TDR University – Real-World Finance Lesson – Cash Flow

The TDR Three Key Takeaways:

  1. Examine All Financial Statements: It’s essential to analyze not just the income statement but also the cash flow statement and balance sheet for a full financial assessment of a company.
  2. Skepticism Towards Pitch Decks: Investment pitch decks may not always present a realistic picture and should be cross-checked against actual financial statements for accuracy.
  3. Cash Flow is Key: A positive income statement can be misleading if the cash flow is negative. Always check the cash flow statement to assess a company’s real financial health.

Today, I want to share a practical example that underscores the importance of not just focusing on income statements. Often, earnings releases of companies predominantly highlight their income statements, emphasizing aspects such as revenue growth, same-store sales, and earnings. However, these are merely outcomes from one of the three principal financial statements. Why is it crucial to examine the remaining statements? Additionally, I’ll discuss why it’s advisable to skip the company’s investment pitch deck.

Recently, I analyzed a Cannabis company, starting with the management representations in the company’s investment pitch deck. This approach is beneficial for two reasons: it provides insight into management’s perspective, and it allows for comparison of the deck’s claims against the actual financial statements. In this case, the deck boasted about revenue growth and future sales opportunities. However, it also included irrelevant details, such as differing preferences for cannabis between men and women. While the imagery was appealing, the information was as irrelevant to an investor as what I had for lunch yesterday. I’ve observed in my career that a focus on flashy, irrelevant content often correlates with inconsistencies in financial statements.

Moving on to the financial statements, the company had a robust income statement, showing modest growth and improvements in profit margins and operating profit. To put it simply, this is akin to an individual’s pay stub improving each year.

However, the narrative changed upon examining the cash flow statement. Here, I found a dangerous inconsistency: the company’s cash flow was negative and not improving, despite the income statement indicating positive growth. This is analogous to having an impressive pay stub, but not receiving actual payment. In finance, such discrepancies often arise from issues in accounts receivable, payables, and inventory buildup. In this case, the company’s actual cash did not align with the income statement or the rosy picture painted in the investment pitch deck.

Finally, examining the company’s balance sheet – its net worth – revealed a dire situation. The lack of cash flow posed a bankruptcy risk, and the company needed to raise capital, which could dilute existing investors’ shares.

In summary, this real-world example highlights key lessons in financial analysis:

This real-world example highlights three key lessons in financial analysis. 

  1. First, while income statements provide valuable insights, they only tell part of a company’s financial story. The cash flow statement is crucial in understanding the actual liquidity and operational efficiency of a business. 
  2. Second, overreliance on flashy investment pitch decks can be misleading; they often mask underlying financial issues. 
  3. Third, a comprehensive analysis that includes income statements, cash flow statements, and balance sheets is essential for a holistic understanding of a company’s financial health and future prospects. These tools collectively offer a more accurate and rounded picture, crucial for making informed investment decisions.

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