The statement of cash flow聽shows how a company spends its money (cash outflows) and from where a company receives its money (cash inflows). The cash flow statement includes all聽cash聽inflows a company receives from its ongoing operations and external investment sources, as well as all cash outflows that pay for聽business activities聽and investments during a given quarter.聽This article will explain the cash flow statement and how it can help you analyze a company for investing.聽

Key Takeaways

  • The statement of cash flow depicts where a company receives its money from and how it expends its money.
  • The three main components of a cash flow statement are cash flow from operations, cash flow from investing, and cash flow from financing.
  • The two different accounting methods, accrual accounting and cash accounting, determine how a cash flow statement is presented.
  • A company's cash flow can be defined as the number that appears in the cash flow statement as net cash provided by operating activities.
  • Important indicators in cash flow analysis include the operations/net sales ratio, free cash flow, and comprehensive free cash flow coverage.
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Analyze Cash Flow The Easy Way

Why the Cash Flow Statement Is Important

There are two forms of accounting that determine how cash moves within a company's financial statements. They are accrual accounting and cash accounting.

Accrual聽accounting is used by most public companies聽and is聽the accounting method where聽revenue is reported as income when it's earned rather than when the company receives payment.聽Expenses are reported when聽incurred, even though no cash聽payments have been made.

For example, if a company records a sale, the revenue is recognized on the income statement,聽but the company may not receive cash until a later date. From an accounting standpoint, the company would be聽earning a profit on the income statement and be paying聽income taxes聽on it. However, no cash聽would have been exchanged.

Also, the transaction would likely聽be an outflow of cash initially, since it costs money for the company to buy inventory and manufacture聽the product to be sold.聽It's common for businesses to extend terms of 30,聽60, or even 90 days聽for a customer聽to pay the invoice. The sale would be an聽accounts receivable with no impact on cash聽until collected.

Cash聽accounting is an accounting method in which payment receipts are recorded during the period they are received, and expenses are recorded in the period in which they are paid. In other words, revenues and expenses are recorded when cash is received and paid, respectively.

Earnings and cash are two completely different terms. Earnings happen in the present when a sale and expense is made, but cash inflows and outflows can occur at a later date. It is important to understand this difference when managing any business payments.

A聽company's profit is shown as net income聽on the income statement. Net income is the聽bottom line for the company. However, because of accrual accounting, net income doesn't necessarily mean that all receivables were collected from their customers.聽

From an accounting standpoint, the company might be profitable, but if the receivables become past due or uncollected,聽the company could run into financial problems.聽Even profitable companies can fail to adequately manage their cash flow, which is why a cash flow聽statement is a critical tool for analysts and investors.

Cash Flow Statement

A cash flow statement has three distinct sections, each of which relates to a particular component鈥攐perations, investing, and financing鈥攐f a company's business activities. Below is the typical format of a cash flow statement.

Cash Flow From Operations

This section reports the amount of cash from the income statement that was originally reported on an accrual basis.A few of the items included in this section are accounts receivables, accounts payables,聽and income taxes payable.聽

If a client pays a receivable, it would be recorded as cash聽from operations.聽Changes in current assets or current liabilities (items due聽in one year or less) are recorded as cash flow from operations.

Cash Flow From Investing

This section records the cash flow from聽sales and purchases of long-term investments like fixed assets that include聽property, plant, and equipment. Items included in this section are purchases of vehicles, furniture, buildings, or land.聽

Typically,聽investing transactions generate cash outflows, such as capital expenditures for plant, property and equipment, business acquisitions, and the purchase of investment securities.

Cash inflows come from the sale of assets, businesses, and securities. Investors typically monitor capital expenditures used for聽the maintenance of, and additions to, a company's physical assets to support the company's聽operation and competitiveness. In short, investors can see how a company is investing in itself.聽

Cash Flow From Financing

Debt and equity transactions are reported in this section. Any cash flows that include payment of dividends, the repurchase or sale of stocks, and bonds would be considered cash flow from financing activities. Cash received from taking out a loan or cash used to pay down long-term debt would be聽recorded in this section.

For investors who prefer dividend-paying companies, this section is important since it shows聽cash dividends paid since聽cash, not聽net income, is used to pay dividends to shareholders.

Cash Flow Analysis

A company's cash flow can be defined as the number that appears in the cash flow statement as net cash provided by operating activities, or "net operating cash flow." However, there is no universally accepted definition. For instance, many financial professionals consider a company's cash flow to be the sum of its net income and depreciation (a non-cash charge in the income statement). While often coming close to net operating cash flow, the聽shortcut can be inaccurate, and investors should stick with using the net operating cash flow figure.

If your cash flow analysis shows that you are about to be low on cash and not able to make your payments, you can adapt by obtaining financing, cutting costs, or trying to increase income. This is why cash flow analysis is important.

While cash flow analysis can include several ratios, the following indicators provide a starting point for an investor to measure the investment quality of a company's cash flow.

Operating Cash Flow/Net Sales

This ratio, which is expressed as a percentage of a company's net operating cash flow to its net sales, or revenue (from the income statement), tells us how many dollars of cash are generated for every dollar of sales.

There is no exact percentage to look for, but聽the higher the percentage, the better. It should also be noted that industry and company ratios will vary widely. Investors should track this indicator's performance historically to detect significant variances from the company's average cash flow/sales relationship along with how the company's ratio compares to its peers. It is also essential to monitor聽how cash flow increases as sales increase since聽it's聽important that they move at a similar rate over time.

Free Cash Flow聽

Free cash flow (FCF) is often defined as the net operating cash flow minus capital expenditures. Free cash flow聽is an important measurement since it聽shows how efficient a company is聽at generating cash. Investors use free cash flow to measure whether a company might have enough cash,聽after funding聽operations and capital expenditures, to pay investors through聽dividends聽and聽share buybacks.

To calculate FCF from the聽cash flow statement, find the item聽cash flow from operations鈥攁lso referred to as "operating cash" or "net cash from operating activities"鈥攁nd subtract capital expenditures聽required for current operations from it.聽

You can go one step further by expanding what's聽included in the free cash flow number. For example, in addition to capital expenditures, you could also include dividends for the amount to be subtracted from net operating cash flow to arrive at a more comprehensive free cash flow figure. This figure could then be compared to sales, as聽shown earlier.

As a practical matter, if a company has a history of dividend payments, it cannot easily suspend or eliminate them without causing shareholders some real pain. Even dividend payout reductions, while less injurious, are problematic for many shareholders. For some industries,聽investors聽consider聽dividend payments聽to be聽necessary cash outlays similar to聽capital expenditures.

It's important to monitor free cash聽flow over multiple periods and compare the figures to companies within the same industry. If free cash flow is positive, it should indicate聽the company can meet its obligations, including funding its operating activities and paying dividends.

Comprehensive Free Cash Flow Coverage

You can calculate a comprehensive free cash flow ratio by dividing the free cash flow by net operating cash flow to get a percentage ratio. Again,聽the higher the percentage, the better.

The Bottom Line

If a company's cash generation is positive, it's聽a strong indicator that the company is in a good position to avoid excessive borrowing, expand its business, pay dividends, and weather hard times.

Free cash flow is an important evaluative indicator for investors. It captures all the positive qualities of internally produced cash from a company's operations and monitors the use of cash for聽capital expenditures.