Cash Flow from Financing Activities
A crucial section of the cash flow statement
The cash flow statement is one of the three main statements that comprise a company's (the other two and the statement of profit or loss). It gives us an idea about the company's actual cash position rather than simply presenting on-paper profits .
Knowing the amount of cash a company generates and possesses and the activities it generates it from can be extremely useful in most cases.
This article will cover cash flow from financing activities, one of the three activities from which a company generates cash flows (the other two being operating and investing activities) present in a firm's.
What is it?
Cash from financing activities represents the source or way a company raises capital and covers the return of the capital raised to the investors. In simple words, it monitors the net change in cash related to capital raising and related activities.
Examples of financing-related activities are - borrowing or repayment of the debt, issuing additional stock orof existing stock, and paying dividends to investors.
Cash flow from financing activities is considered one of the most important sections of the statement of cash flows. This is especially true for large companies as this section can represent transactions that lead to sizable inflows/outflows of cash.
These can often lead to the nullification of cash generated/used in the company's core operations. However, there are certain exceptions in the format of the statement of cash flows,
For instance, small businesses which do not usedividends to their shareholders do not include cash flow from financing in the cash flow statement.
Investors used to look at the income statement and balance sheet for hints about the company's financial status. However, over time, investors have begun to independently examine each of these statements, with more importance on the cash flow figures.
This increase in the importance of cash flows is primarily due to the increasing use of the( ) to evaluate companies and assets.
Understanding the cash flow allows one to understand the business better and make informed investment decisions. In simple terms, cash flow statements tell us how efficient a company is in converting its profits into real cash.
However, certain industries/companies are not cash-rich; hence, looking at their cash flow statements for investment decisions will not be appropriate. We will cover such companies later in this article.
How is it Different from Other Types of Cash Flows?
There are typically three types of cash flows presented in a cash flow statement:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
Having talked about the financing activities, let us see how it differs from the other two.
Cash flow from operating activities is often presented first in a company's cash flow statement. It tracks the change in cash related to the daily operations of a business such as - manufacturing, selling a good or service, etc., therefore focusing only on the core activities.
On the other hand, cash flow from investing activities presents the cash generated or used in investment-related activities of a business. These activities include purchasing or selling fixed assets (also known as), acquiring or selling other businesses, and buying or selling marketable securities.
The differences between them can be summarized as follows:
- Cash Flow from Operating Activities - A company's operating activities may have several components and may differ depending on the type of company.
These may include the production, sales, delivery of the product/service, payment collection, buying raw materials,, etc.
- Cash Flow from Investing Activities - Investing activities of an organization can usually be categorized into the purchase or sale of fixed/long-term assets (such as land, building, plant, machinery, etc). These also include transactions related to mergers and acquisitions.
- Cash Flow from Financing Activities - This is the section we will focus on in this article. These activities, as discussed above, usually include transactions such as issuance or buyback of stocks, payment of cash dividends, borrowing or repayment of borrowings, etc.
Therefore, just by glancing at the components of each type of cash flow, one can spot the differences between them. Let us now shift our focus to the calculation of these cash flows.
Knowing what comprises financing activities is the first step to calculating cash flow from financing activities. A generally followed rule of thumb is that all changes in the long-termsection of the balance sheet are due to financing activities.
For example, repayment or issue of long-term bonds, buyback of shares, and payment of dividends () are some examples of financing activities.
Exceptions to this rule exist, and it is advisable to exercise proper judgment while classifying cash flows. For example, the deferred tax might be a long-term, but taxes, in general, are accounted for under operating activities as they are considered crucial to a company's operations.
The formula to calculate it is given below:
Components of Cash flow from Financing Activities (CFF)
CFF has various line items presented under it; to comprehensively understand the entire concept, we will have to study each line item.
- Issuance of stock - Whenever a company issues additional stock/shares of its businesses, it receives cash from the investors.
Additional stock can be issued for various reasons such as - expansion of business, repayment of the debt, etc. This issuance of stock is categorized as a positive change in the financing cash position of the company.
- Buyback/Repurchase of shares - Sometimes, a company uses its cash to repurchase the company's shares from the open market.
This is usually done to reduce the equityarising from ESOPs, signal the company's confidence in its business, or reap tax benefits. The most common reason for a stock buyback is because the company believes that its stock is undervalued.
This is considered an outflow of cash and is therefore subtracted.
- Dividends - Companies often pay cash dividends to their shareholders using surplus cash present in the company.
This gives investors an incentive to hold the company's shares apart from capital appreciation. However, since this requires cash from the company's end, it is considered an outflow of cash.
- Borrowings - Companies use debt/borrowings to finance a range of activities and capital expenditures (purchase of fixed assets), to name a few. As borrowings lead to an inflow of cash, this is added to cash from financing activities.
- Repayment of borrowings - When companies possess surplus cash or have a healthy cash flow, they usually repay borrowings when the purpose of borrowing is fulfilled. Repayment of debt involves paying the debtor cash and is therefore considered an outflow from financing activities.
The following is an example from Alphabet's 2021 annual report. The highlighted region is where you would find the cash flow from financing activities.
Alphabet's cash flow statement clearly shows a net outflow of cash due to the company's financing activities. The primary reason is that it spent a lot of cash on repurchasing its shares and repaying debt, which was not fully offset by the cash inflow from borrowings.
However, these figures in isolation mean nothing; it is crucial for investors to first look at the trend of cash flows by comparing it with cash flow statements of previous years.
Second, one has to analyze the transactions which lead to these cash flows, as they provide us with a better understanding of the underlying operations.
Let us take another example from a company that belongs to a completely different industry.
Amazon's cash flow from financing activities looks significantly different than that of Alphabet. Here are some observations from its 10-K:
- raising money by taking on short-term debt in the recent past. This has resulted in an inflow of cash into the company.
- Interestingly, it has also paid the majority of its short-term borrowings, which is a healthy sign. However, this has led to an outflow of cash from financing activities.
- It has spent a lot of cash on repaying the principal amount of financial leases. This is a type of lease where a financial institution has legal control over a specific asset while the lessee company enjoys operating control of the asset.
- It has turned net positive in cash from financing activities in FY-21, unlike the last financial year where there was a net outflow.
While these two companies belong to two entirely different industries, the calculation and categorization of these cash flows remain the same. However, it must be noted that the cash flows must be interpreted differently for companies that operate in various industries.
The net change in cash flow from financing activities of a company may either be positive or negative depending on various factors. However, one must look beyond whether the number is positive or negative, as various factors might lead to the final cash flow. Let us understand this in detail.
A company that frequently raises capital through debt or equity might show a positive cash flow from financing. However, this might signal the fact that the earnings of the company are not enough to support its operations or other plans.
Also, there might be a case where financial institutions (debtors) raise interest rates resulting in higher debt servicing charges for the company, which might not be adequately reflected in the financing activities section of the cash flow statement.
Another red flag would be if the company continuously repurchases shares or pays dividends to its shareholders even though it is not generating enough profit. Companies make these attempts to keep their stock price intact.
Therefore, any notable change in the cash flow from financing should be probed by investors. Also, it is essential to check the other sections of the cash flow statement, such as cash flow from operating and investing activities, as these also depict a company's financial health.
Another important factor when analyzing cash flows from financing is the frequency of cash inflow across multiple timeframes.
This is to understand if a company has been issuing additional stocks or borrowing from debtors very frequently, which will result in a high inflow of cash. However, this is a major red flag as this implies that the firm cannot generate sufficient earnings to finance its core operations.
Therefore, investors must study the reasons behind unusual inflows or outflows of cash from financing activities.
- A cash flow statement contains three types of cash flows: cash flow from operating operations, cash flow from investment activities, and cash flow from financing activities.
- Cash from financing activities explains how a firm raises money and covers the return of the cash raised to investors. In layman's terms, it tracks the net change in cash due to capital raising and related operations.
- The formula for cash flow from financing activities includes adding all items contributing to an inflow of cash, such as issuing stock, borrowing, and subtracting all items that lead to a cash outflow, such as repaying debt or paying cash dividends.
- It is critical for investors to carefully analyze transactions leading to change in net cash flow from financing rather than simply looking at whether the value is positive or negative.