Line of Credit Fuels 9,210% Return
Who doesn't like cash? Be it currency, or even Johnny Cash, either one is music to the ears of most people. And for investors, cash is king. So today let's take a closer look at how public companies report cash flow on their financial statements. Understanding how cash flows through a company can give you an edge when evaluating a potential investment for big profits.
This is another in a series of educational issues of Small Cap Investor Daily that I hope help you find profitable small-cap investments. You can find past issues on the 'Today's Trading' section of the Small Cap Investor Daily website. Do you have an investing related question you'd like answered? Feel free to ask me and I'll include the answer in a future issue. My address is: editorial@smallcapinvestor.com
Cash Flow Statement: The statement of cash flows tracks the movement of cash in and out of the business through operations, investment (purchases or sales of assets), and financing. Simply put, the cash flow statement measure the ability of a company to generate cash through various activities. Since we know cash is the lifeblood of a company, it is important to examine how a company converts revenues into cash. We then want to see how the company reinvests that cash to grow the business and generate a return for shareholders.
The income statement ties in, or articulates, with the statement of cash flows. You will see net income is the first line item on the cash flow statement. Net income is then adjusted for non-cash income and expenses such as accruals and depreciation.
These adjustments are made because even though something like depreciation decreases net income on the income statement, the company didn't actually pay depreciation costs out of pocket. Recall that depreciation is an accounting method that reduces the value of assets as their useful life decreases. A depreciation expense is typically recognized on the income statement, and lowers net income. So we add things like depreciation expense back in on the cash flow statement to get a sub-total for Total Cash Flow from Operations. This is what the company brought in from normal operating activities.
The next section covers cash used in investing activities. This includes capital expenditures for items such as buildings and equipment. Also included are loans made to suppliers or customers, and then this section is sub-totaled as Total Cash Flows from Investing Activities.
The third section shows the inflow and outflow of cash from financing activities. These include inflows from investors like shareholders or banks, as well as outflows such as dividend payments to shareholders. This section also includes repayments of long-term loans. Basically it tells you how the company is financing operations through both debt and/or equity.
The final line of the cash flow statement is the net increase or decrease in cash after adding the sub-totals from the three sections I just discussed. The net change in cash shows you how effective management is at generating cash to fund the business. I like to invest in companies that are growing their cash through profitable operations, and not just raising funds through increasing debt, or issuing new stock.
I'd just love to see a cash flow statement for Greece! The country's debt is 12.7% of GDP which tells me 'management' is not very effective at generating cash. In fact, you've most likely been hearing about how Greece has done a very poor job of collecting taxes in the past, a major reason why the country is now looking to Germany and France for a bailout.
Ok, back to small-cap stocks. Most small-cap companies fund their growth through the issuance of equity, or through a short-term line of credit. This is the strategy employed by high flyer Green Mountain Coffee Roasters (Nasdaq: GMCR), who has relied on its line of credit with Bank of America (NYSE: BAC) to fund acquisitions over the years. The strategy has clearly worked for the coffee company, between 2000 and 2010 the stock has soared 9,210%!
We also saw a ton of secondary equity offerings in 2009. Very few small caps, especially those with market caps under $1 billion, issue bonds in the form of long-term debt.
The balance between issuing debt or equity to raise cash is a fine line, and really depends on a company's financial standing, its stock price, and the interest rate environment. Increasing debt loads alone isn't a bad thing. It just may mean higher future debt levels and interest expense. But if interest rates are low, it can be a relatively cheap source of capital.
On the other hand, issuing new shares of stock dilutes existing shareholders, eroding shareholder value. But if the stock price is high, a company can bring in a ton of cash by issuing new shares. Conversely, you don't see many companies issuing new shares if the stock has recently tanked. Why sell it for below fair market value?
What I really like to see is a company that doesn't need to issue a lot of new debt, or new equity. Truly healthy companies are more or less self-sustaining and only need to raise cash to fund major expansions or acquisitions. They should not depend on raising more money through debt or equity to fund normal operations. This is a red flag to be sure. If total cash is decreasing, this can mean that the company will be in trouble down the road if it isn't able to improve profits, and curb money-losing operations.
Remember, investors in small caps stocks (like most stocks for that matter) are buying the future earnings of a company. If those earnings don't exist, or are not turning into cash, than you need to question the value of the proposed investment.
I talk a lot about earnings per share (EPS) here in Small Cap Investor Daily. In fact, last week I wrote an issue all about earnings, Conservatism Leads to Higher Share Prices. Earnings per share are essential in order to calculating a price-to-earnings (PE) ratio. But there is a valuable variation of EPS that you can use when analyzing cash flow statements. This variation uses operating cash flow per share instead. But that's another story, and I'll discuss it in more detail in tomorrow's issue.
There is a lot of analysis you can do when it comes to evaluating the cash flow of a potential investment. But this brief overview is enough to get you started.
