As with the income statement, investors like companies that raise cash predominantly from operating sources
Measures profitability :
When looking at a cash flow statement, investors tend to look at the component of operating cash flows with the greatest interest.
The other two activities should ideally be financed in totality by operating cash flows. Investors don’t mind negative investing and financing flows as long as the figure for operating cash flows is positive and greater than the combined outflows on account of the other two. (Although negative values must be investigated further.)
If this is the case, it means that the company has raised enough money from its operations to finance its investments, as well as repay money to creditors and shareholders. Such a company must be doing rather well!
Cash flow forecasting :
In case operating cash flows are negative and investing cash flows are positive, it means the company has sold its assets to raise money for its ailing operations.
In extreme cases, it may even be facing prospects of a shutdown, and is therefore selling parts of its business to support its operations and repay capital.
In case financing cash flows are positive and operating cash flows are negative, it may again mean that the company doesn’t have sound operations and therefore has to raise fresh capital to finance them. Shareholders are very sensitive about negative operating cash flows.
Investing v/s operating cash flows :
Negative investing cash flows generally signify that the company is expanding its operations or replacing old, worn-out assets. In such cases, you must be concerned as to the purpose of these investments. Negative investing cash flows are frequently found together with large, positive financing cash flows. This is because funding for these investments comes from financing inflows. You may be interested in the source of this funding-debt or equity. Sometimes, there is no increase in either. This means the company is using its retained earnings to finance these investments. In the section on the income statement, we defined retained earnings as the pool of net income not distributed as dividend over the years. This is the best and the cheapest source of financing.
Why operating cash flow matters
An extension of the concept of cash flows is the concept of free cash flows. It is an important part of cash flow analysis. We just discussed how a company should ideally use its operating cash flows to finance investments in new opportunities (i.e. fixed assets). In very crude terms, the portion of cash flows that is left after making such investments and fulfilling all other cash obligations is called free cash flows. There are two types of free cash flows-free cash flows to firm (FCFF) and free cash flow to equity (FCFE).
The cash flows available to the company after all its investing needs are met are free to be used for the third avenue of outflows – financing outflows. The financing (or capital) for running the company is provided by two categories of investors – creditors and equity shareholders. Together, the funding provided by them therefore, forms the company, i.e., the firm. The cash flows available for distributing to capital providers are therefore called free cash flows to the firm.
Since shareholders are owners of the company, creditors always have the first right over FCFF. As such, FCFF should be first directed towards making interest and principal payments. Post-tax interest expense has been added here because interest anyway goes to creditors. Thus, it should be a part of the funds available for them. However, interest is subtracted in the income statement while calculating net income. Since net income is the starting point of operating cash flows, interest is not able to flow into operating income. For this reason it has to be added back.