DIGESTING FINANCIAL STATEMENTS: SYSTEM
A financial statement serves as an avenue for assimilating the overall health of a business. Let’s illustrate the four key steps in a cash-based dealing of a company:
Step 1: Shareholders and/or creditors inject capital into the entity.
Step 2: Capital is used to finance acquisitions or projects. Investors and/or lenders claim a certain amount of debt or dividend on the company.
Step 3: Money is disbursed accordingly to create a cash flow for the current fiscal year.
Step 4: The firm earns money, which can be utilized to distribute dividends to shareholders, repay debts, and reinvest or maintain the remainder of profits.
A financial report is comprised of two parts: balance sheet (shareholders’ equity, assets, and liabilities) and cash flow statement (disclosed quarterly to the SEC and the general public). This document encompasses the cash flowing in and out of the firm based on the following facets:
Cash flow from financing - Money equity and debt issuance, which is subtracted by dividends paid.
Cash flow from investing - The largest portion is the outflow for buying long-term assets. Usually negative, it can include money from joint ventures or unconsolidated investments, as well as one-time acquisitions and/or divestitures.
Cash flow from operations - Costs for bolstering sales such as taxes, but is reduced by interest rate on debt and money paid for keeping inventory.
In simplest explanation, net cash flow = CFF + CFI + CFO. Since it entails financing flows, this may not be considered the best metric for gauging the performance of a company. Moreover, it can be unusually low since money is used to retire debt or unusually high because the firm released debt to generate money.
CFO is a good yet imperfect performance gauge, for sure. The downside of this measure is that dividends are not seen in CFO. A company can replace equity with debt to amplify CFO, granted all things are equal.
How to attain the ideal gauge of cash flow? Stay tuned for the next tutorial session.
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