Motley Fool Hidden Gems Investing - Guide to Financial Statements (2 of 2)

Episode Date: April 9, 2022

Motley Fool Senior Analyst John Rotonti continues his discussion on the most important financial statements, focusing on the cash flow statement and what it reveals to investors. In part two of this two-part series, Rotonti discusses: - How net income becomes free cash flow - The choices companies can make with free cash flow (and why investors should care) - Margins that can indicate the health of public companies Bonus resource! How Net Income Becomes Free Cash Flow: https://www.fool.com/investing/general/2014/09/24/reconciling-net-income-to-free-cash-flow.aspx Stock discussed: CMG Host: John Rotonti Producer: Ricky Mulvey Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it. I'm Siaya and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll.

So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. the intrinsic value of a business is all of the future free cash flows that business will generate from now until eternity discounted back to present value because of the time value free cash flow is what drives business growth free cash flow is what drives intrinsic value growth and therefore free cash flow is what drives compounding which is what we're all looking for in our investments I'm Chris Hill, and that was Motley Fool's Senior Analyst, John Rotonti.

On last Saturday's show, John walked through two of the most important financial statements that public companies release to shareholders, the income statement and the balance sheet. This week, John ties it all together with a discussion on the cash flow statement and the delicious information it tells investors. Remember how I just said net income is the bottom line of the cash flow statement? Well, guess what? Net income, the same exact number that's on that income statement, then becomes the top line of the cash flow statement.

This is critical to understand. This is critical. the bottom line of the income statement net income becomes the top line of the cash flow statement okay now the cash flow statement has three primary sections cash flow generated from operations cash flows from investing and cash flows from financing right now we're going to focus on the cash flows from operations section. It's at the top of the cash flow statement. And what happens in this top section of the cash flow statement, in this cash flow from operations section of the cash flow

statement, is we're going to make several adjustments or what are called reconciliations to get, to convert net income into cash flow from operations. All of these adjustments that we're about to go through line by line, because they're important that you understand them, all of them are either adding or subtracting something from net income. All of them are either adding or subtracting something from net income. That is why net income becomes the top line of the cash flow statement. And all the cash flow from operations section of the cash flow statement is a reconciliation of converting net income into cash flow from operations. So what are these adjustments that we need to make? There are

several. We're going to go through a few of the most common. The first one is you add back depreciation and amortization because these are non-cash charges that show up on the income statement, but they're non-cash. What does that mean? It means they subtracted from net income. They were expenses on the income statement. They decreased net income, but they're non-cash. No cash actually leaves the door. Chipotle doesn't actually pay any cash to anyone. Because it is a non-cash expense, it is added back on the cash flow statement.

this first reconciliation this first adjustment we add back depreciation and amortization because no cash leaves the door the next one we add back stock-based compensation according to accounting rules you add back stock-based compensation because this is paid in shares not cash so no cash leaves the door chipotle doesn't have to pay cash to any employee when it's giving out stock-based comp. Because no cash leaves the door, you add it back on the cash flow statement. Here's another one. You subtract a deferred tax asset. Why? Because a deferred tax asset is a tax the company pays out now, pays out today, but will not owe later down the road.

Since the cash is paid out now, cash leaves the door. So it is subtracted on the cash flow statement. There's also the opposite. You add back deferred tax liability. This is also called deferred tax, deferred income taxes, also called deferred income taxes. You add back deferred tax liabilities. These are taxes the company decides not to pay out today, but will instead pay out at a later date. since no cash is leaving the door today that is added back on the cash flow statement then there's a variety of working capital adjustments you make we subtract an increase in accounts receivable why do you subtract an

increase in account receivable because account receivable remember this is from the balance sheet we went over this account receivable is payment owed to a company that has not yet received in cash since the company has not yet received the cash remember accounts receivables are going up this is an increase in accounts receivable so the amount of cash the company has not yet received is increasing since the company has not received that cash no cash has entered the door today it therefore it is subtracted on the cash flow statement there's the opposite you add back a decrease in accounts receivable this

means the company is receiving cash from customers that purchased on credit it's receiving cash. Cash is entering the door. So you add it back. You subtract an increase in inventory. Why? Because when you buy inventory, you are spending money on that inventory. You are spending cash. Inventory is a use of cash. Cash is leaving the door. So when inventory goes up you subtract that on the cash flow statement you also add back a decrease in inventory if inventories go down that is not a use of cash that is a cash in flow cash is entering the company so you add back a decrease in inventory there are lots of these fools we could you add back an increase in accounts payable this is an important one this is an important one when companies want

want to increase their cash flow, they try to extend the terms that they have until they need to pay their vendors. Accounts payable, remember, is money the company owes to its vendors but is not yet paid yet. An increase in accounts payable means the company owes its suppliers even more, but no cash has left the door. If accounts payable increases, the company is taking longer to pay its suppliers. No cash is leaving the business. So you add that back on the cash flow statement. But what happens if accounts payables decrease? If accounts payables decrease, this means cash is leaving the business because the company, Chipotle, is paying off what it owes. So you subtract a decrease in accounts payables. The last one I'll go through is you add

back deferred revenue. Deferred revenue is cash collected up front for a product or service that has not yet been delivered to the customer, like a yearly newspaper subscription, for example. Because the company collects the cash today, that is a cash inflow, so it is added back on the cash flow statement. Okay. Once you do all those pluses and minuses, fools, you get a very important number called cash flow from operations. So we have just converted net income into cash flow from operations. The very next line down on the cash flow statement is capital expenditures, also called property, plant, and equipment. How much money the company is investing in any given year in its property, plant, and equipment.

The common, the most common definition of free cash flow, the most common formula used, whether by Wall Street analysts or by companies themselves when they're telling you, we generated X amount of free cash flow, 95, maybe 98% of companies, 98% of public companies that say they generated X amount of free cash flow. They are using this formula I am giving you now. Cash flow from operations, which comes right off the cash flow statement, minus capital expenditures,

which comes right off the cash flow statement. They are right next to each other for that very reason, fools. Cash flow from operations, the very next line down on the cash flow statement is capital expenditures. You take cash flow from operations. You subtract that very next line down, capital expenditures, and you get free cash flow.

That is the most common definition of free cash flow. If you want to get a little more robust, okay, if you have an acquisitive company, Chipotle is not acquisitive. Chipotle doesn't make acquisitions, okay? Let's say it did. Let's say it made acquisitions every single year. In that case, you would have to consider the amount it spends on acquisitions as a capital expenditure. Because it's spending that money on acquisitions year in and year out, those

acquisitions have become part of its growth strategy, of its investment strategy. So if you want to get more robust, more thorough in your definition of free cash flow, you would take cash flow from operations, you would subtract capital expenditures, and then you would subtract cash spent on acquisitions. Fools, once again, these three line items come directly off of the cash flow statement. You go to a company's cash flow statement, you will see a line item called cash flow from operations. You go to a company's cash flow statement, you will see a line item called capital expenditures. You go to a company's cash flow statement, you will see a line item called cash acquisitions. Okay, so now we have this really robust definition of free

cash flow now, or this more robust definition of free cash flow. Cash flow from operations minus capital expenditures minus acquisitions, and you get free cash flow. Free cash flow with the all-important number that is what we are ultimately after as investors why because the intrinsic value of a business the fundamental value of a business is the present value of its future free cash flow said another way the intrinsic value of a business is all of the future free cash flows that business will generate from now until eternity discounted back to present value because of the time value of money free cash flow is what drives

business growth free cash flow is what drives intrinsic value growth and therefore free cash flow is what drives compounding which is what we're all looking for in our investments. Okay. The definition of free cash flow is the amount of money left over, the amount of excess cash left over, excess, unencumbered. That's why it's free. It's unencumbered. The amount of excess unencumbered cash flow left over after a company has invested to both maintain its assets. Remember, back to the balance sheet now. To both maintain its assets and to grow its assets. A company has to both spend, let's say it has a factory. That's an asset. Well, that factory is going to rust and that factory is

going to break down. So it's going to have to maintain that factory. That's maintenance capital expenditures that company is also going to have to build new factories if it wants to grow that's growth capital expenditures and then if the company is growing through acquisitions that's another form of growth investment or growth capital expenditures the acquisitions so free cash flow is the amount of excess unencumbered cash flow left over after a business has invested to maintain and grow its assets. This is also the amount of cash flow that is available to the enterprise,

which means it's the amount of cash flow available to both debt and equity holders. We have just calculated the all-important number of free cash flow. And we have just said free cash flow is the amount of unencumbered excess cash flow that is available to debt and equity holders. There are only, I think, four things.

I'll tell you for sure after I say them out of my head. But there are only, yes, there are only four things a company can do with its free cash flow. That's it. That's it. The most creative person in the world could not come up with another use of free cash flow. some people say, well, you can use your free cash flow to invest in research and development.

Incorrect. Incorrect. You have already invested in research and development through the income statement to get net income. And then remember, net income, the bottom line of the income statement, net income, became the top line of the cash flow statement. And then we made all of these adjustments to net income to get cash flow from operations. So research and development has already been accounted for. Remember the definition of free cash flow. So when you hear other people tell you that you can invest in all this growth stuff

with free cash flow, you'll know that they're incorrect. The definition of free cash flow is the amount of excess cash flow left over after the company has invested in growth. Okay? So after the company has invested in R&D, after the company has invested in capital expenditures,

after the company has invested in acquisitions. All of those growth investments have already been made. This is the excess free cash flow. The only four things a company can do with their free cash flow is pay a dividend. That's number one. And guess what, fools? That is a line item on the cash flow statement.

That's why the cash flow statement is so beautiful. That's why the cash flow statement gives you so much beautiful delicious information all of these are line items it tells you exactly how the company is generating its cash flow that's cash flow from operations how the company is investing that's the capital expenditures and the cash acquisitions these are line items all of these are line items boom you pull them right off the cash flow statement one after the other and then it tells you what the company is doing with its free cash flow. The first line

item you can pull right off the cash flow statement is dividends. That's the first thing a company can do with its free cash flow. Pay a dividend to its shareholders. So that's a way to return cash to shareholders that comes out of free cash flow. The second thing a company can do with its free cash flow repurchase stock or buy back stock that is also a line item right on the cash flow statement okay the the third thing a company can do with its free cash flow is repay debt, which is a line item on the cash flow statement. By the way, that's also a way to return cash to shareholders because remember from our income statement

analysis we went through earlier, debt holders have primary claim on a company's cash flows. Well, if you pay down all the debt, there's no debt holders left to have a primary claim. So, whether you're paying a dividend, whether you're buying back stock, as long as you're buying it back at attractive prices, or whether you're repaying debt, you're returning capital to shareholders with that free cash flow. Those are the three things you can do with free cash flow, or three of the things. We're going to get to another one. Pay a dividend, number one.

Buy back stock, number two. Pay down debt, number three. if you are not subtracting acquisitions from your definition of free cash flow then acquisitions would be a fourth thing a company could do with its free cash flow but we subtracted acquisitions so we're not going to include it but that would be a fourth thing and then the fifth thing and the final thing is let it build up on the balance sheet that's the fifth and final thing a company can do with the free cash flow let it build up on the balance sheet and when you have companies that generate all of this excess unencumbered free cash flow, like Apple, like Alphabet,

you get these massive, massive cash balances on the balance sheet. I'm almost done, fools. We went through the three statements now. We went through the balance sheet. We went through the income statement. We went through the cash flow statement. The last thing I want to do is talk about really quickly some of the connections between these statements. For example, net income, the bottom line of the income statement. I already

talked about how it connects to the cash flow statement, because the bottom line of the income statement becomes the top line of the cash flow statement. Net income becomes the top line of the cash flow statement. With net income, according to accounting principles, a company can either pay a dividend or retain all of that net income to invest in future growth. Whatever the company does not pay out as a dividend shows up on the balance sheet as retained earnings. So there's how, that's one way how net income connects to the balance sheet. So now we have connected net income to both the cash flow statement and the balance sheet. Most companies that pay a dividend don't pay out 100% of their net income as a dividend. They'll pay

something like 30 or 40 or 50 percent of their net income as a dividend and then they will retain the rest remember that shows up as retained earnings on the balance sheet retained earnings on the balance sheet increases shareholders equity what do we say shareholders equity was book value so when net income grows if you retain your earnings your shareholders equity or your book value grows. We already said how the cash generated on the cash flow statement relates to the balance sheet because if you generate all this excess cash and you don't pay it all out as a dividend, you don't use it to buy back us, you don't use all of it to buy back stock, and you don't have

any debt to pay down, then it just builds up as cash on the balance sheet. So that's how the cash flow statement relates to the balance sheet. You can also create various formulas and ratios by mixing and matching these three financial statements. For example, net income off of the income statement divided by shareholders' equity off of the balance sheet equals return on equity, a measure of profitability and efficiency. Here's another one. Net income off of the income statement divided by total assets off of the balance sheet equals return on assets. Another measure of profitability and efficiency. Last thing, margins. I told you how to calculate gross margins. Back to the income statement here, fools. That gross margins was

gross profit divided by sales. I also told you anytime you want to calculate a margin, you just divide the absolute dollar amount by sales. But let's go through them really quickly. So gross profit margin we know? Gross profit dollars divided by sales. What about EBIT margin? That would just be EBIT dollars divided by sales. What about net income margin? That would just be net income dollars divided by sales. Well you can also, fools, calculate a free cash flow margin. That would just be the free cash flow that we calculated from the cash flow statement divided by sales, which is on the income statement. All of these three primary financial statements connect to each

other. They all drive each other. That's the beauty of accounting, which is the language of business and investing. And this, my friends, was Motley Fool Financial Statement Analysis 101. I am John Rotonti. Thank you so much for tuning in. Fool on. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening, we'll see you tomorrow.