The cash flow statement tracks actual money moving in and out of a business. While the income statement can be manipulated through accounting choices, cash is concrete - either you have it or you do not. Many investors consider the cash flow statement the most important financial document.
Why Cash Flow Matters
A company can show profits on the income statement while actually running out of cash. The reverse is also true - a company can report losses while generating strong cash flow. Cash pays bills, funds growth, and survives downturns.
Key insight: "Cash is king" because earnings can be manipulated through accounting, but cash is real. Companies go bankrupt from lack of cash, not lack of profits.
The Three Sections of Cash Flow
The cash flow statement divides cash movements into three categories:
1. Operating Activities (CFO)
Cash generated from core business operations - the most important section for most investors.
Starting Point
Begins with net income from the income statement, then adjusts for non-cash items and changes in working capital.
Common Adjustments
- Add: Depreciation & Amortization: These reduce income but are not cash expenses
- Add/Subtract: Changes in Receivables: If receivables increased, cash was not collected
- Add/Subtract: Changes in Inventory: If inventory increased, cash was spent building it
- Add/Subtract: Changes in Payables: If payables increased, cash was conserved
- Add: Stock-Based Compensation: An expense that does not use cash
Positive Operating Cash Flow means the company generates more cash than it spends running the business. This is the foundation of a healthy company.
2. Investing Activities (CFI)
Cash spent on or received from long-term investments and assets.
Cash Outflows (Negative)
- Capital Expenditures (CapEx): Buying property, equipment, or other assets
- Acquisitions: Purchasing other companies
- Investment Purchases: Buying stocks, bonds, or other securities
Cash Inflows (Positive)
- Asset Sales: Selling property or equipment
- Investment Sales: Selling securities
- Divestitures: Selling business units
Negative Investing Cash Flow is often a good sign - it means the company is investing in future growth. Consistently positive investing cash flow may mean the company is selling assets to survive.
3. Financing Activities (CFF)
Cash from transactions with owners and creditors.
Cash Inflows (Positive)
- Issuing Stock: Selling new shares to raise capital
- Borrowing: Taking on new debt
Cash Outflows (Negative)
- Dividends: Cash payments to shareholders
- Share Buybacks: Repurchasing company stock
- Debt Repayment: Paying down loans
Negative Financing Cash Flow often indicates a mature company returning cash to shareholders through dividends and buybacks. Positive financing cash flow means the company is raising capital.
Real Example: Analyzing Cash Flow
Let us analyze a simplified cash flow statement (in millions):
Operating Activities
- Net Income: $1,000
- Add: Depreciation: $300
- Add: Stock Compensation: $100
- Subtract: Increase in Receivables: ($150)
- Subtract: Increase in Inventory: ($50)
- Add: Increase in Payables: $100
- Cash from Operations: $1,300
Investing Activities
- Capital Expenditures: ($400)
- Acquisitions: ($200)
- Cash from Investing: ($600)
Financing Activities
- Dividends Paid: ($250)
- Share Buybacks: ($300)
- Debt Repayment: ($100)
- Cash from Financing: ($650)
Summary
- Net Change in Cash: $50 ($1,300 - $600 - $650)
This is a healthy profile: strong operating cash flow, investing in growth, and returning cash to shareholders.
Key Metrics and Ratios
Free Cash Flow (FCF)
Cash available after maintaining and expanding the business.
Formula: Operating Cash Flow - Capital Expenditures
Example: $1,300 - $400 = $900 million
Free cash flow is what the company can use for dividends, buybacks, debt repayment, or acquisitions.
Operating Cash Flow to Net Income
Measures quality of earnings.
Formula: Operating Cash Flow / Net Income
Example: $1,300 / $1,000 = 1.3
A ratio above 1.0 indicates high-quality earnings. If this ratio is consistently below 1.0, earnings may not be backed by real cash.
Cash Flow Coverage Ratio
Ability to service debt from operations.
Formula: Operating Cash Flow / Total Debt
Higher ratios indicate better ability to handle debt obligations.
CapEx to Operating Cash Flow
How much of operating cash is reinvested in the business.
Formula: Capital Expenditures / Operating Cash Flow
Example: $400 / $1,300 = 31%
Lower percentages mean more cash available for shareholders.
What to Look For
Positive Signs
- Growing Operating Cash Flow: The business generates more cash over time
- CFO Exceeds Net Income: High quality earnings backed by cash
- Positive Free Cash Flow: Cash left after necessary investments
- Consistent Shareholder Returns: Regular dividends and buybacks from FCF
- Declining Debt: Using cash to strengthen the balance sheet
Red Flags
- Negative Operating Cash Flow: Core business burns cash
- CFO Much Lower Than Net Income: Earnings not converting to cash
- Constantly Issuing Stock: Diluting shareholders to fund operations
- Rising Debt to Fund Dividends: Unsustainable shareholder returns
- Selling Assets to Stay Afloat: Positive investing cash flow consistently
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Cash Flow vs Earnings
Why can these differ significantly?
- Accrual Accounting: Revenue recorded when earned, not when cash received
- Non-Cash Expenses: Depreciation, stock compensation reduce income but not cash
- Working Capital Changes: Inventory buildup, receivables collection affect cash
- Capital Expenditures: Cash outflows not on income statement
Always analyze cash flow alongside the income statement for the complete picture.
Cash Flow Patterns by Company Type
- Growth Companies: May have negative FCF as they invest heavily (negative CFI)
- Mature Companies: Strong FCF, returning cash to shareholders (negative CFF)
- Struggling Companies: Negative CFO, raising capital to survive (positive CFF)
- Turnaround Companies: Improving CFO trend is the key indicator
Summary
The cash flow statement tracks actual money moving through the business across three activities: operating (core business), investing (growth spending), and financing (shareholder and creditor transactions). Operating cash flow is the most important - it should be positive and ideally exceed net income. Free cash flow (CFO minus CapEx) shows cash available for shareholders. Watch for growing operating cash flow, CFO exceeding net income, and sustainable shareholder returns. Be cautious of negative operating cash flow, earnings far exceeding cash, and constant capital raises.
Learn more: free cash flow explained, income statement guide, and fundamental analysis basics.