“Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.” ~ Peter Drucker

In our roles as both head of finances at Fortune 500 companies and as co-founders of AcceleratingCFO, Scott and I have spent a lot of time analyzing the financial statements of companies to identify performance indicators and whether a company is a success as defined by those measures.There are a wide range of statistics used to measure financial strength, liquidity, ability to pay back debt, and return on investments. But if there is one financial statement that can tell you the most about a company’s financial performance without paying accounting “games”, it is the cash flow statement.

As Mr. Drucker’s quote illustrates above, the primary indicator of success is cash flow. And the cash flow statement can best reveal a company’s true financial performance. Whether you are seeking to purchase a company or are trying to figure out your personal portfolio of investments, here are some things to look for when you are examining the cash flow statement:

- - Irrespective of whether the cash flow statement uses the direct or indirect method (sorry – accounting technical terms!), a company needs to disclose details on its cash flow from operating activities (CFFO). One quick metric to look at is the net income to CFFO comparison — if the net income is significantly higher than CFFO, it could be a sign that the company is using one-time items to boost its bottom line. Some sources of one-time items include gain on sale of assets, forgiveness from PPP borrowings, and/or deferred tax liabilities. These types of items, if included in a company’s CFFO, indicate that the earnings are inflated by non-recurring, unsustainable items.
  - Investors and owners typically view rising earnings year-over-year as a good sign. However, if you see accounts receivable increasing at a rate greater than the increase in net income, it is an indication that cash collections are not strong and might indicate the need to write off uncollectible accounts. The cash flow statement will show you (a) how much accounts receivable has increased over the past two years; and (b) will also disclose what bad debt expense was recorded over the periods presented, which is a non-cash way to remove customer balances that will not be collected.
  - One section of the cash flow statement shows the changes in investing activities of a company. This is where a company discloses how much money has been spent on fixed assets and other long-term assets during the year. If a company is thinking long-term, you should see investments that will typically be in the range of 10% to 30% of the total long-term asset class. If you see a company that is spending less than this range, or you find depreciation expense is greater than the amount invested, then this is an indication that the company is sacrificing long-term investments to fund short-term needs.
  - One way that a company can fortify its cash balances is by issuing debt or equity securities. The cash flow statement provides a way for a potential investor to see if a company is borrowing funds for today and then figuring out if it has the funds to pay for it in the future. The financing section of the cash flow statement can clearly show if a company is using debt to raise cash and if the company is hiding deficiencies in its operating cash flow.

The cash flow statement can reveal even more about a company’s financial position, especially when compared to the income statement or balance sheet, but I think you get the point. When evaluating a company and how it is performing, you need to consider all sorts of data points, ratios, and financial figures. There is one place, however, where a company has to “open its kimono” financially and reveal all of its sources and uses of funds. The cash flow statement acts like a confessional in that it clearly spells out how cash is being utilized by management in a clear, organized manner and helps to demonstrate the short-term and long-term prospects of the company.

Takeaway: If you need assistance in evaluating a potential acquisition’s financial statements, or if you are putting your company up for sale and want to see where your potential blind spots are, contact Brian or Scott at info@acceleratingcfo.com.

Brian Califano