operating cash inflow (outflow) tell you about the health of the business?

Generally speaking, a positive cash inflow from the business’ operating activities tells you that the Company can generate cash from its normal operations without the help of external sources of funding. This cash flow assumption continues if straight quarters or years of cash inflow from operating activities. In a word, the Company is considered “self-sustaining” from its core operations. If there is an inflow, the Company can use the money for other business areas, such as new equipment, investments, or other companies via an acquisition.

If the operating cash has an outflow, the Company spends more money to keep its operations running than receiving money. If this happens occasionally, it’s not necessarily a bad thing. It could be as simple as there may be a difference in the timing of receiving cash or paying out to vendors. Often, this situation occurs with a company that is recently about to reach profitability. However, if this outflow is consistent quarterly or annually, it indicates that the Company has a problem with its operations. Common reasons for the cash burn are high operating expenses. For example, a company is spending too much on advertising or not receiving enough return on investment to justify its marketing method. Salaries could be too high, or it costs too much to have the current sales and research team because there are not enough sales generated. Overhead is another common issue because there is too large of a finance team or insufficient utilization of the Company’s assets (i.e., buildings, machinery, etc.) to create products or services. The Company could also be spending too much on inventory that isn’t selling at a high enough price (e.g., the margins are too low). These explanations are not an inclusive list. However, I am highlighting an issue with the Company’s core operations, and it boils down to how the Company uses its cash daily.

There may be times when there is a mismatch between the income statement and operating activities of the cash flows within a period, such as having a positive net income and a negative cash outflow. Or, there may be a net loss and a positive cash inflow. The first scenario may indicate that the Company has received a temporary gain or temporary increase in revenue. But, their core operations are still not sustainable.
In the second situation, the Company may have too many non-cash expenses, which may indicate a difference in timing or mean that it invests too much in assets and is not generating enough return on investments. A typical example of this is when a company has too many long-lived assets. Depreciation expense for the assets are significant on the income statement and is high enough to offset revenue significantly, showing a net loss. The investments are not generating enough return to justify their purchase. The Company is investing too much into assets when they could use the money elsewhere, such as on marketing or a better sales team. On the cash flow statement, however, the Company receives cash because, when removing the asset’s depreciation, the actual expenditures are not more than their cash acquired through their operations.

Another example of a discrepancy between the net income and operating activities is when a company decides to delay the payments to their vendors. The Company may be recording a net loss on their income statement since the expense still needs to be incurred in the current period. However, it will record a net gain in cash flows since they did not pay their vendors in the same period. Therefore, this is a difference in timing. Investors should be cautious of this timing difference to pay vendors later because this can indicate that the Company needs to retain cash. It means they have trouble keeping their business afloat. This situation may be misleading, so it’s essential to understand why the operating activities records show discrepancies in the income statement.

What does the investing cash inflow (outflow) tell you about the health of the business?

Generally speaking, if the Company is self-sustaining, i.e., its operating activities show a consistent cash inflow, it is normal for a company to invest its cash into either more assets or securities to generate more money in the future. Therefore, it would be a healthy sign to see cash outflows in the investing activities when there is a positive inflow from operating activities.

However, it would be a red flag if the Company showed a cash outflow from investing activities and the operating section. The reason is that a regular company would not lock their cash into illiquid assets if they are losing money and would instead be choosing to enter a state of cash preservation. However, it is common to see companies invest their excess cash into stable liquid securities such as treasuries to generate some yield when in a cash conservation mode. However, if they are still investing activities into new assets, this may indicate that the business structure or industry forces the Company to invest in keeping the business competitive.

A typical example of this happening is within the airline industry. The airport terminals, airplanes, and machines used to maintain their planes require a high expense to keep up with regulations and quality standards. Even if the Company is pouring cash out of their operating activities, they still need to continue to invest in the latest technologies and maintenance since airplanes are delicate and the industry is highly competitive. If they don’t, airlines run the risk of having one of their airplanes malfunctioning and thus would cause a more significant problem not maintaining their equipment. Therefore, airlines are constantly buying new equipment and machinery to keep the operations running, even if the Company is losing money because of a lack of flights or demand.

What does the financing cash inflow (outflow) tell you about the health of the business?

You start to see a trend about when a cash inflow or outflow is suitable for a company. When the Company receives positive cash flow from operating activities, the cash inflow from financing activities is generally a healthy sign. Companies will typically try to expand their operations or provide greater returns for their investors when they do well. However, companies don’t always have the free cash flow to expand their operations or buy back shares from their investors. Or, a company may have the cash to expand their operations but find that they can use their money on hand in case there better opportunities down the road. Companies will take on debt or issue shares to fund their strategy to solve this situation. Again, this is okay if the Company is generating positive cash inflows from operating activities because the assumption is that it can back its debt. If the Company is issuing stock, the assumption is that the proceeds can provide more return on the investors’ money by investing in more assets to generate higher revenue.

The danger of a company taking on more debt or selling more shares to investors when the business is not self-sustaining because now it implies that the Company is asking for money to keep its operations afloat (i.e., not go out of business). Is this such a bad thing, though? The answer is it depends. This investor outreach situation is quite common in the industry that I audit, which is biotech. Many venture capitalists invest in these start-up biotech companies hoping that one of these companies will reach FDA approval and sell their products exclusively to recover the losses incurred during their research and development phase. However, the Company will need to raise funds periodically to keep its dream alive. So it’s pretty common to see in the cash flow statements an increase in cash inflows from financing activities while the operating activities are bleeding cash. However, this is not always the case with other industries as there may not be interest to keep a struggling operation afloat since there is nothing novel or exclusive to sell in the future. This scenario is why it’s common for venture capitalists to invest in tech but maybe more reluctant to keep a heavy cash outflow company in another industry that’s well established and unlikely to have disruptions in technology, such as a company involved in aviation.

The opinions expressed herein are my own and do not represent my employer’s views in any way. Nothing posted here should be considered official or sanctioned by my employer or any other organization I’m affiliated with.