What an Investor Needs to Know About The Statement of Cash Flows

The Statement of Cash Flows

The statement of cash flows is arguably the most important financial statement. Revenue and profits are great, but when the dust settles and everything is tallied company performance boils down to cash generation. Cash is king! Just reading the change in cash and cash equivalents over the period can be misleading. An investor needs to know how the company made or lost money. This article will analyze each section of the statement of cash flows and how each item affects cash.

There are 3 main sections to the statement of cash flows:
1. Cash Flows from Operating Activities
2. Cash Flows from Investing Activities
3. Cash Flows from Financing Activities

Cash Flows From Operating Activities

Cash flows generated from operating activities pertains to the companies main line of business. In this section you will commonly see: Accounts Changes in Accounts Receivable
• Changes in Accounts Payable
• Changes in Liabilities
• Changes in Inventory
• Depreciation
• Amortization
• Adjustments to Net Income

Lets look at each item one by one so you can learn how to read a statement of cash flows and how each item affects overall gain/loss in cash.

Accounts Receivable

Accounts receivable (AR) is the money owed to a business from its day to day operations. The first thing to note on accounts receivable on the statement of cash flows is if the number is negative or positive. A negative number means AR increased and the company extended more credit. While a positive number means AR decreased during the period. As an investor you like to see companies that are able to collect their accounts receivable quickly, and that they are not writing-off a large amount of receivables.

To calculate how quickly a company is able to collect its AR use the Accounts Receivable Turnover Ratio. This formula calculates how many times the average amount of AR is collected. A high ratio signals that a company is able to collect its AR effectively. Here is the formula:

Accounts Payable

Accounts payable is the money that a company owes. Accounts payable is different than long-term and short-term debt. An easy way to think of accounts receivable is like layaway at a department store. You bought something and instead of paying it off all at once you are able to make a few payments over time to pay it off. When you look at accounts payable on the statement of cash flows a negative number means AP increased, and a positive number means AP decreased over the period. If the company takes on more credit (debt) then its cash increases, but if the company pays down its AP then the cash decreases.

Liabilities

Liabilities are debts taken by the company for various reasons, but most of the time it is to expand their business. On the statement of cash flows changes in liabilities tells investors if the company paid down its debt or took more debt on over the period. A positive number means the company took on more debt, and a negative number means the company paid down its debts. If the company takes on a new debt their cash will increase. Just like you would have more cash if you took out a loan from the bank.

Inventory

Inventory is the products a company sells. For a retail business it is extremely important to understand inventory. On the statement of cash flows if inventory is positive then the company has less inventory on hand then the previous period. If changes in inventory are negative then the company has more inventory on hand then last period. For investors an important ratio to measure how quickly a company is able to sell its inventory is the inventory turnover ratio. This ratio tells investors how quickly a company is able to sell its inventory.

Depreciation

Depreciation is an expense that is recorded on the income statement to reduce overall net income and lower taxes. However, the company didn’t actually pay any money. Over time assets decrease in value. Companies account for this decrease in value by using depreciation. Since they are not actually losing any money, because just the value of their equipment is going down the depreciation expense must be added back to cash on the statement of cash flows.

Amortization

Amortization is similar to depreciation some companies even combine these two numbers. Like depreciation, amortization is an expense the company incurred, but did not actually exchange any cash. Just like depreciation amortization expenses must be added back to cash on the statement of cash flows because the company did not actually lose any cash from this expense.

Adjustments to Net Income

Not all a company’s expenses have cash that actually exchanged hands. An example of this is depreciation and amortization costs. These are costs that the company incurred but did not actually use any cash. Adjustments to net income can be a number of different things depending on the company and its operating activities. To find out what this for a particular company look at its 10k or 10q.

Cash Flows From Investing Activities

Cash flows from investing activities report the changes in cash from a companies investments. This could be a reinvestment in itself, investments in subsidiaries, and/or investments in financial markets. In this section you will commonly see:
• Capital Expenditures
• Fixed Assets
• Other Cash Flows from Investing Activities

Lets look at each item one by one so you can understand how each item affects cash.

Capital Expenditures

Capital expenditures is a reinvestment of cash back into the company. This could be for a number of different things and the only way to find out exactly what a company used its cash for is in its annual and quarterly reports. An example of this would be if a newspaper company purchases a new printer. This would be an investment in itself so it could expand its operations or become more efficient. This number will always be negative because a company uses its cash to purchase new equipment or machinery.

Fixed Assets

This is an investments in fixed assets the company purchased or sold over the period. An example would be a company purchased or sold real estate during the period. This number represents the cash inflow or cash outflow from a company’s fixed assets. A positive number means the company sold more fixed assets then it purchased, and a negative number means it purchased more fixed assets then it sold.

Other Investments

Other investments are investments other than fixed assets. This could be the purchase or sale of another company, or the buying and selling of stocks and bonds. A positive number means the company sold its investments then it purchased, and a negative number means a company purchased more investments.

Cash Flows from Financial Activities

Cash flows generated from financial activities measures changes in external activities during the period. In this section you will commonly see:
• Dividends Paid
• Sale or Purchase of Stock
• Net Borrowings

Lets look at each item to see how it affects overall changes in cash for the period.

Dividends Paid

When a company pays dividends to investors it has to use it cash to make those payments. The total represents how much cash the company used to pay dividends during the period.

Sale of Purchase of Stock

A company will issue stock to raise cash. If this number is positive then the company sold more stock to raise funds. If the number is negative then the company purchased shares of its own stock. There are a number of reasons why a company would repurchase its own stock.

Net Borrowings

When a company wants to raise funds to expand it has two options issue stock or borrow money. Net borrowings are the changes in long-term debt the for the period. If the company takes on additional long-term debt it receives cash and if it pays down its long term debt it loses cash. If this number is positive it means the company took on more debt. If this number is negative it means the company paid down its long-term debt.

Changes In Cash and Cash Equivalents

Now that you understand each section of the rest of the statement of cash flows the final item changes in cash and cash equivalents. This number is calculated by summing up all the previous three section plus net income/net losses to determine if the company gained or lost cash during the period. A positive number means the company generated more cash during the period, and a negative number means the company lost cash during the period.

Cash is the most valuable asset a company has. It needs cash to pay its employees, purchase inventory, expand, etc. As an investor it’s important to understand how the company generated (or) lost its cash to fully understand the health of the business. Its not always a bad thing if a company loses cash over a particular period, and similarly its not always a good thing if it gained cash. By analyzing each item of the statement of cash flows you will be able to understand where cash was spent and where it was made.

To learn more on analyzing companies read my value investing, how to buy penny stocks, and how to diversify your portfolio articles.

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