Hedge Fund Investment Thesis: How to read an annual report: The Cashflow Statement. What I Learnt on Wall Street March 2016

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Beatrix Stanley
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1 Hedge Fund Investment Thesis: How to read an annual report: The Cashflow Statement What I Learnt on Wall Street March 2016

2 Core Parts of a Stock Thesis 2 This session is going to follow on some of the ideas we discussed at the last session We are going to continue review the filters we discussed last time As a reminder at the last session we reviewed the income statement

3 Investigating an idea 3 How do we develop an idea? Ø As a reminder, we use progressive filters Industry model How does the industry work? Business model How does the business work? Financial model What do their finances look like? Valuation model Can you value the company, is it cheap? This session is going to get you started on building a financial model the first step in this is reading an Annual Report we ll focus on the cashflow statement

4 What we are going to cover today 4 The goal of this session is to help you build a better financial understanding of a business, and therefore, build better financial models and be a better investor. We are going to do it in the following steps: 1. Balance Sheet Analysis 2. Income Statement Analysis 3. Cash flow Statement Analysis 4. Management Discussion & Analysis

5 What are we looking for? 5 Before we build a financial model, we have to read the annual report But lets not read the annual report without thinking about what we are looking for. What do we look for: 1. Companies that are doing well 2. and have a durable competitive advantage

6 Where do we look? 6 Lets start with the Annual Report. Key sections: 1. The Balance Sheet 2. The Income Statement 3. The Cash flow statement 4. Management Letter - also known as MD&A

7 Reminder: What is an Income Statement 7 The basic equation for the Income Statement is: Revenue Expense = Net Income

8 The interconnections 8

9 Conclusions on Income Statement 9 Don t just look at a number, but understand where its coming from What direction are the numbers trending and how do they compare with competitors? Is there anything that seems unusual? Can you explain why the numbers are what they are? Does the company spend more or less on certain things than other similar companies? Is this an advantage or disadvantage? Does this company have operating leverage? If so, how do I feel about that and it s usage versus the economic cycle? Does my capital base allow me to own a business with operating leverage?

10 Some tips before we start 10 Don't trust everything you read - focus on the number, not the commentary Understand the accounting conventions for the industry Understand the key variables for the industry Pay attention to the direction of numbers, not just the current state

11 What is a Cashflow Statement 11 Free Cashflow = Operating Cashflow Capital Expenditure

12 Lets start with the definitions 12 Cash flow from Operating activities = the cash the company generates or consumes from its core operating activities Cash flow from Investing activities = cash the company generates or uses when it invests Cash flow from Financing activities = cash inflows / outflows resulting from financing activities including obtaining or repaying capital, such as equity or long term debt

13 Cash flow from Operating Activities 13 Cash inflows are from cash sales or collection of trade receivables. While cash outflow results from cash payment for inventory, salaries, taxes and from paying account payables.

14 Working Capital Impact 14 Account Receivable Impact Increases subtract from profit before tax to get to operating cash flow Decreases add to PBT to get operating cash flow Inventory Increases subtract from PBT to get operating cash flow Decreases Add to PBT to get operating cash flow

15 Working Capital Impact 15 Account / Trade Payable Increases add to PBT to get to operating cash flow Decreases subtract from PBT to get operating cash flow

16 Real example lets turn PBT into cash flow 16 Cashflow from Operating Activities Net Profit before tax (PBT) 100,000 Adjustments Add: Depreciation & Amortization 45,000 Less: Interest on long-term investments 20,000 Dividend Income 10,000 Operating Profit before Working Cap 115,000 Changes in working capital - assets Inventories - 3,000 Trade recievables - 4,000 Cash outflow from working capital - assets - 7,000 Changes in working capital - liabilities Trade Payables - 5,000 Cash outflow from working capital - liabilities - 5,000 Total working capital outflow - 12,000 Cashflow from Operations 103,000 Less direct taxes paid 26,000 Net cash from Operating activities 77,000

17 Real example lets turn PBT into cash flow 17 In the prior example since trade receivables are an asset - when you see the negative number, it means that the asset on balance sheet has increased, and therefore there has been a cash outflow. When you see a negative number of a liability, such as trade payables, this means that there has been a cash outflow, and the liability has gotten smaller. The direction on the CFS is determined by its impact on cash

18 Cash flow from Investing Activities 18 A company can use its cash to purchase investments such as debt securities from other companies or government or even shares of other publicly traded companies. This section also records the amount of cash a company has spent on investing into its own business capex.

19 Cash flow from Investing Activities 19 Cashflow from Investing Activities Proceeds from sale of assets 5,000 Sale / Purchase of investments 30,000 Dividend Income 10,000 Total 45,000 Less: Capital Expenditure 55,000 Net cash used in investing activities - 10,000

20 Cash flow from Financing Activities 20 This section tells us the cash inflows / outflows that result from financing activities, including obtaining and repaying capital, such as equity and long-term debt. Cash inflows here include cash receipts from issuing stock or bonds and cash receipts from borrowing. Cash out flows include cash payment to repurchase stock, to pay dividends and to repay bonds and other borrowings.

21 Cash flow from Financing Activities 21 Cashflow from Financing Activities Interest Paid 1,000 Bond repayment 20,000 Dividend Paid 2,000 Net cash used in financing activities - 23,000

22 Putting the pieces together 22 Putting it all together Cashflow from Operating activities 77,000 Cashflow from Investing activities - 10,000 Cashflow from Financing activities - 23,000 Increase / Decrease in cash 44,000

23 What s the take away 23 Income statement doesn t tell the full story about how much cash you are going to generate. Lots of places where money can leak out. As an investor, you want to know how much cash a company is actually collecting from its operations because the cash paid out for dividends, repay loans and for capex must come from cash generated, not from profits! Also, you want to make sure that the bulk of the cash being generated by a business is from operating activities, not financing activities.

24 Questions you need to ask Level What are the major sources and uses of cash in this business? 2. Is operating cash flow positive and sufficient to cover capital expenditure?

25 Questions you need to ask Level What is earnings quality if net income is high, but cash flow is low this indicates low earnings quality. The company might be too aggressive in its earnings accounting, or maybe its selling goods on credit? 2. Can the company raise cash for its business without have to tap capital markets see Amazon or Tesla recently

26 Questions you need to ask Level Where is capex going? Is my money being invested well? How do I know? 2. Are they over paying for M&A? 3. Are they overpaying to buy their own stock? 4. What assets are being sold to raise cash?

27 Conclusion 27 Cash available to you the shareholder is the only thing that matters everything else is make believe

28 Books to Read 28 Financial Statement Analysis Martin Fridson Mary Buffett Warren Buffett and the Interpretation of Financial Statements

29 Next Time 29 We'll build a quick model and discuss assumptions

30 Next Time 30 We'll build a quick model and discuss assumptions

Cash Flow Analysis. 15.511 Corporate Accounting Summer 2004. Professor SP Kothari. Sloan School of Management Massachusetts Institute of Technology

Cash Flow Analysis. 15.511 Corporate Accounting Summer 2004. Professor SP Kothari. Sloan School of Management Massachusetts Institute of Technology Cash Flow Analysis 15.511 Corporate Accounting Summer 2004 Professor SP Kothari Sloan School of Management Massachusetts Institute of Technology June 16, 2004 1 Statement of Cash Flows Reports operating