How Investors Use Cash Flow From Financing Activities Helps Investors

Summary:

In a company's cash flow statement, cash flow from financing activities is the section that is crucial for evaluating the organisation's financial performance and health. Investors, both old and new, use this information to make informed decisions. This blog explains how investors go about it.  

Introduction to cash flow from financing activities 

In a company's cash flow statement, cash flow from financing activities is the section that is crucial for evaluating the organisation's financial performance and health. Its focus is mainly with regard to the flow of cash for the company from capital structure and financing activities. These are indicative of how a firm repays and raises capital to finance its growth and operations. 

For a typical firm, cash flow from financing activities usually entails the following:

• Issuing and repurchasing of stocks: The cash generated from the issuing of new shares and the cash paid to repurchase the existing shares of stock.
• Issuing and repayment of debt: The cash received from borrowing money, such as the issuing of bonds and/or taking loans and the money paid to repay debt, such as repayment of loans and maturing of bonds.
• Dividend payments: This includes the cash that is paid as dividends to shareholders.
• Interest payment: This includes the cash that is paid as interest on debt.
• Other types of financing activities: This generally includes other types of cash flows that pertain to financing activities which don't fall into the categories stated above.

Formula and calculation: 

The following is the formula used to calculate cash flow from financing activities:

Net change in equity + net change in debt = cash flow from financing activities

This formula contains the following aspects:

• Net change in debt: This is a calculation of the difference between the money received from issuing debt or from borrowing and money paid to retire or repay debt. This includes alterations in short-term and long-term debt.
• Net change in equity: This is a calculation of the difference between the money received by issuing new shares of stock and the money paid to buy back or repurchase shares of stock and any cash that is paid to shareholders as dividends.

The value that is arrived at is either negative or positive. It depends on whether the organisation is raising more money through its financing activities (positive) or utilising cash to clear its debts, repurchase shares, or to pay shareholders’ dividends (negative). 

It is imperative to keep in mind that cash flow from financing activities is a part of the firm's cash flow statement. It is calculated and derived from the organisation's financial statements, which include the income statement and the balance sheet.

Example:

The following example will make it simpler to understand cash flow from financing activities by using hypothetical data for a company's financials:

Let us assume company ABC had the following activities: 

• Issuing of new bonds: INR 50 lakh
• Repaid long-term loans: INR 20 lakh
• Buying of its own shares: INR 10 lakh
• Payment of dividend to shareholders: INR 5 lakh 

Therefore:

• Net change in debt = INR 50 lakh - INR20 lakh = INR 30 lakh 
• Net change in equity = INR 10 lakh - INR 5 lakh = INR 5 lakh 

From this, we can calculate cash flow from financing activities, which is net change in debt + net change in equity: INR 30 lakh + INR 5 lakh (positive). Therefore, we can say that company ABC had a cash flow from financing activities that was positive, indicating that it is effective with regard to financing activities to aid its growth and operations.

Benefits of understanding using cash flow from financing activities:

By using this crucial financial metric, investors are able to better understand companies for the following reasons:

• Assessing capital structure: This helps to understand how a company is handling its capital structure. They can get a clearer picture of whether a company is depending on equity or debt to finance its expansion and operations. A company that has a lot of debt may be susceptible to financial distress.
• Evaluating payment of dividends: For investors keen on generating income, this metric is effective for indicating whether the company will be paying out dividends. 
• Scrutinising share buybacks: This metric reveals if the organisation is buying back its own shares, which means the management perceives the stock to be undervalued.
• Monitoring debt levels: Investors who are cautious can use the cash flow statement to monitor changes in both the short and long term. A swift spike in debt without a corresponding cash flow increase could make investors wary.

Summing up

Cash flow from financing activities is used by investors to make strategic decisions regarding whether they should buy, sell or continue to hold shares of a company. However, most investors use this information in conjunction with other important financial metrics to have a comprehensive understanding of the financial health of a company. With the details listed in this blog, understanding and calculating cash flow from financing activities should be much easier.