Understanding the cash flow statement
Once you have calculated EBITDA, the cash flow statement is where you make adjustments for items that don’t appear in the Profit and Loss Statement, but that consume or release cash.
These are typically: Interest paid, Tax paid, Changes in Working Capital, Capital Expenditure, Loan repayments and Dividends.
So if you have successfully calculated EBITDA, the first thing to do is to deduct interest and tax.
There are three parts to working capital: trade debtors (how much the company is owed – which will hopefully turn into cash), trade creditors (how much the company owes to others - which is just like short term debt) and stock (which is also a bit like cash in terms of its value to the business).
These figures are all in the accounting notes and need to be treated individually.
Changing levels of working capital can really threaten (or improve) the health of a business. It's perfectly possible that a profitable business can be consuming cash if the trade debtor figure is increasing (sometimes known as “Growing Broke”), and equally possible for a loss making business to be generating cash by shrinking inventories, chasing trade debtors and not paying its bills punctually.
Once the net effect of working capital is dealt with, the next thing to do is to try to isolate the value of the Capital Expenditure (which is the amount of cash spent purchasing fixed assets for the business). This is the real world equivalent of depreciation that we mentioned above. You’ll find this noted as an “Addition” in the Tangible Fixed Asset section of the notes.
If this figure is significantly different to depreciation, then it merits further investigation to ascertain what the real level of average fixed asset spend is likely to be.
The next item to take account of is any increase or decrease in bank debt. Equally, if there have been any dividends drawn, you need to capture these too.
And now the moment of truth.
If you add up your EBITDA, interest costs, tax costs, change in working capital, CapEx, loan repayments and dividends, with any luck you will see that this matches exactly the difference in cash from one year to the next.
Having done all this, you will have effectively:
2. figured out how cash is being generated by the business, and whether or not this is due to normal trading activity or whether this is as a result of aggressive working capital management
3. have a good sense of whether depreciation matches CapEx and whether this is likely to mean the company is under or over investing (or indeed, whether the depreciation figure includes a load of nonsense that doesn't matter to the everyday operations of the business).