If you read and analyze a cash flow statement, it means you are evaluating how much money the company is making and spending. And, this article presents everything about a cash flow statement. The first part is about what is a cash flow statement? Why is it important? And why should you read it?
In the next section, you will see out how companies present it. Is it in a direct format or an indirect format, and what is the difference? Then, you will find what the items in the cash flow statement are? At the end of the article, you will find several cash flow ratios, which are important in analyzing company finances.
What is a cash flow statement?
Cash flow statement breaking down the company’s cash inflows and outflows over an accounting period, say one year. Cash inflows include money from selling goods, interest and dividends earned, selling assets, and issuing bonds or shares. Meanwhile, cash outflow includes transactions such as paying suppliers, paying interest, paying off debt, buying back shares and paying taxes.
The cash flow statement comprises three parts, cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.
- Cash flow from operating activities describes the cash in and out of the core business.
- Cash flow from investing activities relates to growing the business in the long term, such as buying capital goods or divesting subsidiaries.
- Cash flows from financing activities describe how a company finances its operations and long-term growth.
- When you add them up, the net cash flows of the three equal the net change in cash and cash equivalents on the balance sheet.
Managing cash flow is vital for a company. If not managed properly, companies may not be able to cover their bills and liabilities because they do not have enough cash. Even successful companies, if they don’t manage their cash flow well, will run into problems.
Guide to Understanding and Analyzing Financial Statements
How does a cash flow statement differ from an income statement and balance sheet?
The statement of cash flows is one of the three important financial statements besides the balance sheet and income statement. They measure different but equally important metrics when you are analyzing a company’s financial statements.
The balance sheet details the company’s resources and claims to those resources (liabilities and equity) during the reporting date. It doesn’t matter how the money goes in and out of the company. It simply presents how much cash the company had at the reporting date. Both are linked through the cash and cash equivalents accounts, where its balance equals the previous period’s balance plus the net cash change in the cash flow statement.
Meanwhile, the income statement tracks when the company earns revenue and incurs expenses. It works under accrual accounting. The company recognizes revenues and expenses when they are incurred, not when cash is received or paid.
The income statement shows you whether a company is profitable or not. Meanwhile, the cash flow statement shows how liquid the company is. Some companies may be profitable but have liquidity problems and cannot pay their bills on time.
Ideally, profitable companies should be liquid because they show good cash management. As a result, they can collect money from every profit they book.
What is the purpose of a cash flow statement? Why is it important?
The cash flow statement aims to provide insight into what happened to a company’s cash during an accounting period. Together with balance sheets and income statements, it helps external users assess how the company manages its financial resources.
As you read and analyze it, you will gain insights such as:
- Where does the company’s money come from? Is it from the main activity or from financing?
- Does the company generate enough cash to meet its short-term and long-term obligations?
- Do the company’s operating cash flows reflect recorded net income?
- What are the future prospects of the company? Is the company’s capital expenditure equivalent to depreciation, or is it higher?
- How does the company finance its long-term growth?
Where do companies make money and spend it?
In the cash flow statement, you will know where the company is making money and spending it. Ideally, the company makes money from its operations. A positive operating cash flow indicates the company is making more money than it spends on day-to-day operations. Thus, the company does not need to borrow money to cover expenses.
Generating more cash from operations means more cash remaining after the company meets its expenses. Companies can pay interest on debt regularly. They also provide more money to shareholders through dividends. They can use the remaining cash to grow the business business.
But, for the new company, a negative operating cash flow may still be tolerated. Their operations have not generated enough money to cover expenses and investments. Finally, they are more dependent on cash inflows from financing activities.
Furthermore, fast-growing companies also need a lot of money for expansion. They may generate positive operating cash flow. However, that may not be enough to finance the expansion. They may have to go into debt or raise money by issuing stock. As a result, their net cash flow is negative.
How much cash is generated to pay the obligations?
A successful company must have sufficient cash at all times. They need it to pay suppliers, pay employee salaries, pay interest on loans, and pay off debts. It is essential for the business to remain solvent. If the company does not have enough money to pay its obligations, it can lead to bankruptcy.
- Operating cash flow replaces some earnings measures such as net income or EBIT to calculate leverage ratios. It provides a more realistic insight because it does not involve accrual items.
Is the company’s net income in line with cash from operations?
Net cash flow from operations should reflect recorded net income. Indeed, when a company posts higher net income, it doesn’t necessarily mean making more money. You need to confirm it with a cash flow statement.
- Companies may report big profits but bad cash because the money from their sales is still in customers’ hands. In other words, the company has delivered the goods – recognized as revenue in the income statement – but has not received any cash payments. Thus, it is only recorded as trade receivables on the balance sheet, not in cash and cash equivalents.
- Although cash from operations and net income are somewhat different, the difference between the two should not be much different. Significant differences between the two may indicate earnings manipulation practices.
How significant is the money spent growing the business?
In the cash flow statement, you will know how much the company allocates capital expenditures. You should compare it to depreciation – the difference between the two is called the net investment.
If the net investment is positive, it indicates the company is spending more money than it needs to maintain its current production capacity. In other words, the company is expanding to produce more output in the future.
How is a cash flow statement presented?
The cash statement details the cash in and out of the company. Companies report cash receipts as inflows, while cash payments as outflows. There are two formats for reporting it: the direct method and the indirect method. You can then verify the accuracy of the cash flow statement by matching changes in cash and cash equivalents on the balance sheet.
Direct cash flow statement method
The direct method is based on transactional information that affects cash during the reporting period. The presentation is similar to the income statement for operating cash flows, except that the accrual items are converted to a cash basis. In addition, they are adjusted for changes in the working capital account on the balance sheet to eliminate the effect of the time difference between revenue and expense recognition and actual cash receipts or payments.
- The cash flow statement begins with cash receipts from customers and then deducts all cash payments for direct and indirect costs.
Indirect cash flow statement method
The key difference between direct and indirect methods is related to cash flows from operating activities. Under the direct method, companies itemize cash receipts and cash payments.
In contrast, the indirect method initiates operating cash flows by presenting net income. Then, we adjust it by adding back non-cash items such as depreciation expense and amortization expense.
- We also add back non-operating items such as gains on the sale of fixed assets.
- Finally, we adjust the results for changes in net working capital, the difference between non-cash current assets and non-debt current liabilities.
What are the items in the cash flow statement?
The cash flow statement divides business activities into three for reporting purposes:
- Operation activity
- Investing activity
- Financing activity
The report only details the money coming in and going out of the company. Maybe you will find a company’s transactions without involving cash, such as dividing stock dividends, barter transactions, and exercising convertible bonds into common stock. Because they do not involve the receipt or payment of cash, they are excluded from the statement of cash flows.
The grouping into the three categories above helps external users to see which part is generating cash flow. The company presents net cash on the last line for each category, which can be positive or negative. The three are then added to calculate the net change in cash flows during the reporting period, which acts as a link between the cash flow statement and the balance sheet.
- Changes in cash = Net cash flow from operating activities + Net cash flow from investing activities + Net cash flow from financing activities
- Ending balance of cash and cash equivalents = Beginning balance of cash and cash equivalents + Change in cash
Cash flow from operating activities
Cash flow from operating activities details the cash inflows and outflows associated with the company’s day-to-day core business activities. It may be negative or positive, usually related to how long the company has been operating.
- Young or new companies may have negative operating cash flows. They are growing and need more cash than can be generated from selling goods or providing services. To finance expenses, they usually rely on cash from financing activities.
- Mature companies should post positive net operating cash flows. It shows they are successful in selling goods or providing services. They make more money than they pay for day-to-day operations, such as paying suppliers, hiring employees, paying rent, and advertising spending. They can also use net operating cash flow to repay debt or distribute dividends.
What items you will find on the cash flow statement depends on the reporting format. If the company uses the direct format, you may find the following items:
- Cash from selling goods and services
- Cash to pay employee salaries
- Cash to pay suppliers
- Interest income receipt
- Tax payment
Items classified as operating activities also depend on the accounting standards adopted by the company, whether IFRS or U.S. GAAP. For example, interest and dividends earned may be classified as operating cash flows or investing cash flows under IFRS, but they are cash from operation under U.S. GAAP.
Meanwhile, under the indirect method, operating cash flow items include:
- Net profit
- Non-cash items comprise items such as depreciation and amortization expenses
- Net working capital change
Net profit or net income. You can find this figure on the income statement at the bottom. It represents a rough figure of money generated by the company because it still considers non-cash items such as depreciation and amortization expenses. So, you should exclude them when calculating net cash flow from operating activities.
Depreciation and amortization. Depreciation is the cost of fixed assets allocated by the company in the reporting period. It represents how much the economic benefits of fixed assets decrease during the accounting period. The company may show it on the income statement. If you don’t find it, you can see it in the notes to the financial statements.
- Amortization is alike to depreciation, except that it applies to intangible assets. Companies may present it on the income statement; if not, try looking in the notes to the financial statements.
Changes in the net working capital equal to the current year’s net working capital minus the previous year’s net working capital. Net working capital only takes into account non-cash current assets and non-debt current liabilities. To calculate it, you subtract non-cash current assets by non-debt current liabilities.
- Net working capital = Non-cash current assets – Non-debt current liabilities
- Net working capital change = Current year’s net working capital – Previous year’s net working capital
Non-cash current assets typically include items such as:
- Accounts receivable
- Prepaid expenses
- Other current assets
Meanwhile, non-debt current liabilities include:
- Accounts payable
- Taxes payable
- Accrued expenses
- Unearned revenue
- Other current liabilities
As a note:
An increase in assets consumes cash.
- Take, for example, prepaid expenses. It represents an early payment to a supplier, where the company is expected to receive goods or services from the supplier after the reporting period. So, if it increases, then more money is used to pay.
On the other hand, increased liabilities indicate more money is being held by the company. Therefore, it becomes a source of cash for the company.
- Take accounts payable, for example. It arises when a company owes a supplier for goods and services it has received. In other words, the company has received the goods but has not paid for them. If it increases, it means less money is spent.
So, suppose you use the formula above. In that case, the net cash flow from operating activities is equal to net income + depreciation and amortization expenses – Changes in net working capital.
Cash flow from investing activities
Cash flows from investing activities record the cash flows associated with acquiring and selling a company’s long-term assets. In other words, it is related to how the company grows its productive capacity, especially related to capital expenditures, long-term investments, and acquisitions.
This section does not cover highly liquid short-term investments. Likewise, held-for-trading securities are also excluded. Instead, their transactions are reported in cash flows from operating activities.
In this section, you may find items such as:
- Capital expenditure
- Fixed asset sale
- Long term investment
Capital expenditures (CAPEX) – money spent by companies to purchase capital goods (such as property, plant, and equipment – called fixed assets). On the other hand, the company may also sell some of its aging fixed assets to obtain fresh funds to add capital expenditures.
- When the increased capital expenditures exceeded depreciation of fixed assets, it shows the company is expanding to increase production capacity, for example, by building new factories. Thus, we expect the company to sell more goods and make more money in the future.
Investment proceeds – money from the company’s long-term investment results. Instead of putting their money in money market instruments, companies may allocate it to long-term instruments such as bonds and stocks. The company holds the investment for more than one year to earn a higher return than in the money market.
- Companies may also invest in property to earn rent or capital gains. Such properties are not for day-to-day operations such as factories and office space.
Cash flows related to acquisitions or divestments – a company may spend money acquiring a subsidiary or investing in an associate or joint venture. In this case, the company pursues an inorganic strategy to grow the business rather than through internal development. On the other hand, the company may also earn money from divesting its subsidiaries.
Cash flow from financing activities
Cash flows from financing activities are related to financing the company’s long-term investments. They include transactions with shareholders and creditors, such as issuing shares, issuing bonds, applying for bank loans, buying back shares, paying off debt, and paying dividends.
Issuance – repurchase of shares. This is an important number for you to look at because it shows how the company finances its activities. For example, new companies need funds and usually raise funds by issuing new shares.
- Equity capital is a better alternative than relying on debt because they still don’t make much money from operating activities. If they raise capital from debt, they must pay regular interest, regardless of whether they generate sales or not.
- When the company has grown and generates a lot of free cash flow, they may buy back their own stock to increase the current existing stock’s value.
Issuance – repayment of debt. Debt capital is an alternative to equity capital. Companies may raise it by issuing bonds or borrowing from banks. However, unlike equity capital, debt capital requires the company to pay regular interest and, at maturity, pay the principal.
- They may also withdraw expensive old debt when interest rates fall. Then, they issue new, cheaper debt.
- Debt is usually an option for older and more mature companies. They can borrow at lower interest rates than startups because they have a more proven track record. In addition, they should also have generated positive cash flow from operations.
- Because debt interest is tax-deductible, the company strives to achieve an optimal capital structure and maximize the company’s market value.
Dividend payment. Mature companies may distribute a portion of net income as dividends to shareholders. Meanwhile, young companies tend not to pay dividends because they are building internal capital for expansion.
- This account links the statement of cash flows to the equity on the balance sheet. Dividends are a deduction for net income and, thus, retained earnings. This year’s retained earnings equals the previous year’s retained earnings plus net income minus dividends.
Next calculation: Free cash flow
Free cash flow shows the remaining cash generated during the reporting period after deducting essential expenses. Thus, it shows how much money the company generates and can freely use for purposes other than working capital and capital expenditures.
To calculate it, you subtract cash from operations (CFO) by capital expenditure. For example, suppose you calculate CFO from the income statement. In that case, you add back depreciation and amortization expenses and interest expenses to net income. Then, you reduce the results with capital expenditures.
Free cash flow can be negative or positive. Negative free cash flow can indicate significant spending on equipment or other investments to grow the business. But, it can also indicate the company is failing to generate adequate cash inflows from operating activities (CFO may be negative).
Free cash flow to the firm (FCFF)
Free cash flow to the firm is available to suppliers of the company’s capital. It equals net income plus non-cash items on the income statement (such as depreciation and amortization) plus after-tax interest expense minus capital expenditures and changes in working capital.
FCFF = Net income + Non-cash items + After-tax interest expense – Capital expenditure – Change in net working capital
- Net income plus non-cash items represent the amount of cash the company generates for one year after paying interest and taxes.
- Non-cash items can be in the form of depreciation, amortization, depletion, share-based compensation, and asset impairment.
- Since FCFF represents the total amount of cash available to investors (shareholders and creditors), we must add back after-tax interest expense.
- Changes in working capital represent net cash from routine operations.
- Capital expenditures represent the cash outlays the company plans to grow its long-term assets.
Free cash flow to equity (FCFE)
Free cash flow to equity is available to shareholders of the company’s common stock. It is calculated by adjusting the free cash flow to the firm (FCFF) with after-tax interest expense and net borrowing.
- FCFE = Net income + Non-cash items – Changes in working capital – Capital expenditures + New debt – Debt repayment
- FCFE = Cash from operations – Net capital expenditure + Net borrowing
How to analyze a cash flow statement?
Analyzing cash flow statements usually uses cash from operations (CFO). It substitutes for items like net income or EBIT and provides a more accurate picture of how much money a company is making. It can be compared to a company’s debt, interest expense, or current liabilities, similar to other non-cash ratio calculations.
Cash flow analysis can cover various ratios. And, the following cash flow ratios provide a starting point for you to measure a company’s financial performance:
Cash flow to revenue = CFO / Revenue
- How much revenue in one year is eventually converted into money. A higher ratio is better because the company can collect money from sales instead of being owed by customers as receivables.
Cash return on assets = CFO / Average total assets
- How much the company makes money from its assets. It tells how well the company is managing assets to make money.
Cash to capital expenditure = CFO/Capital expenditure
- How much money generated can be used to finance business growth. A higher ratio indicates more sufficient funds are available to meet the capital investment.
Cash flow to net income = CFO / Net income
- How well the profit eventually converts to cash. A ratio close to one indicates the company is less likely to manipulate earnings.
Cash flow per share = (CFO – Preferred dividends) / Number of common shares outstanding
- How much cash is available to common stockholders. It is similar to earnings per share (EPS) but is based on how much money the company makes.
Price-to-cash-flow ratio = Share price/CFO per share
- How expensive a company’s stock is compared to its ability to make money. It is an alternative to the price-to-earnings ratio. A low ratio indicates the company’s stock is undervalued, so it has the potential to rise in the future.
Operating cash flow ratio = CFO / Current liabilities
- How much the company can generate money to cover its current liabilities. If the ratio is less than one, it indicates the company is not making enough money to pay its short-term liabilities.
Debt coverage = CFO / Total debt
- How capable the company is to bear debt comfortably. A high ratio indicates a low leverage level, indicating the company can cover its debts with cash from operations.
Cash interest coverage = (CFO + Interest paid + Taxes paid) / Interest paid
- How capable the company can pay interest using the cash generated from operations. Because it uses cash, it is more realistic to describe the company’s ability to pay interest.
Dividend payment = CFO / Dividend paid
- How capable the company is to pay dividends with its operating cash flow. Ideally, the company has cash remaining after some are distributed as dividends. Companies can reinvest them to grow the business, generate returns, pay off debt, or increase cash reserves.