How can one company report substantial revenues, profits and growth and yet not generate any real cash and another company to have cash flow that are much higher than the reported profits? Doest this make sense? How will you reconcile these two seemingly inconsistent data points. We can answer these important questions as we analyze the statement of cash flow.

Why is the statement of cash flow so important

First and foremost the Cash flow statements allows us to bridge accrual accounting and its impact on reported revenues and profits with actual cash flow. An income statement may simply be inadequate for shareholders and others to completely assess a firm’s financial performance.

The second reason that the statement of cash flow is so important is that the value of any asset, stocks, bonds or piece of income-producing real estate should be the current or present value of the cash flow that we expect the specific asset to generate in the future.  This is why it is important to understand the substantial differences between revenues, profits and cash flow.

Some differences between revenues, profits and cash flow

There are certain non-cash expenses that appear in the income statement and reduce profits, for example think about depreciation expenses. We take the initial investment in a building or piece of machinery and expensive over time. Those periodic expenses reduce report profits but are non-cash Thus to reconcile between reported net income and actual operating cash flow we add back the sorts of non-cash expenses.

Organizations following generally accepted accounting principles typically record revenues upon the delivery of the product or service to customers. While collectibility of any amounts owed by the customer must be reasonably certain the customer may or may not ultimately make good on amounts if they do not make payment at the time of the sale.

Companies with really high depreciation and amortization cost the actual operating cash flow can be higher and substantially higher the reported profits.  Therefore one of the things we are going to want to do when evaluating companies and their financial statements is to compare reported accrual-based profits and cash flow We want to is to see if a close relationship exists between the two.

How the statement of cash flow is structured

Overall the statement of cash flow lays out both the sources and the uses of cash during a particular period of time generally a quarter or a year. The same period covered by the income statement the statement of cash flow is divided into three separate sections:

  1. operating cash flow,
  2. investing cash flow and
  3. financing cash flow.

If we add up the total of operating, investing and financing cash flow we will derive the total change in cash for the period.

Something to note before going into details: the Black Friday is a matter of cash flow.  Many successful retailers bleed cash three quarters of the year that make until they start making some money in the fourth quarter, between Thanksgiving and Christmas.

That is why the Friday after Thanksgiving is traditionally known as Black Friday, since for many it represents the first day of the entire year when retailers are finally in the black and profitable.

The operating cash flow section

The operating section of the cash flow statement discloses the actual cash either generated by or used by the company in the normal recurring and routine course of business. This should remind us of how the income statement is also divided into operating and non-operating sections.

The operating section of the statement of cash flow starts with the net income as reported on the income statements and then by making certain additions and deductions to reconcile the reported income to cash flow they derive the actual operating cash flow.

As a starting point firms add back any non-cash expenses they may have recorded in the income statements, things like depreciation and amortization expense or compensation expense from stock options, all of which require no outlay of cash, then to the extent they reported various revenues and/or expenses either greater or less than the actual cash received or spent they add or subtract those differences.

The operating section of the statement of cash flow is the most important section of a quarterly or annual report since allows us to see in a birds-eye view whether a firm is actually generating or bleeding cash. It also shows us how closely or not cash flow are tracking net income knowing that most companies over 70% in fact generate positive cash flow from operations.

The investing cash flow section

The second section of the statement of cash flow the investing section which lays out the cash flow from various nonrecurring non-operating activities of the firm. These may include investments in property plant or equipment generally called capital expenditures. It also may include mergers and acquisitions or even investments in stocks and bonds that a company makes while using its excess cash.

Because they are not considered core or central to the company’s everyday activities or operations, they are included in the investing section of the statement of cash flow, not the operating section. Of course companies with strong operating cash flow could afford to then invest that cash flow. Not surprisingly were operating casuals are typically positive for most companies investing cash flow are usually negative.

All organizations, even those that are losing money, still to make at least some investments, if just in replacing outdated computers and equipment . In fact were over 70% of public companies report positive cash flow from operations over 80% of US companies experience negative cash flow from investing activities.

In other words all firms need to reinvest at least some amount of cash in the business just to maintain their current level of operations as machinery wears out and computers and other equipment become obsolete. Thus the companies need to invest something just remain in business and need to invest even more if they intend to grow.

Free cash flow

The difference between operating cash flow and capital expenditures is something often referred to as free cash flow.  That’s the leftover cash that firms can spend on any number of additional things acquisitions dividends stock repurchases reductions in debt or the purchase of stocks and bonds.

Free cash flow are arguably the most important link between accounting and finance, certainly when it comes to the valuation of stocks.  What you are paying for or buying when purchasing shares of stock in a particular company is a share of the free cash flow that the company is expected to generate in the future and which we as shareholders own a right to or an interest in.

Therefore in accounting and finance terms we say that the price of any stock should be the present value of the company’s expected free cash flow to be earned by shareholders over time.  Free cash flow, therefore, represent the cash that a company or organization is able to generate from its core operations less any expenditures is required to spend in order to maintain its asset base.

The financing cash flow section

Financing activities include any cash transactions involving an organization’s debt or borrowings as well as its equity or stock. For example these transactions may include borrowing issuing bonds or taking a loan from a bank paying back such debt issuing stock or repurchasing it or paying dividends.

These are all examples of financing activities and not surprisingly are directly tied to operating and free cash flow. Companies with lots of free cash flow generally can pay down debt and pay dividends, which does not mean that even successful companies with lots of free cash flow could issue stock or debt to fund growth or acquisitions or just to take advantage of opportunities in the market.

Understanding a Cash flow statement

The fundamental analysis we must do when we review a Cash flow statement means that you should:

  1. Review the total amount of operating cash flow generated for the year to see if there is a noticeable trend over recent years. Clearly what we would like to see are positive opulent cash flow that are growing from year to year.
  2. Compare the reported operating cash flow to net income. If you note large differences you should investigate what might be driving them. Is the company not collecting its receivables? Does the company have significant non-cash income?
    Because the operating section of the statement of cash flow requires firms to reconcile net income to offering cash flow we can generally see what is driving the difference.
  3. Understand what the company actually did with the money it made or if the operating cash flow are negative, meaning the company actually bled cash during the period. You would want to know how they dealt with the shortfall. Did the firm sell assets issue stock borrow money use cash reserves?
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