Understanding a company’s financial health is a vital part of credit risk management. While analysis of the income statement and balance sheet can provide valuable information, the insight into the movement of money in and out of a business that a cash flow statement provides is second to none. By scrutinizing a company’s inflows and outflows, you can foresee financial stability, identify potential weaknesses, and ultimately mitigate risks, leading to a more informed credit decision. The cash flow statement cuts through the noise and reveals a company’s cash reality. Cash flow impacts all levels of business operations and decision-making, including expansion, hiring, and capital investments. It also directly affects a business’s ability to pay employees, suppliers, and creditors. Without sufficient operating cash flow, even a profitable company can default.

A cash flow statement covers three primary areas from which cash flows in and out of the business: operating activities, investment activities, and financing activities.

Cash Flow from Operating Activities (CFO): This is arguably the most crucial section for credit risk analysis. It reflects the cash generated and used by a company’s core business operations.

• What to look for: A consistently positive and growing CFO indicates a healthy, self-sustaining business. Negative CFO, especially over multiple periods, is a red flag that suggests a company isn’t generating enough cash from its primary activities to cover its expenses and may indicate operational inefficiencies. Look for trends in inventory and accounts receivable – large increases in receivables or inventory without corresponding sales can impact cash flow. When customers delay payments, your cash flow can suffer. Excess inventory can tie up cash.

Cash Flow from Investing Activities (CFI): This section reports the cash inflows and outflows resulting from the investment activities. These activities primarily involve the acquisition and disposal of long-term assets such as property, plant, equipment, and investments in marketable securities.

• What to look for: Significant cash outflows for capital expenditures can be positive if they are for growth initiatives that are expected to generate future returns. However, excessive capital spending without a clear strategy, or a sudden halt in investment, could be a warning sign. Proceeds from the sale of assets might be a one-time boost, but relying on them to fund operations is unsustainable.

Cash Flow from Financing Activities (CFF): This section encompasses borrowing and equity issuance.

• What to look for: Large inflows from new debt issuance might be necessary for growth. For high-growth companies, or those in capital-intensive industries, debt can be a vital way to fund significant expansion, R&D, or large-scale acquisitions that will generate future revenue and profits. However, if a company constantly issues new debt to cover operating shortfalls, it’s a warning sign, potentially masking deeper financial problems. Conversely, consistent repayment of debt signals financial strength, demonstrating a company’s ability to generate sufficient cash to meet its obligations. Similarly, share repurchases or dividend payments indicate a company returning cash to shareholders, which can be a sign of strength if operating cash flow is healthy, but a concern if it drains essential liquidity. Excessive payouts when cash flow is tight can lead to a liquidity crunch.

Poor cash flow management can be the downfall of any business. In an uncertain economic landscape, even strong companies can face cash flow challenges. While profitability is important, cash flow is king for business survival and growth. As a credit professional, this is why it is crucial to analyze your customer’s cash flows to help mitigate risk.