26. What is a Cash Flow Statement Video Lecture | Become an Expert: Value Investing - Business Basics

welcome the course to unit 5 lesson 2
what is a cash flow statement in this
lesson you'll learn what a cash flow
statement is and you also learn how to
use cash flow statements to identify
strong companies versus risky companies
so let's get started
if you remember back to course 1 unit 1
you'll remember a scenario where I was
teaching people about income statements
and balance sheets with an ice cream
stand owned by owner Nancy one of the
things that I had briefly mentioned was
the existence of a cash flow statement
but I didn't get into any details on how
the cash flow statement was used and
what its purpose was and so that's what
this lesson is going to do is we're
going to go back to the basic
understanding of the income statement
the balance sheet and now we're going to
incorporate into that the cash flow
statement
so before 1987 a cash flow statement
wasn't even required but in order to
provide more fidelity as to what's
happening inside of a publicly traded
company of cash flow statement is now
required so just a quick recap the
income statement which you'll find on
the bottom left there and what I'm going
to use for this scenario is a basic
candy store we're going to say it's
called the ends candy store and we're
going to just use some real generic
money to show how that money flows
through the ends candy store and we're
going to show how with each one of these
three statements do okay so the very
first one that you have to understand is
the income statement and you should be
basically familiar with this and the
income statement demonstrates the amount
of money being generated from the
operating activities of the business so
this report will show you how much money
is flowing into or out of the company
based off of that product so this would
be the sale of Dan's candy so let's say
that Dan sells enough candy to generate
enough income of $100 as net income
would be $100 and so that hundred
dollars would be reported off of that
income statement at the top of the
income statement is going to be the
revenues and at the bottom is going to
be the net income or the profit okay so
that $100 of profit flows into Dan's
candy store that's the profit that he
made and so that income statement would
capture
now once it's inside a band store before
we were showing how that money could be
paid to the owner through a dividend or
the money could then be listed as an
asset on his balance sheet or that money
could be used to pay off debts which
would lower the liabilities on the
balance sheet so if you were just
looking at the income statement or the
balance sheet which is how you would be
viewing this before 1987 you would have
to see the money flowing in off the
income statement and where that money
was going would be whether the assets
were becoming a higher value where the
liabilities were decreasing you would
have to surmise how that money was being
employed based off of how the balance
sheet changed from month to month so
what the cash flow statement does is it
it shows you where that money's being
generated and where it's being spent and
employed throughout the company so
that's where the cash flow statement
comes in and that's going to be its
purpose so let me give another example
let's go back and let's say that $100
flows into Dan's candy store okay and
this is something that you might not
have thought about before but now as
we're getting closer to the advance
lessons some of this will start making
sense for you but let's say that $100
comes into Dan's candy store through the
the sale of his product okay once that
hundred dollars reaches his corporate
bank account his company's bank account
there's a lot of things that he can do
with that money a lot more than what
I've you know the basic things that I've
described earlier so not only can he
have money flowing in from the product
that he has produced that the candy the
hundred dollars from the candy but then
let's just say that he has that this is
a publicly traded company dan could
actually raise revenues for his company
through the issuance of stock so let's
say that there's a hundred shares
outstanding on danced or let's say Dan
wanted to issue another hundred shares
so there'd be two hundred shares
outstanding well when he sells those
shares that's going to bring additional
revenues a lot of additional funds and
cash into his business so instead of
just making a hundred from the candy
that he that he sells he might make
another hundred dollars just
the sale of his stock another way Dan
can raise money as he can issue bonds
I'm sure you've already realized that
but that's not something that you're
going to capture on the income statement
you're just going to see that he has
more cash on hand or whatever the case
would be off the balance sheet and you
wouldn't really understand how it got
there and the cash flow statement helps
us identify that so let's just say Dan
issued a hundred dollars worth of bonds
so he collects a hundred dollars from
some investor in addition to the hundred
dollars he's already making from his
product so there's an additional two
hundred dollars that are going to be
going on to his balance sheet now here's
another thing that a lot of people might
not consider is let's say Dan has been
using money in his account to purchase
publicly traded companies just like
you're doing inside of his corporate
account now this would kind of make
Dan's candy store a holding company but
let's just assume that he owns some
shares of a company inside of his
corporate account okay and those those
companies he owns inside of this Dan's
candy store corporate account or making
dividend payments to him so that would
be additional income that would not be
listed on the income statement that
would only be captured off of the cash
flow statement so those are just a few
of the different income streams that
could be coming into Dan's candy store
that aren't going to be listed on that
income statement but need to be captured
somehow and that's where you're going to
find the cash flow statement very useful
when capturing those those resources now
just as we described funds that were
coming into Dan's corporate account that
weren't captured off the income
statement there's also funds that are
flowing out of Dan's candy store that
haven't been properly accounted for
either let's go ahead and describe some
of those the first one that's pretty
obvious is if Dan's paying a dividend to
the owners of his company which would be
himself if he's paying himself a
dividend that's not captured on the
income statement so that dividend
payment has to be captured somewhere and
that dividend payment is captured on the
cash flow statement you'll see the funds
flow out of the company let's say Dan is
using the money that let's say that
hundred dollars that that
flowed into his company let's say he's
taking a portion of that hundred dollars
let's just say 25 that of those dollars
he's reinvesting that back into
inventory or he's using that 25 dollars
to upgrade his facilities or his
equipment that's all going to be
captured on the investing portion of the
cash flow statement another thing that
you're going to find on the cash flow
statement is that the money that he's
using to pay off his debts or to make
payments on his coupons for the bonds
that he might issued when you were just
working with an income statement and a
balance sheet you would see that maybe
the liabilities would decrease but you
wouldn't know how much of his cash was
being allocated towards paying off those
debts but with the cash flow statement
you can now see how how much money he's
using to pay off his debts and how much
money he might be using to retire stock
let's say before he was raising money by
selling stock let's say he's buying 100
shares back let's say there's 200 shares
outstanding and he is using $100 in
order to buy 100 shares back of his
business because that increases the
value of the shares that he's holding so
that would be the incentive for him to
do something like that so all of these
things all these nuances that I'm
describing are all captured in this very
important document called the cash flow
statement so when we open up a cash flow
statement and we look at it the cash
flow statement is broken down into three
categories okay the first category is
operating activities okay and the
operating activities are all those funds
that are flowing into the into the
business so if he was receiving dividend
payments from companies and he owns
inside of his corporation that would be
listed on the operating activities if he
the net income is the first thing listed
on them on the operating activities
which comes straight off of the income
statement so all that money that's being
generated for the business that he is
doing that he's producing is listed
there on the operating activities now
the invent the next one is the second
one here is investing active
so the money that he's using inside of
his a corporate account in order to buy
more supplies in order to upgrade his
facility's inverter by new buildings in
order to purchase stock and other
companies in order to buy bonds all
those investing type activities are the
second item that's listed on the
cashflow statement and then the third
item that's listed on the cash flow
statement is financing activities so
when I was talking about how maybe he
was issuing more shares that's a way of
financing and raising money for his
business a lot of people might not do it
that way but that's exactly what's
happening whenever a company issues more
shares
the other way that a company finances is
that they issue bonds so he could either
take out a loan he could issue bonds and
that will raise money and that's the
third category listed on the cash flow
statement and that's financing
activities okay so the important number
to watch out of those three out of those
three categories on the cash flow
statement is really that operating
activity because this is the this is
where you should see the green on the
sheet when you see a positive number
under the operating activities that's
the true number that's providing the
lifeblood of the company if you see a
positive number under investing
activities that actually means he sold
some of his investments and that's the
positive cash flow and same goes for the
financing activities if you see a
positive number on that third category
in the financing activities that
actually means that he has sold bonds
and he's incurred debt so that's not a
good thing so when you look at the cash
flow statement you're going to want to
see the operating activities as a
positive number hopefully a large
positive number and then the investing
and the financing activities as the
negative number because he's either
buying investments or he's paying off
debt okay so that's important the first
one needs to get positive in the second
two need to be negatives so let's just
go through a generic example here we're
going to call this company a and this is
going to be the cash flow statement for
company a as you can see from the from
the right to the left I have years 2010
2011 and 2012 the first line is at opera
activity the next line is the investing
activity and then the third line is the
financing activity and you'll see that
the fourth line is this just the change
if you summed up all three of those
categories the sum is at the bottom okay
so let's start with 2010 and work our
way across the operating activities so
in 2010 you can see the company a
generated a thousand dollars in
operating activity the next year was a
eleven hundred dollars in the third year
was twelve hundred dollars so you see a
nice steady growth in it's all positive
number like what we wanted to see
because this is the money this is this
is what the business does this is what's
producing the income so if it's a candy
store the candies are the primary thing
that's generating that operational
activities income now as we move down to
the next line and we look at the
investing activities you'll see that
they're all negative and like I said
before this is a good thing because this
means that he's taking $500 in 2010 he's
going to take $500 of the thousand that
his company produced and he's taking
that $500 and he's investing it
he's either investing it into a new
candy product a new building for his
candy company or maybe he's just going
on buying $500 of stock in another
business that could be any of those
things for maybe he's buying bonds $500
worth of bonds and he's going to be
collecting coupons from that investment
it could be any of those things but what
you want to see is you want to see a
negative number because that means he's
investing now if you saw a positive
number on that line that would mean that
he sold his stock or he sold his bonds
or he sold half of his plant to some
other company that is now producing
candy and now he doesn't have that
capability to generate that cash flow
for the next period so his you would
expect if the if the investing
activities were a positive number
depending on whether it was a good asset
or a bad asset you could maybe expect
operating activities to go down the
following quarter that for the following
year if there's investing activities
were positive number so you can see in
this scenario that is investing also
increase
he keeps investing a larger sum as he
kept making more money under that
operating activities now as we look at
the third line which is the financing
activities it's also a negative number
it's four hundred dollars five hundred
and then six hundred dollars this is
also a good thing because this means
Company A is paying off its debt in 2010
it paid off four hundred dollars of its
debt and it had $100 remaining after
that year then as we look at 2011 they
paid off another five hundred dollars of
debt that's good if this number was
positive that means the company would be
taking on debt now they'd have more cash
in their bank account that do whatever
it is that they need to do but in the
long haul that company's going to have
to pay off that debt and you're going to
see that being sucked out of the
operational activities and you're not
going to have that positive cash flow
potentially in the future depending on
how they how they use that capital that
they borrowed so this is what you're
really looking for this is a good
example of a cash flow statement you
want that first operating activities to
be positive and you want the investing
activities and financing activities to
be in the negative and then your net
change needs to generally be a constant
and consistent theme across the board
the fact that the net change in cash is
zero in 2012 really doesn't mean all
that much to me because I don't at that
point that the company has a very
positive operating activities are using
that money to invest and they're paying
off their debt so for me that all has a
good sign now if the company needed to
let's say they needed a lot of cash in
order to conduct an acquisition of
another business or something like that
you would see the company start
stockpiling their cash and you'd see
that net change in cash be a positive
number quarter after quarter as they
prepare for that acquisition that's
usually a good sign if you see a company
kind of stockpiling money you probably
know that they're getting ready to
conduct an acquisition of another
business so in company a I was showing
you a good cash flow statement now in
Company B I'm going to show you one
that's not looking as good so let's
start from right to left and look at the
operating activities and you can see
the operating activities cash flow is
slowly decreasing it's going from 500 to
450 to 400 that's bad because this means
that the income the lifeblood of this
company
is slowly decreasing as you know the
equity growth of a business and there's
dividend payments which we're using the
value of the company in the long haul it
has to be consistent and it has to be
slowly growing in order for them to
continue making those dividend payments
and for them to continue growing their
book value and their equity so a company
like this would have a hard time meeting
that because their earnings and their
overall operating activities are
decreasing with time so when we move
down to the next line and we look at the
investing activities you can see that
the investing activities are also slowly
decreasing now from 2011-2012 of when up
$50 but generally speaking went from 600
to 300 to 350 and the reason that those
investing activities are going down is
because the operating activities are
going down they can't continue to invest
at the same level that they were
investing when they don't have the funds
to do it so let's get on to the third
line and look at the financing
activities and you can see that these
are positive numbers so instead of the
company paying off debt it's actually
incurring another $500 at that and for
2011 it's incurring another $300 a day
2012 it doesn't look good at all they
took out another $600 in debt that's
that's them putting money in their bank
account that they're borrowing from
somewhere somehow either they're they're
making that money from issuing more
shares or they're issuing bonds or
they're taking out loans but that is not
what you want to see you want to see
that first line positive in the next two
lines negative and you can see the net
change in cash was zero in 2012 450 and
400 and 2010 so the net change in cash
was a lot higher here compared to
Company A but in my opinion this is a
much worse looking cash flow statement
because of the trends and the direction
that the the money is flowing so
just a quick recap here's company and
you can see how I have the first line in
green and the second two lines in red
and this is what we're looking for we
are looking for that operating activity
to really be generating that net change
in cash flow so I hope that this is a
lesson helped give you a general idea of
how a cash flow statement works this is
really general and basic but in the next
lesson we're going to go ahead and pull
up real companies and pull up their cash
flow students so you can kind of
identify a good company versus a bad
company with respect to how the cash is
flowing through the business so this
concludes course to unified lesson two
what is a cash flow statement and in
this lesson we learned what a cash flow
statement is and we also learned how to
use a cash flow statement to identify
strong companies versus risky companies
so I look forward to working with you
guys in the next lesson where we
actually apply the cash flow statement
to real businesses