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27 Aug 2008
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Introduction to Financial Statement Analysis. Part 2: System of Flows
by David Harper, CFA, FRM, CIPM
Note: this a blog highlight of our 12-minute movie: An Introduction to Financial Statement Analysis. Chapter 2: Financial Statements record a system of flows.
1. Creditor and investors (capital providers) start the business with invested capital
Creditors and investors give the company cash. In return for their cash, they have a claim on the business and its assets. The creditors (e.g., banks) hold debt; the shareholders hold stock. These holdings are recorded on the right-hand side of the balance sheet. The balance sheet is a record of the invested capital. Debt, as a liability, is listed first. This matches the debtholders' claim: it is "prior to" or "superordinated to" the equity claims. It gets paid first. In short, the creditors give the company cash in exchange for the promise of repayment plus interest, but little upside.
The shareholder give cash, too, but they have a "residual" claim and shareholders' equity is listed at the bottom of the right- hand side of the balance sheet. The shareholders have a risky position: there is no promise of repayment, but their gain is theoretically unlimited.
The above is a simple capital structure. The capital structure refers to the mix of capital provided by creditors and investors collectively. It is basically listed on the right-hand side of the balance sheet, if you exclude liabilities that are not really sources of invested capital (e.g., accounts payable is an obligation of the company, but the company's vendors are really financing the company, they hope!). Nowadays, capital structures are getting more complex. Especially popular are hybrid instruments that have both debt and equity features:
2. The company buys assets with the cash
The right-hand side of the balance sheet has a claim on business assets, which are listed on the left-hand side. The other way to look at this is, the assets (left) are funded by the capital (right):
And you have probably heard that left and right must balance. In this way, since assets = liabilities plus equity, the equity is the residual value in the business (E = A - L).
3. The assets (hopefully) generate net (excess) cash flow
So far, the capital providers (debt + equity) gave the business cash to fund assets. Why does the business have assets? To generate cash flow! That cash flow is captured in the statement of cash flows (we cover this is more detail later):
The first thing to notice about the statement of cash flows is that is contains three buckets: operating, investing and financing. Cash flows in two directions, in and out. So the company has cash inflows and outflows. These inflows and outflows are "classified" as either operating (CFO = cash from operating activities), investing (CFI) or financing cash flows (CFF).
CFO, CFI and CFF are just categories, they are neither scientific nor economic. A common mistake is to use the operating cash flow (aka, cash flow from operations) without adjustments, simply because it exists. But typically we will want to manually reclassify items to better calculate business performance.
4. Excess cash is either retained or returned
The excess cash flows (total cash inflows minus total cash outflows) are called the net cash flows. What can the business do with net cash flow? Broadly, the business can do two things. One, it can keep or retain the cash. Two, it can return the cash to capital providers:
Cash is returned in different ways. To prepay debtholders, the company can paydown principal (i.e., retire debt early). To prepay equityholders, the company can pay dividends or buyback shares.
Hopefully, you can see how a business is a cash generating machine, where cash pulses through the business in a cycle: capital providers loan or invest cash, which buys assets, which generate excess (net) cash flow, which is both retained (for reinvestment) or returned to the capital providers.
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It was really a very informative article and very helpful to understand Finance.
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