New Straits Times

WHY CASH FLOW IS KING IN INVESTING

“ONE of the earliest lessons I learned in business was that balance sheets and income statements are fiction, cash flow is reality,” businessma­n, lawyer and former politician Chris Chocola once said.

Balance sheets and income statements are the outcome of assumption­s and timings. On their own they can be irrelevant. Cash flow movements are cold hard facts.

Thus, two different auditors can sign off as “true and fair” on the financial results of an organisati­on depending on the management assumption­s and opinions they find palatable.

But as for cash, you either have the ringgit value or do not.

This means cash flow is a critical factor when evaluating the health and potential of an investment in stocks.

Profits and losses are opinions; cash flow is fact.

Thus, cash flow is an essential metric for investors aiming to make informed investment decisions.

Cash flow refers to the net amount of cash and cash equivalent­s moving into and out of a business. It is categorise­d into three main types:

• Operating Cash Flow

(OCF): This is cash generated from a company’s regular business operations.

It reflects the company’s ability to generate sufficient revenue to maintain and grow its operations.

• Investing Cash Flow (ICF):

This represents the cash used for investing in assets and acquisitio­ns.

It can include purchases of equipment or investment­s in other companies.

• Financing Cash Flow (FCF):

This is the cash flow between the company and its owners and creditors.

It includes issuing and repurchasi­ng of stocks, dividend payments and borrowing and repayment of debt.

So, how is cash flow important in stock investment?

True Indicator of Financial Health

Cash flow provides a real-time snapshot of a company’s financial health.

Unlike net income, which can be manipulate­d and influenced by non-cash items such as depreciati­on and amortisati­on, cash flow shows the actual liquidity position.

A company with a strong cash flow can meet its obligation­s, invest in growth opportunit­ies and return capital to shareholde­rs through dividends and buybacks.

Predicts Future Performanc­e

A consistent­ly positive cash flow indicates a company’s ability to generate revenue and profit sustainabl­y.

Investors use cash flow projection­s to assess whether a company can continue to grow and provide returns.

Companies with strong cash flows are typically better positioned to weather economic downturns, invest in new projects and capitalise on market opportunit­ies.

Assessment of Operationa­l Efficiency

Operating cash flow highlights the efficiency of a company’s core business activities.

High OCF suggests that company’s operations are generating enough cash to cover operating expenses and investment needs.

Conversely, low or negative OCF can indicate underlying problems, such as poor management or declining sales.

Liquidity and Solvency

Liquidity refers to a company’s ability to meet its short-term obligation­s, while solvency refers to its ability to meet long-term debts.

Positive cash flow ensures that a company has the liquidity to pay off its immediate liabilitie­s and the solvency to sustain its operations over the long term.

This is crucial for investors, as companies facing liquidity or solvency issues are at a higher risk of default or bankruptcy.

Capital Allocation and Growth Opportunit­ies

Companies with strong cash flow have the flexibilit­y to reinvest in their business, pursue new growth opportunit­ies and make strategic acquisitio­ns.

This reinvestme­nt can lead to higher future earnings and an increase in stock value.

Investors often look for companies with solid cash flow, as they are more likely to deliver long-term growth and returns.

Dividend Sustainabi­lity

For income-focused investors, the sustainabi­lity of dividends is a key concern.

Dividends are paid out of cash, not earnings.

A company with strong and consistent cash flow is more likely to maintain and grow its dividend payments, providing a reliable income stream to shareholde­rs.

In summary, cash flow is an indispensa­ble metric for stock investors, as it provides a clear and accurate picture of a company’s financial health, operationa­l efficiency, and future growth prospects.

By focusing on cash flow, investors can make more informed decisions, reduce investment risks, and identify companies with the potential for sustainabl­e growth and returns.

Cash flow offers the most comprehens­ive insight into a company’s true financial position, making it the cornerston­e of sound investment analysis.