It is difficult to overstress the importance of cash flow to the dividend investor. Cash flow is the life blood of the company and holds the key not only to its future growth, but also to the investor’s dividend.
Cash flow is a measure of the monies that flow into and out of the company over a specified period of time. A positive cash flow means that the company has reserves to pay debts, reinvest in the business, and offer a continuing (and hopefully, increasing) dividend to the company’s owners.
While looking at profits is important, evaluating the cash flow does not include transactions that are not directly tied to cash receipts and payments. These items can cloud the earnings picture, which is why cash flow offers a more clear and accurate metric. While it is possible to use accounting tactics to influence the cash flow numbers, it is considerably more difficult than modifying reported earnings. We will encounter an example of a cash flow statement later in the article.
The cash flow statement summarizes the cash and equivalents that move through the company. It offers insight into the company’s operations – where money is coming from and where it is going. It allows us to judge how efficiently the company is utilizing its resources, as well as evaluate whether or not the company will be able to maintain or increase their dividend.
In 1994 it was mandated that firms provide cash flow statements as part of their financial reporting. The statement shows how cash moves through the company, and is useful in determining whether or not the company will be able to meet its obligations.
The cash flow statement is offered in three sections, operational cash flow, investing cash flow and financing cash flow.
This is the measure of cash generated through the company’s business operations, and is an important benchmark of the core activities of the business. Because of its importance this group is listed at the top of the cash flow statement.
Analysts prefer using this information to simple earnings numbers because it strips away a number of accounting oddities and offers a better view of the company’s operations. It gives a clearer picture of the business’s ability to fund general operating expenses, have capital to grow the company, and pay debt, including dividends.
This is cash into and out of the company through investing activities, and is the second section of the cash flow report. It might include the acquisition and maintenance of physical assets, acquisition of other companies, or the purchase and sale of securities.
A negative investment cash flow is not necessarily a bad thing because the flows might be due to items such as research and development or the building of a new plant, which can be beneficial to the company’s long term benefit.
This section is the final part of the cash flow report, and covers cash that comes into the company through the payment of issued debt, and out of the company through the repayment of debt. It can include issuing equity, paying debt, capital leasing obligations, and the payment of dividends.
Financing cash flow shows how the company funds its operations. By mixing debt and equity the business can optimize its weighted average cost of capital to make it as low as possible.
As an example we look at MMM’s cash flow statement, provided by Seeking Alpha. There is no need to examine each line, just looking at the main numbers will suffice here. Of course, if anything raises an eyebrow then it would be prudent to start examining each section, line by line, to better understand the anomaly.
Looking at the bottom line of the operational cash flow from the above table we see that there is a positive value of $6.439 billion. It is a rather hefty number, meaning that the company is bringing in a lot more money through its operations than is going out.
This next table shows money that has been used to grow the company business through investing activities. In the case of MMM in 2018 the number shows a positive flow of $222 million. The bottom line from investing activities is oftentimes negative, as the outflow is used to promote the company’s growth. It could be positive if selling assets or receiving cash from investments.
The financing section for 2018 shows MMM negative to the tune of $6.701 billion. This number is oftentimes negative, but could be positive depending upon what the company is doing. If it is positive then the company may be in the process of raising money, if negative then buybacks or dividends are probably involved. That appears to be the case here, as the dividends paid out are nearly half the total.
After an adjustment for foreign exchange rates MMM in 2018 showed a negative cash flow of $200 million, so the cash inflows were less than the cash outflows. This is not necessarily a bad thing, but if an investor was considering a purchase then further evaluation should commence to better understand the final number and gauge its importance.
Cash flow is not to be confused with profit, and this difference is why the cash flow statement is so important. As previously mentioned, accounting gimmicks can muddle the water when it comes to understanding a company’s situation. As most businesses use the accrual method of accounting, this can mask difficulties, potentially making profits appear larger than they actually are. One problem is that the accrual method records income and expenses as they happen, whether or not cash has actually changed hands.
An example would be if a business sent an invoice for $10,000. Using the accrual method that $10,000 is recorded as a profit whether or not the bill is paid right away. Needless to say, if a bill comes into the company for $5,000 and that $10,000 has not been received, the business may be in trouble. The cash flow statement only records monies that actually move through the company, so these would not be reported. Since only cash and equivalents are reported, this gives a truer picture of the conmpany’s financial standing.
Free cash flow is an indicator of how efficiently a company is able to generate cash. It measures how much the company has after funding operations and capital expenditures, and is an indicator of the ease in which the company is able to offer dividends and share buybacks.
This number can be sector-sensitive, depending upon the requirement the company has on long-term investments. Companies that do not have to regularly purchase equipment will oftentimes have a steady free cash flow. Those that need to build factories and large machines will have free cash flows that are more volatile.
Additionally, the more mature a company is, the more stable their free cash flow may be. They have already built their buildings, and while they may need to build more, they do not need to pour what few resources they have into quick expansion, as can be the case with smaller companies.
Finally, examining free cash flow is just not important to financial companies, like banks and insurers, so in those instances there is no need to consider free cash flow.
The calculation to find the free cash flow is to subtract capital expenditures from the operating cash flow. Macrotrends offers the information in a convenient form, and the free cash flow for MMM can be found here.
The cash flow statement distills the company’s health to an easily understandable set of numbers. Examination of the statement gives an insight into the quality of the company’s earnings, and the potential for the company’s continued future growth.
High positive cash flow generally means that the company has the ability to take advantage of opportunities that can build the business through hiring new employees, adding locations, scaling up the purchase of raw materials, and so on. The lack of this ability is one of the biggest reasons that small businesses fail.
When there is sufficient cash on hand to pay expenses, build the company, pay off debt, and handle company operations essential to its wellbeing, this makes it possible to offer dividends to investors. Those who expect continually growing dividends can look to the cash flow statement to make sure that the company will actually have the ability to deliver.