The Cash Flow Waterfall
Just by reading the cash flow statement from two different directions, we are able to identify different insights (such as structural mismatch), and by being specific, we could also quantify the size of mismatch.
We can think of the cash flow statement as a waterfall, where the water represents cash. The water source at the top of this waterfall, is cash generated from sales. As we go each line item, some water will flow out from the waterfall (i.e. cash outflow), or being added to the waterfall (i.e. cash inflow).
The purpose is to identify:
- At which point did the water dry up? (When does company start having cash deficit?)
- What keeps the water flowing? (What kind of financing has the company raised?)
- How are the pipes being built? (Which line item is being financed?)
This analogy helps us to be crystal clear on the cash movement and in turn, identifying potential issues and areas of leakages.
Fact-based vs Faith-based
In a lending business, it is dangerous to lend based on faith, such as ‘Maintaining relationship’ or ‘Believing in customers’. These notions create emotional bias, which will in turn shroud our mind and analysis. Instead, we should always be fact-based in our thinking, in order to remain objective and rational.
So, to fully assess a company’s health, it is crucial to have a thorough view on its cash flow movements, paying attention to potential areas of leakages, or diversion. Remember, the number 1 rule is: Cash flow comes first!