Earnings, dividends and growth rates are useful figures in investment analysis. However, like water to humans, there is an underlying element essential to the survival and success of any firm—cash flow.

In this installment of the financial statement analysis series, we discuss the corporate cash flow statement, providing an in-depth look at its sections and explaining what the line items mean.

The Importance of Cash Flow Statements

The statement of cash flows is useful because it shows whether a company is generating positive cash flow through its normal business operations. Cash flow is less subject to accounting variations than earnings are.

Sources of cash can easily be determined on the cash flow statement. Similarly, investors can see where cash is being spent—such as on inventory, for the purchase of new capital assets or to reduce debt.

For investors, the importance of cash flow statements is in their ability to show whether the company is and has been realizing enough positive cash flow to not only sustain operations but also expand, pay dividends, reduce debt or repurchase shares. Additionally, the cash flow statement serves as a bridge between the balance sheet and the income statement, providing insight into the factors influencing the company’s profitability and its leverage.

Why Do You Need a Link Between the Balance Sheet and Income Statement?

Under accrual accounting (the methodology followed by publicly traded corporations), earnings and cash flow are two very different figures. The earnings figure, the income statement’s “bottom line,” is based on the principles of accrual accounting. Accrual accounting attempts to match expenses with revenues regardless of when the cash transactions that deal with the creation of the goods being sold and the receipt from the sale occurred. In essence, accrual accounting is not entirely concerned with when “cash trades hands.” This method of accounting introduces many interpretations and estimates from management that can vary from firm to firm.

For example, higher sales may not translate into higher cash flow if accounts receivable are allowed to rise. (Customers may not pay when goods are delivered, but rather may be invoiced.) Furthermore, cash may be used to build up inventories, which may depreciate in value or even become obsolete if products are not sold in a timely manner. The expenses to build up these inventories are not recorded until products are actually sold. Even inventory recognition may vary from firm to firm if one company uses first in, first out (FIFO) accounting and another uses last in, first out (LIFO) accounting.

The cash flow statement helps alleviate the opaqueness of accrual accounting by showing the sources and uses of cash. The cash flow statement links the income statement to the balance sheet, helping to explain differences in the timing of when transactions are reflected on each.

Think of the cash flow statement like your checking account. Once a transaction occurs and the cash is used, the cash is gone. There is no waiting to expense the spending throughout the life of your purchased product. The cash flow statement works in the same way: It allows you to see whether a company was able to generate more cash than it used during the stated period. If the company spent more cash than it brought in in, its cash balance is reduced. If the cash balance is depleted significantly (or if there is a threat of a significant depletion), the company must either take on additional debt or sell more stock—both of which may have negative financial implications. Because the cash flow statement links the income statement to the balance sheet, it can show signs of strength or weakness not reflected in reported earnings.

The Three Parts of the Cash Flow Statement

Cash flow statements are separated into three segments: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. Figure 1 shows an example of cash flow statement information. We delve into each segment of the cash flow statement to help you understand its overall purpose as well as how investors can use this information to invest in a company with confidence.

Figure 1. Sample Cash Flow Statement

Cash Flow From Operating Activities

Cash flow from operating activities has a very simple objective—to show whether a firm’s day-to-day operations generated or depleted cash. If net cash flow from operations is negative, it means that the company is spending more cash than it is generating in producing and selling its goods and services. If it is positive, the company is generating more cash than it is spending on its day-to-day operations.

Needless to say, cash flow from operating activities is vital to understand. Negative cash flow from operating activities will eventually lead companies to seek funding from outside sources, either through increased debt load—which increases interest payments, hinders growth and makes the company more vulnerable to business downturns—or by issuing stock, which dilutes ownership. Although a rapidly growing company may have negative operating cash flows as it expands its inventory and pays its increasing bills, the cash flow from operating activities must eventually turn positive for the firm to survive. Conversely, a contracting company may exhibit positive cash flow from operating activities during a period of time, as spending falls at a faster rate than sales and earnings. If the sales and profits fall far enough, however, the firm will have to liquidate portions of its business or declare bankruptcy.

The net income figure at the top of the cash flow statement is pulled directly from the income statement.

Typically, depreciation is the first line item that is reconciled. It is a noncash expense, meaning that depreciation does not require the expenditure of cash. Rather, it is used to reduce the value of an asset throughout its useful life in an effort to properly match revenues with expenses. Amortization, like depreciation, is also a noncash expense. Unlike deprecation, however, this figure measures the decline in value of an intangible asset. Both these figures lower net income and shareholder’s equity, but since they do not affect a company’s cash balance, they are added back to net income.

In most cases, companies will break down changes in working capital accounts such as accounts receivable, inventory and accounts payable. Firms may also provide this balance as one single item; however, a breakdown offers a clearer picture. Changes in working capital must be adjusted in order to identify the flow of cash. For example, an increase in accounts receivable increases net income and shareholder’s equity since a sale has been made and the company can reasonably expect payment in the future. However, cash has yet to be received for accounts receivable. In order to adjust net income to cash flow, the increase in accounts receivable for the period must be subtracted from net income. Conversely, accounts payable measures payments owed to suppliers. An increase in accounts payable decreases net income but increases the cash balance when adjusting net income in the cash flow statement. An easy way to see this increase is to recognize that a company taking longer to pay its bills will see a rise in its cash balance as well as its accounts payable.

Direct Versus Indirect Methods of Determining Cash Flow From Operating Activities

There are two ways firms determine cash from operating activities: direct and indirect. The direct method of cash flow statement reconciliation reports major sources of cash receipts and payments, starting with cash receipts from customers. Cash payments for inventory purchases and operating expenses are deducted from this initial balance to arrive at cash flow from operating activities. The premise of using the indirect method for the statement of cash flows is to start with net income and then adjust for noncash expenditures to arrive at cash flow from operating activities. The vast majority of firms use the indirect method on their cash flow statements, which is outlined here and in Figure 1.

Noncash Items Included in Cash Flow From Operating Activities

Several other noncash items appear often on the cash flow statement, including prepaid expenses and unearned revenues. Prepaid expenses are assets on the balance sheet that do not reduce net income or shareholder’s equity. However, prepaid expenses do reduce cash. Adjusting for an increase in prepaid expense is similar to adjusting for an increase in accounts receivable: they both decrease cash flow. Unearned revenues are a liability, so it works in the same way as accounts payable. An increase in unearned revenues does not affect net income or shareholder’s equity, but it does increase cash since payment has been received for future delivery of products or services. Again, the key is when cash was actually received or spent, which cash flow from operating activities shows.

As mentioned in previous articles in this series, firms often maintain two sets of accounting books—one for reporting to tax authorities and one for reporting to shareholders. It may be advantageous for a firm to pay a large tax bill up front and slowly deduct the expense from earnings over the next several years. As the tax expense is realized in subsequent periods, earnings and shareholder’s equity will decrease, but cash is not expended. A deferred tax expense on the cash flow statement is used to adjust net income to the cash balance.

Net operating cash flow is the sum of the previous line items. Expanding firms may have negative operating cash flows as they build up inventory and provide more credit to customers, but eventually this figure needs to turn positive. For most firms, positive cash flow from operating activities is crucial.

Cash Flow From Investing Activities

The investing activities section of the cash flow statement measures a company’s investment in itself. Long-term expenditures and investments in other firms are recorded here. These expenditures are intended to produce profits in the future.

Capital expenditures (also referred to simply as “capex”) represent purchases in fixed assets, mainly in the form of plant, property and equipment. This figure is usually negative as the firm spends money on fixed assets but can also be positive if a firm is selling more of its assets than it is buying. Capital expenditures can be very large and are long term in nature. As previously mentioned, in an effort to properly match expenses with revenues on the income statement, companies typically expense a capital expenditure over the course of its useful life. However, the effect of capital expenditures on cash flow works differently. In the initial purchase year, cash is used immediately, resulting in a large negative outflow for a single year as opposed to being expensed over a period of several years. A negative number for capital expenditures can be a good sign for a company: It means the company is spending money to expand its business by purchasing additional fixed assets. However, be sure to ascertain whether the company is making wise investments and has good growth prospects.

When analyzing capital expenditures in the investing activities section of the cash flow statement, it is important to make sure the figure is growing at a clip relatively similar to revenues. A firm that is growing at a rapid pace will not be able to maintain its pace without making capital expenditures for expansion. Conversely, spending cash on capital expenditures while revenues are stalling can be problematic if the sales decline is due to competitive threats and poor management decisions, instead of simply economic and industry cycles.

Furthermore, capital expenditures vary by industry. Manufacturing firms that require large plants typically have higher capital expenditures than firms with a high amount of intangible assets or intellectual property, such as investment firms. This is a key concept to keep in mind when looking at it’s the cash from investing activities section on the company’s cash flow statement.

Other spending included in the investing activities section of the cash flow statement arise from investments in other firms, acquisitions and divestitures of subsidiaries. This section also includes commodity hedges (for firms that depend heavily on commodities) or currency hedges (for international firms). In addition, financial companies make significant investments in marketable securities. You’ll need to keep the company’s industry in mind when examining cash flow from investing activities.

Net cash from investing activities is the sum of these line items. The figure for most healthy firms will be negative, as they drive cash from operations back into the firm for expansion to generate future profits.

Cash Flow From Financing Activities

Cash flow from financing activities includes three primary main transactions: stock transactions, debt transactions and dividends. Other items included in the cash flow from financing activities section may include:

• Equity issuing
• Payment of dividends
• Repayment of equity
• Issuance of debt
• Repayment of debts and other liabilities
• Additional lease payments

Cash is received and ownership is diluted when a company issues stock. Raising capital by issuing additional shares is not necessarily a bad sign, as long as the firm is expanding at an acceptable rate. Keep in mind, though, that selling additional shares means that less income is attributable to each shareholder. The repurchase of shares increases the ownership of shareholders and decreases cash.

The cash flow from financing activities section also includes the issuance of debt and the repayment of debt. When debt is issued, the firm receives cash that needs to be paid back at a later date. In between the repayment date and the issuance date, interest is paid. The repayment of debt issued represents a cash outflow. [Note that interest payments are not a financing activity. Rather, they are included in cash flow from operating activities since these expenses are considered a part of normal business operations. However, interest expense is not broken out in the operating activities section of the cash flow statement since it is already calculated into net income.]

Dividends are outflows of cash since cash is paid out to shareholders. Furthermore, the money spent on dividends should increase (become more negative on the cash flow statement) in subsequent periods. A decrease in dividends is often a sign that a company is experiencing difficulties, especially if the decrease is greater than the corresponding reduction in the number of shares outstanding. A firm offering no dividends is not uncommon. Preferably, a firm with no dividends should be experiencing significant growth.

The net cash from financing activities figure is helpful when gauging its overall effect on the cash flows of the firm. However, it is more important to study the individual line items to see how the firm is raising cash or repaying cash.

Currency Translation on the Cash Flow Statement

The cash flow statement can also include a section that reconciles currency translation (not shown in Figure 1). Multinational firms with operations in several different countries will generate revenues in several different currencies.

There are accounting rules written to supervise how currency is translated. A separate line item, often called “cumulative effect of exchange rate changes,” details the effect of the currency exchange rate changes on the company’s cash flow.

The Net Change in Cash Section of the Cash Flow Statement

Net change in cash is the aggregate of cash flows from operating, investing and financing activities. This figure should equal the difference between cash the firm holds at the beginning of the reported period (e.g., one year) and the amount that it holds at the period’s end. Positive net cash flow means the firm has more cash, and negative cash flow means the firm has less, compared to the beginning of the period.

It is easy to say that a positive change in cash is good while a negative change is bad, yet what matters is how cash is increased and spent. Generally, you want cash to come from business operations: Increasingly positive cash flow from operating activities is a good sign. A few periods of decreasing total cash is not worrisome if a firm is spending on worthwhile projects, paying high dividends, paying down debt or repurchasing shares. Also, keep in mind that excess cash does not provide a return for shareholders. Firms run the risk of management making risky decisions with a stockpile of cash, such as investing in questionable acquisitions or pet projects.

Calculating Free Cash Flow From the Cash Flow Statement

Free cash flow represents cash that management is able to use at its discretion. Free cash flow can be calculated by taking the net total from the cash flow from operating activities section of the cash flow statement and subtracting any capital expenditures and dividends paid. The importance of free cash flow should not be underestimated. Positive cash flow from operations is great, but cash must be driven back into the firm to upgrade obsolete machinery or buy newer buildings or for expansion purposes. Without these capital expenditures, a firm cannot remain a going concern that is able to generate future revenues.

Some sources simply list free cash flow as cash from operating activities less capital expenditures, since dividends are paid at management’s discretion and can be canceled if need be. It can be argued, however, that once a company starts paying a regular dividend, investors expect the payments to continue. Very rarely does a firm decrease or cancel dividends unless it is forced to do so.

Free cash flow can be put to several uses: retire debt, repurchase shares, pay additional dividends and create new products or expand current offerings. Depending on the type of company, free cash flows may show significant trends. For financial firms, most investments come in the form of loans, but loans are considered part of normal business operations. On the flip side, there are companies with extremely long and expensive product cycles, such as Boeing Co. (BA) and Airbus SAS. As new planes are conceptualized, developed, manufactured and delivered, cash flows devoted to those projects may be negative for years before profits are realized and net cash flows become positive.

How to Evaluate the Cash Flow Statement

Since the cash flow statement was first required to be provided in 1987, analysts have increasingly compared net income and cash from operating activities. Each figure has its strengths and weaknesses for analysis. Net income that appears on the cash flow statement is derived using the principles of accrual accounting, ignoring the effect of noncash items. Increasingly lax credit standards and aggressive revenue recognition can all be missed by looking simply at net income. Additionally, the noncash items listed on the cash flow statement are dependent on management estimates and discretion, and treatment may vary slightly from firm to firm.

On the other hand, cash flow from operating activities fails to account for earned revenues that will be collected in the future, or accrued liabilities that will need to be paid. In addition, the figure is difficult to evaluate for young, rapidly growing firms. These firms are increasing inventory, increasing current assets and extending credit to new customers to drive revenue growth. Typically, this leads to negative cash flow from operating activities that is supported by debt and issuance of stock.

The Bottom Line: How to Use the Cash Flow Statement When Investing

The cash flow statement links the income statement to the balance sheet, helping to explain differences in the timing of when transactions are reflected on each. Additionally, the cash flow statement helps you ascertain whether cash is coming from normal operations, whether a firm is reinvesting in itself and if a firm is raising additional cash.

It is important to analyze a firm’s cash flow statement in relation to industry norms. Different industries will have different trends in cash flows. Separately, rapidly expanding firms will have significantly different breakdowns for each section of the cash flow statement than slower-growth companies. Typically, rapidly expanding firms have negative cash flow from operating activities and investing activities as well as positive cash flow from financing activities.

The cash flow statement should be used as a tool to help you tie the income statement and the balance sheet together and more fully understand a company before investing.

More Resources About the Cash Flow Statement and Other Financial Reports

If you’re interested in learning more about how the cash flow statement links the income statement to the balance sheet or how to interpret cash flow from operating activities, as well as investing and financing activities, you can check out our other resources:

• Show Me the Money: Tracing a Firm’s Cash Flow
• The Balance Sheet: Assets, Debts and Equity
• The Income Statement: From Net Revenue to Net Income
• Investing in Price-to-Free-Cash-Flow

Understanding the cash flow statement as well as how to use it to your advantage when evaluating companies is important to becoming a well-informed individual investor. AAII has countless educational resources and stock screening tools that help investors invest with confidence, no matter the strategy or style. Check out A+ Investor to learn more about the available tools and resources that can help you reach your financial goals.

This article was originally published in the July 2012 AAII Journal. Click here for a PDF of the original article.

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