How to Analyze a Cash Flow Statement Like a Hedge Fund Analyst

There's an old saying: cash is king. However, when it comes to investing, cash flow is king. In this video, we are going to go over how to analyze a company's cash flow statement. I'm going to draw upon my experience as an investment analyst at a large investment firm to help you better understand what to look for when investing. Whether you are a new investor just getting started off or if you've been investing for years, I guarantee if you stick around to the end of the video, you will learn something new and useful that you can begin applying to your own investment research process today. Let's get into the video.

A cash flow statement, also called the statement of cash flows, is a financial statement that summarizes the amount of cash that enters and exits a company. Think of the cash flow statement as showing all of the cash that comes into the business and all of the cash that goes out of the business. A positive number represents cash coming into the business, while a negative number represents cash going out of the business. A cash flow statement allows you, as an investor, to understand how a company's operations are running, where its money is coming from, and how its money is being spent.

The reason the cash flow statement is so important is that it tells you, as an investor, how much cash a business is generating. At the end of the day, how much cash a company is able to generate over its lifetime is what determines that company's stock price. Put simply, the more cash a stock is able to produce, the more that stock is going to be worth, all else being equal.

Before we go into the specific items on the cash flow statement, it is important to understand how it is laid out. The cash flow statement is broken up into three distinct sections: operating activities, investing activities, and financing activities. The operating activity section includes any sources and uses of cash from business activities. Put simply, it reflects how much cash is generated from a company's products or services. These operating activities might include receipts from sales of goods and services, interest payments, income tax payments, payments made to suppliers of goods and services used in production, salary and wage payments to employees, rent payments, and any other type of operating expense.

Next up, we have the investing activity section of the cash flow statement. This section includes any sources and uses of cash from a company's investments. So that would include purchases of property, plant, and equipment; investments the business made in other companies; and money spent on acquiring entire companies. The investing activity section is almost always a negative number, especially for companies that are growing, as they are using that cash to grow the business through investing in things like new locations, new equipment to make more products, or even buying other companies.

Then the third section is referred to as financing activities. Cash from financing activities includes the sources of cash from investors or banks, as well as the uses of cash paid to shareholders. Payments of dividends, payments for stock repurchases, and repayment of debt are included in this category. Changes in cash from financing are cash in when capital is raised and cash out when dividends are paid. So if a company issues a bond to the public, the company receives cash financing, and that is reflected by a positive number on the cash flow statement. However, when the company pays back the money that it borrowed, it is a cash outflow and shows up as a negative number.

So now that we understand how the cash flow statement is laid out, let's go line by line of a real company's cash flow statement and talk about the important things you, as an investor, need to watch out for. To do this, we are going to use Coca-Cola, one of the world's most iconic brands and companies, as an example. If you ever wanted to research more about a company like Coca-Cola but didn't even know where to begin, check out one of my favorite investing apps, Quarter. I reached out to Quarter to sponsor this video because it has become an important tool in my investment research process. This app is completely free, and I use it every time I need to listen to a company's earnings call or read through call transcripts. I have included a link in the description to download the app if you want. It has saved me a ton of time and makes my own investment research process ten times easier.

The first line of the company's cash flow statement is the company's net income. When someone mentions how much a company made in profit, net income is usually the metric they are referring to. Net income is actually calculated on a different financial statement called the income statement. I made a video on how to analyze an income statement like a hedge fund analyst that you can check out here to learn how that figure is calculated. That video has gotten a ton of great feedback and has over 50,000 views so far, so check it out after this video to learn more about how to analyze financial statements.

Anyways, back to Coca-Cola's cash flow statement. After starting with net income at the top of the cash flow statement, the end goal of the operating activity section is to be able to calculate net cash provided by operating activities, commonly referred to as operating cash flow for short. In between net income and the operating cash flow line, there are a few important items I want to draw your attention towards. The first is the line item called depreciation and amortization. Usually for most companies, this is one of the largest numbers in this section of the cash flow statement.

Keeping it at a super high level, depreciation means that you write off the value of an asset over its expected useful life. The value of almost any asset depreciates over time, and you can write off a certain amount as an expense against taxes every year. So for example, let's say Coca-Cola buys a piece of equipment that costs one thousand dollars that the company believes they will be able to use for five years. So its "useful life" is five years. This means that the specific piece of equipment depreciates by two hundred dollars every year, which is simply the one thousand dollar price of the equipment divided by the five-year useful life.

However, Coca-Cola paid for the one thousand dollar piece of equipment in cash up front, so the two hundred dollar annual depreciation expense is considered a non-cash expense. Because no additional cash is leaving the business each year as a result, the depreciation and amortization expense for the year needs to be added back to the net income when we are calculating cash from operations. I know that may not make a ton of sense, but trust me, I could do an hour-long video on the topic of depreciation just by itself. So this quick high-level overview of it is all you really need to know as an investor.

The next line item that is important to pay attention to is stock-based compensation. This is simply when a company pays its employees in stock instead of purely just cash. So for example, let's say you work at Facebook. Each year, you may get 150,000 dollars in cash and another 50,000 dollars in stock of the company. This is the way companies try to encourage employees to stay employed with a company for longer and is very common in the tech industry. Coca-Cola isn't a technology company, so this number for them is relatively low, but this is a very important item to consider if you are analyzing a tech company. Just for some perspective, Facebook had a stock-based compensation expense of 6.5 billion dollars in 2020.

Just like depreciation, stock-based compensation expense is considered a non-cash expense because no actual cash is leaving the business. So it also gets added back to net income in order to calculate cash flow from operations. Jumping down the cash flow statement a bit, another important line item is the net change in operating assets and liabilities. This is also referred to as a company's working capital. Think of this as the cash needed to run the short-term operations of the business. Things such as paying suppliers and cash that a business is owed from its customers but not yet paid typically.

For companies that are growing, this is a negative number on the cash flow statement as more cash is needed to manage the day-to-day operations of the business as it's growing. However, for more mature companies like Coca-Cola, this number can vary between being a cash inflow (a positive number) and a cash outflow (a negative number) depending on the year. As we see with Coca-Cola, this line was actually a source of cash in 2020 and 2019 but a use of cash in 2018. All of these line items build up to the all-important net cash provided by operating activities or cash flow from operations.

This number represents the amount of money a company brings in from its ongoing regular business activities and is an important benchmark to determine the financial success of a company's core business activities. Additionally, cash flow from operations is used to calculate what is referred to as a company's free cash flow. In my opinion, and from my experience as an investment analyst, free cash flow is the single most important metric in evaluating a business. This is because the value of any investment, whether it is a stock, apartment building, or small business, is determined by the amount of cash flow the business will be able to generate over its life.

In order to calculate free cash flow, we start with the cash flow from operations number. Then we subtract out what is referred to as capital expenditures or capex for short. Capital expenditures are cash used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment. Capex is often used to undertake new projects or help the company grow or even just maintain its operations. Making capital expenditures on fixed assets can include repairing a roof, purchasing a piece of equipment, or building a new factory.

So if Coca-Cola were to increase the size of one of its factories in order to keep up with the increased demand from consumers, the cash spent on increasing the size of the factory would be considered a capital expenditure. We find this number for capex in the investing section of the cash flow statement in the line titled purchases of property, plant, and equipment. However, there is one additional step we need to take in order to calculate what I refer to as netcap x. We need to take the number for purchases of property, plant, and equipment, or pp e for short, which was negative 1,177 in 2020. We then need to take the number for proceeds for disposal of property, plant, and equipment and add it to the negative 1,177 number. This is because we want to get to the true amount Coca-Cola spent on capex in any given year.

So for 2020, we take the negative 1,177 for purchases of property, plant, and equipment and add back 189 for disposal of pp e to arrive at a net capex number of negative 988. Now, to calculate free cash flow, we take our cash from operations of 9,844 for 2020 and subtract out net capex of 988. This leaves us with 8,856. Remember that these numbers are in millions. This means that Coca-Cola generated 8.8 billion dollars in free cash flow in 2020. Remember how at the beginning of the video I said cash flow is king? Free cash flow is my favorite number to look at when analyzing a company because this is the amount of money that can be paid out to you as a shareholder. With this money, a company can pay out dividends, buy back stock, or even pay down debt, all things that are great for you as a shareholder.

So now that we have free cash flow, I just want to share a couple of cool things that will be helpful in your analysis. When I'm evaluating stocks, one of the metrics that I like to look at is called free cash flow yield. This is calculated by taking a company's free cash flow and dividing it by its market cap. This calculation leaves you with a percentage. So in the case of Coca-Cola, we can see that the free cash flow yield has hovered around three to four percent in the past. All else being equal, the higher the free cash flow yield's percentage, the better.

Something else that is also helpful to look at is capex as a percentage of sales. This is a measure of what is referred to as a company's capital intensity, or, put another way, how much money the company has to spend on maintaining and growing its operations. This is calculated by dividing the net capex number we calculated earlier by the company's total revenue. In the case of Coca-Cola, we see that they are spending around three percent of sales each year on capex. This number varies by industry, as certain industries are more asset-intensive than others. For example, a railroad spends a lot more on capex every year than a software company.

Moving down the cash flow statement into the investing activity section, the next items I want to hit on are purchases of investments and proceeds. Typically, when a company has a lot of cash, they will invest it in short-term, non-risky investments such as short-term government bonds. This helps the company generate some return on the money instead of just having it sitting in a bank account and not earning any interest at all.

Next up, we have acquisitions of businesses and disposals of businesses. It is very common for companies to acquire businesses in order to grow the business by entering a new geography or product line. This can take the form of Coca-Cola buying 100% of a company or making a sizable investment in a company where they own a significant stake (10%, 20%, 30%, let's say) but not 100%. For example, in 2019, we can see that Coca-Cola spent 5.5 billion dollars on acquiring businesses. After doing some research, I learned that included the acquisition of a brand called Costa and an ownership interest in C.H.I., a Nigerian producer of value-added dairy and juice beverages and iced tea. These are the things you want to know when researching a company. It's always important for you as an investor to see if a company is spending a lot of money on acquisitions.

Just like companies frequently buy other companies, they also occasionally sell off companies and brands they own because those companies and brands may not fit in with the long-term strategy of the company anymore. These sales of businesses are included in this line titled proceeds from disposals. Moving down the cash flow statement into the financing activity section, I want to spend some time talking about the line titled purchases of stock for treasury. This line shows us as investors how much cash the company is spending on share repurchases. I personally am a long-term focused investor and love to see when a company is able to continue to invest in growing the business while still being able to repurchase shares.

I want to quickly share two examples of why share repurchases are so powerful: one that is high level and one that is specific to Coca-Cola. In this example, let's say we have a company that, for simplicity purposes, has 100 in earnings and 100 shares outstanding. This means that the earnings per share is one dollar. Now let's say the company repurchases 10 of those shares, bringing the shares outstanding down to 90. Watch how that impacts the earnings per share number. We now divide that 100 of earnings by the 90 shares outstanding. This means that earnings per share is now one dollar and eleven cents. This means the company was able to grow its earnings per share by eleven percent from one dollar to one dollar and eleven cents without growing the actual earnings. The company is able to generate. This is why share repurchases can be so beneficial to us as investors.

Another example of the power of share repurchases involves Coca-Cola and its most famous investor, Warren Buffett. Buffett's company, Berkshire Hathaway, is the largest shareholder of Coca-Cola, owning 9.3 percent of the entire company. However, when Buffett made his investment in Coca-Cola, he only bought 6.2 percent of the company. Since that purchase, his stake has grown by 50% without him purchasing even one additional share. This is because Coca-Cola has repurchased shares. This is probably the greatest example I have ever seen of the power of share repurchases for long-term investors.

However, with that being said, to truly determine how much the company is spending on repurchasing shares, we also need to account for the line titled issuances of stock. Share issuances are the exact opposite of share repurchases. Instead of decreasing the number of shares outstanding, share issuances increase the number of shares outstanding. In order to see how much a company is spending on repurchasing shares, we need to subtract the amount of cash received from issuing new shares from the amount of cash the company spent on repurchasing shares. Once we do that, we actually see that Coca-Cola didn't truly spend any cash buying back shares in 2020, because cash from issuing shares far exceeded cash from repurchasing shares. This explains why the number of shares outstanding actually increased for Coca-Cola during 2020 compared to the previous year.

Next up, we have dividends. As we can see, Coca-Cola is a huge payer of dividends to its shareholders. The company paid out over 7 billion in dividends in 2020 alone. A lot of investors want to see the amount of companies paying out in dividends increase every year. We can see that this is the case with Coca-Cola, as dividends paid out were 6.6 billion dollars in 2018, 6.8 billion dollars in 2019, and over 7 billion in 2020. If the company starts reducing its dividend payments or even just keeps them the same year over year, sometimes investors take this as a warning that the company is struggling.

One analysis I like to do that is helpful is to add up the total amount spent on share repurchases and dividends, then take that number and divide it by the free cash flow of the company generated in that year. This leaves me with a percentage. Remember how early in the video I said free cash flow is my favorite metric because it shows how much a company spends on share repurchases and dividends? Well, this calculation shows me how much free cash flow a company is paying out to its shareholders via share repurchases and dividends. A percentage over 100 is considered unsustainable over a long period of time. This is because if a company is paying out more to shareholders than what it is generating in free cash flow, the company will either have to be issuing debt or depleting its cash. However, seeing it in one year, like in 2018 for Coca-Cola, isn't too worrisome.

So there you have it. If you enjoyed this video, make sure to give it a big like and subscribe to the Investor Center, because my goal is to make you a better investor by studying the world's greatest investors. Make sure to let me know your thoughts in the comment below and be sure to look out for a new video on how to analyze a balance sheet like a hedge fund analyst coming up. Talk to you next time.