Cash Flow Statement – Definition and Guide

The value investor’s holy trinity of fundamental analysis: the income statement, balance sheet and the cash flow statement.

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The cash flow statement is different from the income statement and the balance sheet, in that it shows the sources and uses of cash over a certain time period. Value investors can look to the cash flow statement to assess the health of a company. Cash creates earnings and a steady flow is crucial; burn too much cash and liquidity dries up. If that happens, your earnings go away and so does your company.

The statement of cash flows also allows investors to look under the hood. Imagine a pharmaceuticals company reports starting cash as $2 million and ending cash for the period as $1 million. It’s easy to think that the amount of cash used that quarter was $1 million but in this specific example what if the business actually borrowed $10 million in between? That doesn’t immediately show up in the starting and ending numbers and could easily go unnoticed. Unsuspecting investors could then buy in, not knowing exactly what they are getting themselves into.

The statement of cash flows can be broken out into three components. Each one of these components helps an investor understand how money flows in and out of a company.

See also: low liquidity

Cash Flows from Operations

Cash from operating activities refers to the cash flow that comes from the company’s main business activity. This tends to reflect how much money is generated by the business. For example outstanding invoices, or accounts receivable, would show up here.

Another example: if you are the UPS and you have to sell off a number of old service trucks then you might record the amount received from the sale in this area of the cash flow statement. Suppose one UPS truck sold for $4000 and the Kelly Blue Book value of the truck is $5000 (book value example). As a result, there would a line called “Loss from Sale of UPS Truck” representing the $1000 loss ($4000-$5000).

In this case we would subtract a thousand dollars from the company’s overall income.

One thing to note is that cash from operations neglects to take into account any amount spent on capital expenditure. Businesses can spend a lot of money every year this way, perhaps by updating equipment or even buying up land, depending on the industry in question.

Cash Flows from Investing

Cash from investing represents any change in equipment, assets or company investments. While capital expenditure isn’t reflected in the operations section, it rears its head in this section of the statement of cash flows.

Cash flows in this section tend to be negative, but that is not inherently bad. Companies will generally use their reserves of cash to purchase investments such as buildings, equipment or even debt instruments. An increase in capital expenditure means the company is electing to invest in the future. If Hershey purchases a new manufacturing plant, it could potentially increase revenue down the line.

Analyzing capex can be subtle. Companies in a growth phase will need to spend a lot in this area but it is vital that this spending be placed in context. All else equal, a new mining company requiring expensive equipment will spend much more than a startup company in the software industry.

Negative flows occur if the investment is in the form of the purchase of marketable securities (say, shares of another company), the transaction is still considered an outflow but if and when a future divestment decision is made, that cash will be considered an inflow.

Cash Flows from Financing

Cash from financing tracks changes to long-term and short-term debt as well as shareholder’s equity.

For example, McDonald’s might issue additional common stock and the money generated through these efforts would show up as a net positive in the cash flow from financing section. Positive cash flows here indicate that money is coming in, not leaving.

If a company like Siemens is buying back their own shares however, that would be a negative cash flow as they are dipping into the company piggy bank. Dividends paid out would also read as an outflow of cash in this section.

Actual cash on hand, cash and cash equivalents, also make an appearance in this part of the cash flow statement and give you an idea of how big of a war chest the business has. At of Q1 2017 Berkshire Hathaway had a staggering $25 billion in cash and cash equivalents; not all companies can be so lucky but having access to large reserves like this offers protection in case of an emergency. A continuously growing pile of cash also indicates that the business is performing well.

Conclusion: Cash Flow Statement is Key to Understand How a Business Manages its Accounts

The statement of cash flows can be a wonderful tool for value investors seeking to understand how a company is using its income. Is most of the money leaving the business, to pay off debt or is it being cycled back into the company to generate growth?

They key point here is that the quality of cash flow is just as important as the quality. This is perhaps best illustrated through accounts receivables within the cash flow from operations. If accounts receives are going up one might chalk that up as a positive development. Positive cash flow is great, right?

It depends. Increases that are disproportionate to the rate of growth of the company might indicate that the business is having trouble collecting money from its clients (see average collection period formula). Not a good thing. If this becomes a trend then the firm may have to borrow to offset the difference. Taken to the extreme, eventually the business will go bust because not enough cash is coming in.

Use the cash flow statement to go beyond the top line numbers; behind a profitable quarter could lie a cash flow disaster.

Sources

“What are some examples of financing activities? | AccountingCoach.” AccountingCoach.com. N.p., n.d. Web.

Fuhrmann, CFA Ryan C. “Cash Flow Statement: Analyzing Cash Flow From Investing Activities.” Investopedia. N.p., 25 Nov. 2013. Web.

Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.