The Cash Flow Statement
The importance of understanding and interpreting the cash flow statement
The cash flow statement is the most recent of the statements required to be prepared by publicly traded companies and provides important information for the investor that is not in the income statement or the balance sheet. The cash flow statement summarizes the cash that flows in and out of a company within a given period of time (quarterly or yearly). When analyzing stocks for a potential investment opportunity one of the things you should look for are companies that are capable of generating cash. As we’ll see shortly, the free cash flow a company generates is one of the key areas investors look for since this tends to enrich stockholders (through dividend payouts or business reinvestment for future higher potential returns).
While the income statement records revenues and expenses when the transaction takes place in accordance with the conventions of accrual accounting, the cash flow statement records the transaction only once cash is actually received or spent. A company can have an attractive income statement that shows large profits but at the same time it can lack sufficient cash to pay its employees and suppliers if all the company sales are made on a credit basis. This is why you always want to make sure to analyze all the financial statements of the company together.
The cash flow statement is divided into three parts: Cash flows from operating activities, cash flows from investing activities and cash flows from financing activities.
Let’s take a closer look at the three sections.
Cash flows from operating activities
The cash flows from operating activities refers to the cash generated from the company’s core business. Of the three sections, the cash flows from operating activities is the most important to the investor. The more cash the company can generate from its core business the more attractive the company is. In this section the net income from the income statement is shown and is then adjusted for the transactions that do not affect the flow of cash.
Cash flows from investing activities
The cash flows from investing activities records all the cash used or received from investments. These investments include both capital expenditures to keep the operations running, such as equipment, as well as monetary investments such as money market fund investments.
From the investors perspective, one of the most important calculations is the free cash flow which is the excess cash a company has generated which can then be used to reinvest in the company or payout dividends to the shareholders. The free cash flow is calculated by taking the net cash from the operating cash flow section and subtracting the capital expenditures (free cash flow = operating cash flow – capital expenditures). The more free cash flow a company can generate, the more attractive the potential investment.
Cash flows from financing activities
This section records all the transactions involving the company’s owners or creditors, such as dividend payouts, issuance of new common stock and the repurchase of common stock. Growth companies frequently issue new shares in order to raise capital to fund their growth business strategy, while more mature companies which generate large free cash flows tend to payout higher dividends to stockholders or repurchase their stock.