How to Master Analyzing the Cash Flow Statement

In this post, I’ll be going over a few basic ideas of what to look for financial statements, not how to read them, for the beginner investor who wants to research or keep up to date with their companies. AeroGrow (AERO) will serve as a very nice example with plenty of warnings signs.

The purpose of this post is to help you get the idea of a company’s health and let you decide whether it is worth the extra effort to take the next step and plug in numbers for ratios and other metrics.

FYI, I exited my position in AeroGrow with a huge 60% loss even though I had the opportunity to lock in a 20% gain. I made many mistakes on this one (let’s just conclude I didn’t even read the statements to begin with) and you will see why I had no other choice than to sell once I woke up. Hopefully, you won’t make the same mistake as me.


Jae Jun

In this post, I’ll be going over a few basic ideas of what to look for in financial statements, not how to read them, for the beginner investor wanting to research or keep up to date with their companies. AeroGrow (AERO) will serve as a very nice example with plenty of warnings signs.

The purpose of this post is to help you understand the company’s health and let you decide whether it is worth the extra effort to take the next step and plug in numbers for ratios and other metrics.

FYI, I exited my position in AeroGrow with a huge 60% loss even though I had the opportunity to lock in a 20% gain. I made many mistakes on this one (let’s just conclude I didn’t even read the statements properly) and you will see why I had no other choice than to sell once I woke up. Hopefully, you won’t make the same mistake as me.

Financial Statements Basics

There are 3 parts to a financial statement. The Income Statement, Balance Sheet and the Statement of Cash Flows. Online sites usually show them in the mentioned order, but I always start with the Cash Flow statement and work backwards. Usually, a majority of the companies don’t make it past the statement of cash flows.

I will assume you understand the basic definitions of words such as liabilities, assets, depreciation, amortization etc. If not, the following pages should bring you up to speed.

  1. The SEC’s Beginner’s guide to Financial Statements
  2. Moneychimp has a nice and easy to read explanation
  3. This is a 52 page detailed PDF written by Merrill Lynch (a shame they didn’t read their own material)

Intro to Cash and the Statement of Cash Flows

The Statement of Cash Flows details all cash inflow and outflows and boils it down to how much cash the company has generated in a given period. Income statement and balance sheets include the future incoming and outgoing cash recorded as credit.

Cash is king and is the blood of a business – it has to flow evenly. Holding plenty of cash is never a bad thing but there are exceptions to this as well. On the other hand, too much outflow in one area is the equivalent of getting shot and seeing blood pour out from the hole. The basic and key idea is that cash is what a company needs to be healthy and generate earnings.

Cash flow is calculated by adding and subtracting certain items to the net income. These adjustments must be made because non-cash items may be included into the net income even though it does not represent any cash in the bank.

e.g. You sell an item with a condition that the buyer can use it for 30 days, and if they like it, they pay for it. Otherwise they return it during the 30 day period without paying anything. In this case, accounts receivables will go up which makes it seem like the assets have increased, but in cash terms, you did not receive a single cent. Thus the importance of seeing how this number is stated in the statements.

The AeroGrow Statement of Cash Flows

Accounts Receivable

If accounts receivable decreases from the previous years (you have to compare by going back a few years), this means that more cash has entered the company from customers paying off their credit accounts. If accounts receivable increases, this means that the company has sold more products that money received.

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In AeroGrow’s latest filing 10-Q filing (see above), we see that the cash related to accounts receivable decreased by $9.9 million compared to a decrease of $3 million a year ago. In other words, AERO sold $9.9 million worth of goods without being paid, compared to $3 million the prior year. They are both bad numbers, but the latest increase is a whopping 330%!

This is a huge warning sign that management is desperately, in a maniacal way, trying to get their products onto any available shelf. Far too aggressive.

Inventory

Same for inventory, which they burned $5.7 million on. Rather than managing it, they’ve multiplied it like cockroaches. They currently have $8.5 million in finished goods which I assume is supposed to meet the demand they were expecting, except they have announced an expected slow down.

It would have been better to keep it as raw materials and streamline assembly processes in order to meet demand. Raw materials could be sold at commodity prices if it came down to it, but finished goods collecting dust will only fetch 50% at best in a fire sale.

Good indicator that management is unrealistic with performance and does not perform proper market research.

(If raw materials increase but finished goods decrease, it means the company has a problem with efficiency, processes and ultimately meeting demand.)

Accounts Payable

The third big warning sign is accounts payable. Since this is a positive number, the cash hasn’t left yet, so it’s been added back to net income because it is stated as a liability in the Balance Sheet.

This means that AERO has delayed the payment but will have to pay this huge amount in another period. An increase of $7.7 million in payables will surely require the company to look for further credit or dilute shareholders in order to pay it down.

Cash From Operations

For a company to be healthy, the cash from operating activities should be positive, but the quality of the cash is just as important.

The net income at the top of the Cash Flow Statement should preferably be a high positive number and the adjustment differences should not be huge. If this is the case, the majority of cash from net income should drop to the Cash from Operations line.

We see AeroGrow went from a net income of $(2.4 million) to Cash Used in Operations of $(9.2 million) in 6 months. This is $2 million more than the previous year and considering the size of the company, this is a first degree burn.

You can also see the company spending to purchase new equipment and receiving $9 million from financing with over $10 million in debt from $0 one year ago. Not the quality we want to see. Unsuspecting investors may only see the Cash at Beginning of Period of $1.6 million and Cash at End of Period of $0.4 million and think they used up $1.2 million. But we can see the true number is $9.2 million.

Not to mention a $8 million market cap with $10 million in debt and more coming.. you do the math.

Conclusion

The latest news from AERO touts its first every profitable quarter masked behind a mess of cash outflows. We’ve just seen why it’s more important to view cash than earnings.

I don’t mean to pick on AeroGrow, and the company will hate me for writing this, but before getting into the details of ROE, ROA, margins, solvency, turnover etc, taking a quick glance at the statements will reveal the company for what it is and save you from deep trouble.

About Jae Jun


Jae Jun is the founder of Old School Value. He is on a mission to provide practical and actionable value investing tools, tutorials and educational material to help empower the individual investor. Keep in touch with Jae via any of the methods linked below.

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  • http://www.oldschoolvalue.com Jae Jun

    I didn’t go through the income statement or balance sheet because it is fairly similar, but if it’s something you want to see, let me know and I’ll try to write something on it.

  • http://crisiscartoon.blogspot.com/ Crisis Cartoon

    Thanks for the walk through.

    Crisis Cartoon’s last blog post..Recession’s Thanksgiving

  • Marcos

    Good article, Jae. One thing though, the Merrill Lynch PDF link appears to be down (404).

  • http://www.oldschoolvalue.com Jae Jun

    Thanks Marcos, the link is fixed

  • http://www.fatpitchfinancials.com George

    Nice article. I like you spider graph at the end. Did you generate it with your premium spreadsheet?

    George’s last blog post..Constellation Energy Shares Will Pop on New EDF Offer

  • http://www.simoleonsense.com Miguel Barbosa

    Hi Jae Jun,

    Thanks for the walk through. I would love to see you go through the income statement & balance sheet (if you have the time).

    Miguel Barbosa
    http://www.simoleonsense.com

    Miguel Barbosa’s last blog post..Nighty (Value) Investment Links #39

  • http://www.oldschoolvalue.com Jae Jun

    @ George,
    The graph isn’t automated yet, but I’m thinking of possible conditions to get it done.

    @ Miguel,
    Sure. Even if 1 person asks, I’ll comply :) Just need to concentrate on working on the Forbes companies. Been getting stuck on other things at the moment.

  • http://stockmanmarc.blogspot.com stockmanmarc

    Jae,

    This is a very good example

    Great Job!

    stockmanmarc’s last blog post..Mr. 1 Up On Wall Street: Peter Lynch

  • http://www.oldschoolvalue.com Jae Jun

    Thanks Stockmanmarc. Glad you enjoyed it.

  • Jim

    Nice article Jae. I wanted to point out something that I may or may not be correct about but it has been my understanding and maybe you could shed some light on it. You mention:

    “Cash flow is calculated by adding and subtracting certain items to the net income. These adjustments must be made because non-cash items may be included into the net income even though it does not represent any cash in the bank. e.g. You sell an item with a condition that the buyer can use it for 30 days, and if they like it, they pay for it. Otherwise they return it during the 30 day period without paying anything. In this case, accounts receivables will go up which makes it seem like the assets have increased, but in cash terms, you did not receive a single cent. Thus the importance of seeing how this number is stated in the statements.”

    My understanding is that Net Sales is the Total Revenue generated by a business therefore making Net Sales also known as Total Revenue and that Net Sales is also the Gross Sales minus returns, discounts, and allowances. Since ‘Gross Sales’ isn’t reported and Net Sales is and is often referred to as Total Revenue those deductions that you bring up in your article have already been accounted for in the Total Revenue (AKA Net Sales) figure. So, you shouldn’t have to look for situations in which someone may return an item because its already been reported in the Total Revenue figure. And also that this is a GAAP rule to accounting so the conditions aren’t different from industry to industry.

    That has been my understanding for a long time and there are many definitions circling on the web that would point to the same conclusion. I actually can’t find one article that points to any other argument than the one I’ve presented. Maybe you could shed some light.

  • Jim

    Also Jae, is there anyway I could get a copy of your spider graph file? I’m not good with excel. I’m a pencil, paper, and calculator guy but I use the program on occasion and would love a copy of it. It seems like a very accurate tool to me the last 3 times I’ve seen you use it. Thanks.

  • http://www.oldschoolvalue.com Jae Jun

    Jim,

    You are right about sales figures on the Income statement being Net Sales, but this number is also just a rear view number. A representation of what has happened in the stated period only on the income statement.

    I don’t believe Net Sales provides a picture of the future possibility of what could happen with an Accounts Receivable that increased by 330% and inventory increase of over 200%.

    What I have tried to explain in this post is the way for people to look at the numbers and think about the possible future outcomes and warning signs. The whole point is to know what’s going to be bad and staying away right?

    This was and still is my biggest learning experience with financial statements. Getting beyond the numbers and trying to understand how the numbers provides an indication of the future.

    Regarding the spider graphs, I just manually entered all the values so I hope it is accurate otherwise my research and understanding is way off ;)

  • http://dividendtree.blogspot.com/ Dividend Tree

    JJ: Another way to deduce from this statement is take the ratio of FCF-to-debt (long and short). That shows how deep in water the company is. Also good for relative comparison across different companies…..

    Dividend Tree’s last blog post..Market Collision affecting Dividend Investors – Concluding Part

  • http://www.oldschoolvalue.com Jae Jun

    @Dividend Tree,
    Do I know you? because you seem to know my nickname lol =)

    Thanks for that tip. I havent considered that much. Will look into it.

    Also, is it just me, because I cant seem to leave comments on your blog with firefox. I keep getting 404 errors as well.

  • http://www.oldschoolvalue.com Jae Jun

    Visit the site below for a detailed look at inventory turnover and warning signs.
    http://www.vitalentusa.com/learn/turnover.php

  • http://dividendtree.blogspot.com/ Dividend Tree

    JJ: Thank you for point the bug. I have fixed it, and it works now. Let me know, if you still have problems.

    Dividend Tree’s last blog post..Reflecting on Investment Year 2008

  • Sesso

    Great site.

  • B

    Jae, in your Accounts Receivable section, you state:

    “If accounts receivable decreases…this means that more cash has entered the company from customers paying off their credit accounts.

    In AeroGrow’s latest filing 10-Q filing…accounts receivable decreased by $9.9 million… In other words, AERO sold $9.9 million worth of goods without being paid.”

    There’s a contradition there – I think you should have meant AERO got paid for $9.9mil worth of goods. So you’d have to change your conclusion. Perhaps AERO had really bad sales and didn’t replace the expired ARs with fresh ones from new sales. Or maybe they changed their credit policy…

  • http://www.oldschoolvalue.com Jae Jun

    No what I wrote is correct. Accounts receivables increase due to sales made before payment is collected.
    e.g. AERO sold products to Walmart on 90day term. AERO did not receive cash.
    Now when Walmart pays the amount after 90 days, accounts receivables go up but AERO didn’t sell anything.

  • B

    Jae, you’re right that the 9.9mil (increase) in AR represents sales on credit (though in the article it says “AR decreased by 9.9mil”).

    I think it was just the “increase/decrease” wording that was confusing (decrease as in “decrease toward zero,” or as in “more negative”). Perhaps a more precise language would be “debit” on sales and “credit” on payment. I’m relatively new to analyzing financial statements, so this kind of clarity helps me!

  • srikanth

    what are the caveats to look for in a service industry company looking for very high ebidta growth (to improve ev for gettting funds) so that cash flows are not stretched

  • http://www.oldschoolvalue.com Jae Jun

    Not sure I understand your question. I dont search for any company based on EBITDA so that one is beyond me, and what do you mean by “cash flows are not stretched”?

  • Sam

    Thanks Jae, I learnt a lot after reading this article.

  • http://www.anandcpeter.com Anand Claudius Peter

    Hi Jae,

    As a 2 month old MBA student from an engineering background, this article has been very helpful to me as I am preparing for a financial accounting exam and have been struggling with cashflow analysis. Keep up the good work, glad to see that you are Christian, I am too.

    Blessings,
    Anand

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