Unfortunately, specific information on how the derive the net cash from a 10-k’s cash flow statement is practically missing from the internet right now. Let me debunk all of the confusion and options surrounding cash and cash flow analysis, explain the definitions, and tell you why I think the popular opinion of using cash flow to determine intrinsic value is flawed.
There’s various definitions of net cash online, like Investopedia’s “total cash – total liabilities”, or Business Dictionary’s “cash on-hand – current liabilities”.
You can see that immediately, the specific definition of net cash is debatable. We see a commonality between the top two results on Google, but the fact that there’s a discrepancy between either representing total or current liabilities means the definition of net cash may be different depending on who you talk to.
It’s not like net income, which everyone defines as revenue minus expenses. Or shareholder’s equity, which is specifically defined as total assets minus total liabilities.
Also understand that net cash is a different definition of net cash flow. Net cash flow refers to the change in the cash balance between 1 year to the next. I understand this is starting to get really confusing, especially because the word “cash balance” and “net cash” aren’t actually on the 10-k annual report for every company. Let me take the biggest company right now, $AAPL, and show you their cash flow statement and define these terms based on that.
Now, when I say cash balance, I’m talking about the “cash and cash equivalents, beginning of the year” and “cash and cash equivalents, end of the year”. You can use either one of these, depending on which year you are looking at. Notice the beginning of the year cash balance for 2016 is the same as the end of year cash balance for 2015. This makes sense, we are just reporting how much cash a company has “in the bank”, or the cash balance.
Net cash flow is the change in the cash balance between the beginning of the year and the end of the year for the same year. You can see they put this number as “Increase/(Decrease) in cash and cash equivalents” on the 10-k, near the bottom of the page.
Another way to calculate net cash flow, which is a good sanity check to help us understand exactly what is going on with the cash flow statement, is to add all 3 of the following metrics:
- Cash generated by operating activities
- Cash used in investing activities
- Cash used in financing activities
Now let me explain each metric in the simplest of terms.
Operating activities describe the core of a business. It’s what you would think when you just look at how a company produces its profits. For a retail store, this could be the sales brought in minus the cost of employees and inventory. I’m using a basic definition and it’s a little more involved than that. But you get the point.
Investing activities describe how the company “invests” in its business for the future. This can include buying income producing assets, acquiring another company, and buying and selling its own stock or the stock of other companies. Think of Warren Buffett’s Berkshire Hathaway as a company who buys a lot of other companies shares. Insurance companies do this often too.
Financing activities describe any changes in debt, includes the dividends paid out to company shareholders, and includes the cash a company receives from diluting its shares (issuing more stock). You can see in this example that Apple both paid off some long term debt and received some cash for getting into more debt. As long as debt levels are low, this isn’t much of a problem.
Cash Flow Statement Takeaways
A negative number for operating activities can indicate severe problems within a business. In this case, the company’s core business model is likely failing. This can be due to a lack of demand or too many expenses just for the running of the business, either case isn’t a good sign.
You’ll notice that there are negative numbers both for investing activities and financing activities. This isn’t necessarily a bad thing, as there a lot of factors that would cause a company to report these as negative. In a basic sense, a highly negative investing activities number could indicate a company that is investing greatly in its future.
A highly negative financing activities number could just mean the company is rewarding its shareholders with dividends and little dilution of stock, which makes the value of the stock you (as shareholder) hold higher. Of course, a highly negative financing activities number could also indicate a company loading up a lot of debt quickly– which is highly concerning.
I won’t go into each specific possibility, because that would be largely time consuming and useless. The most important takeaway from all of this is that as long as the “cash and cash equivalents at the end of the year” is sufficiently high enough for us, the extent to which the numbers from these 3 categories are high or low doesn’t bother us.
It’s simple and effective and I’ll explain in a bit.
We want “cash and cash equivalents at the end of the year” to be sufficiently high because this effectively shows that the company has an “emergency fund”– enough cash to keep the business running or afloat during years of suboptimal earnings.
In personal finance, it’s always recommended you have some money as a cash balance in your checking account to support you through a layoff or major expense (repair, medical, or otherwise) without forcing you to go into a lot of debt.
With companies, it’s the exact same way. A high cash balance indicates an adequate emergency fund for the company. A low cash balance won’t be bad for a company when things are going smoothly, but as soon as their core business model performs poorly (even temporarily), there are going to either take on more debt or slow the growth of buying income producing assets.
While many investors care about net cash flow (remember the change in cash balance), I don’t because I really don’t care how much they change the cash balance year to year. Even a big negative move in cash balance for one year isn’t necessarily concerning– especially if the company had a large cash balance and will continue to have a sufficient cash balance.