Table of Contents
- Cash flow statement in brief
- Components of cash flow from investing activities
- Why is investment activity important
What’s it: Cash flow from investing activities is the money in and out associated with the company’s long-term investment. It is one of three parts of the cash flow statement. Others are cash flows from operating activities and cash flows from financing activities.
Long-term investment activities include purchasing and selling fixed assets such as property, factories, and equipment. The purchase of equity securities or debt securities of another company is also included in the investment activity category, but with several conditions. Besides the cash flow statement, you can also find these accounts in current assets on the balance sheet.
Broadly speaking, investing activities are concerned with growing the business and bringing profits to the company in the long run.
Purchasing activity contributes to an increase in the size of the business and the production capacity. For example, if it adds a new machine, the company can produce more output. Likewise, when acquiring another company (share purchase), its operations’ scale also increases. Both fall into the investment activity category.
As the company’s operations scale increases, we expect the company to generate higher revenues in the future. Companies can also be more efficient by increasing the economies of scale of their operations. Therefore, many parties, especially stock investors, view negative cash flow from investing activities as a good signal for future growth.
Cash flow statement in brief
In the financial statements, the company divides the cash flow statement into three subsections. Apart from cash flows from investing activities, the other two are operating activities and financing activities.
Operating activities are about how the company makes money from day-to-day operations. It is the core business of the company. This section presents a large number of accounts in the income statement and working capital (current assets minus current liabilities).
Investing activity is all about growing business and making more money in the future. Investments can be through the purchase of machinery or the acquisition of another company. Both usually involve external funding.
Financing activities are related to transactions between companies and suppliers of capital. Examples of transactions are stock issuance, bond issuance, and dividend payment. This section tells you how the company finances its long-term investment.
Components of cash flow from investing activities
The two main components of cash flow from investing activities are:
- Purchase and sale of fixed assets such as property, machinery, plant, and equipment
- Buying and selling of debt securities and other company’s equity (such as acquisitions)
Purchase and sale of fixed assets
Fixed assets are tangible assets to support production activities. Examples are buildings and property, machinery, equipment, and vehicles. They contribute to the production capacity of the company and have economic benefits for more than one year. Hence, the company presents it in the non-current assets section.
The increase in fixed assets is a positive signal for future growth. When a company increases its fixed assets, for example, buys a new machine, we expect its production capacity to increase.
When paying for a machine purchase, the company will record it as a cash outflow from investing activities. In particular, we call this capital expenditure.
Here, another important point you should check is depreciation. Depreciation represents the decrease in the usefulness of a fixed asset over time due to wear and tear.
So, when capital expenditure is more significant than depreciation, the firm is increasing production capacity.
We call the difference between capital expenditure and depreciation as a net investment. In other words, production capacity increases as long as the net investment is positive.
Furthermore, the company may finance the purchase of fixed assets through internal funding. If that is not enough, companies can raise external funding, such as by issuing shares or debt securities.
Meanwhile, sales of fixed assets represent cash outflows. Some machines may be technically and technologically obsolete. So, the company decided to sell it and obtain additional funds to spend on newer machines.
Buying and selling debt and equity securities of other companies
In this case, buying and selling are for long-term goals. The company doesn’t plan to sell it in the short term (less than one year).
Therefore, buying or selling highly liquid debt and equity securities (cash equivalents) is not included in the investment activity category but is included in operating activities.
One of the long-term financial asset investment items is the purchase of shares in another company (acquisition). The acquisition is an alternative to growing a business apart from internal growth (fixed asset spending).
Acquisitions typically scale a company’s operations faster than internal growth. Because they grow their business faster, some companies combine internal growth with acquisitions.
Long story short, the item in the investment activities section will give you an idea of how much the company’s growth will come from internal sources versus acquisitions.
Why is investment activity important
Investment activities are vital in supporting business growth in the future. By investing, companies hope to generate more income and profits.
The prospect of strong growth and returns is attractive to stock investors. Thus, the company’s stock price should rise and make it worthy of collection.
Banks and bondholders may be more skeptical than stock investors in the short term. Big cash out for buying capital goods reduces the money available for regular payments such as interest. Therefore, they are more careful in making decisions.
And, when they see that capital spending is doing well, they see that higher returns should be positively correlated with a healthy cash flow position. Companies have a higher ability to repay loans.
The relationship between investment activities and capital spending
Changes in fixed assets on the balance sheet are a representation of investing activity. As I said earlier, collectively, the cash outlay to buy capital assets is referred to as capital expenditure. You can find the numbers on the cash flow statement.
Analysts look to capital expenditure figures as an essential input in stock valuation. An increase in capital expenditure indicates the company is growing its business. Although capital spending often results in a negative investment cash flow, they usually view it positively. In the end, capital spending will support earning power in the future.
Is negative cash flow from investing bad?
Ii net cash flow from investing activities, it is not necessarily bad. To grow operations, companies should buy new machines or build new factories. It all costs a lot of money. Therefore, initially, companies may report negative cash flows from investing activities.
By spending money on capital assets, the company should generate large cash inflows in the future.
Imagine, the production machine is outdated, and the company doesn’t buy a new one, what will happen?
Cash flows from investing activities also depend on the type and age of the company. Young, high-growth companies may have negative net cash flow. They require significant capital outlays to grow their business and become more competitive in the market.
But, indeed, capital expenditure may be inefficient because it does not increase targeted profits. Therefore, you analyze it further, such as using the internal rate of return (IRR) to assess whether buying a machine or building a new facility is profitable or not.