Cash Flow Statement: Explained
Every business has cash going in and going out. This is cash flow. A cash flow statement accounts for the cash moving in and out of the company. It reflects the cash impacts of revenues, expenses, capital investments, financing, and other items.
ra2studio/iStock via Getty Images
What Is a Cash Flow Statement?
The cash flow statement is one of three key financial statements generated by a business. The other two are a company's income statement and balance sheet. Cash flow statements are typically reported quarterly, and can be found in a company's 10-Q or 10-K filings.
A cash flow statement reports on three areas of business activities: operations, investments, and financing.
Operating activities include revenue generation, costs of goods sold, general expenses related to operations, and working capital changes. Working capital reflects the difference between current assets and current liabilities, and can change when a company chooses to maintain more or less in short-term assets.
Investing activities relate to capital expenditures and long-term investments such as debt and equity instruments of other companies. This section may also include new business acquisitions.
Financing activities include any stocks or bonds issued or repurchased by the company. Financing activities will also include dividend payments made by the company to investors. Essentially, any changes in long-term liabilities and shareholder equity are reported here.
Cash flow statements are often used with balance sheets and income statements to get a broad picture of the financial strength of a company and what stage the company is at (startup, growth, mature).
Takeaway: A positive cash flow statement means the company has more incoming cash than outgoing. This is a positive indicator.
Using & Analyzing a Cash Flow Statement
Since 1987, all publicly traded companies with listings filed with the Securities Exchange Commissions (SEC) must include cash flow statements in their quarterly and annual reporting.
Investors, creditors, and analysts often focus on a company's cash flow from operations (CFO). A positive CFO statement suggests the company is generating cash for potential growth and expansion, or to make distributions to shareholders. Creditors will evaluate a company's cashflows in assessing whether a company can afford to take on new debt.
Accrual Accounting
Another reason why a company's income statement will differ from cash flows in due to the usage of accrual accounting. Accrual accounting assesses when money is earned or expended rather than when money exchanges hands. A company might purchase inventory on December 30th but not actually pay for the inventory until the end of January. The accrual method will reflect that the inventory purchase was made before year-end, but on a cash basis no money has traded hands until January.
As an example, consider a company that sells a product for $1,000 but agrees to receive a downpayment of $250, plus three additional monthly payments of $250 each from the customer. Under the accrual method, the company immediately counts the whole $1,000 as revenue for the income statement. But the cash flow statement will only immediately reflect the initial downpayment of $250 that was collected.
3 Sections of a Cash Flow Statement
There are three parts making up the cash flow statement.
- Cash flow from operating activities is the money that flows in and out from business operations.
- Cash flow from investing can reflect the company’s investments into other companies or new assets such as real estate.
- Cash flow from financing highlights the fund movements from debt and equity financing.
Read on to learn more about each.
1. Cash Flows From Operations
Cash flow from operations is calculated by taking net income and adjusting out all noncash items. Companies with positive operational cash flow may have the resources to sustain growth, whereas those without enough cash flow may have a hard time sustaining existing operations activities. Companies with continuous negative cash flows may need to secure some form of additional financing to survive or grow.
There are two ways to calculate CFO:
- Direct method: involves adding and subtracting all cash inflows and outflows for the period
- Indirect method: begins with net income, and then makes adjustments for non-cash elements from the income statement
To calculate cash flow from operations using the indirect method, begin with net income (total revenues - total expenses). From this point, add depreciation, amortization, and deferred income taxes along with other prepaid items. Any increases to accounts receivable and inventories are subtracted while increased accounts payable and deferred revenue result in positive additions.
CFO = Net Income + Non-Cash Expenses - ∆ Other Current Assets + ∆ Current Liabilities
As an example, the cost of equipment depreciation is deducted in arriving at a company's net income, however, depreciation has no direct impact on cashflow. Therefore, the cost of depreciation can be added back to a company's net income in calculating cash flow from operations.
Learn more about cash flow vs. net income.
2. Cash Flows From Investing
Cash flows from investing may reflect cash outlays into a manufacturing plant, major equipment, and other real estate, or even capital investments into a subsidiary or joint venture. Divestitures are also accounted for in the cash flows from investing section. The higher the capital expenditure, the bigger drag it has on overall cash flow for the measurement period.
Comparing annual capital expenditures against annual depreciation may provide insight as to whether the company is growing its production base.
Tip: Companies that are expanding may be regularly investing in new property or equipment.
3. Cash Flows From Financing
The cash flow from financing (CFF) section accounts for dividend payments, new stock or bond issuances, as well as stock and bond repurchases. This section summarizes to investors whether the company has been increasing its capital base, and threw what means.
- When CFF is a positive number, it suggests that new capital is flowing into the company.
- When CFF is a negative number, it may indicate that the company is paying off debt and/or repurchasing stocks.
Cash Flow Statement Example
Let's take a look at a fictional company cash flow statement.
Cash Flow Statement - Peter Oda Dental Practice
Month Ending May 30, 2022
| Cash Flow From Operations | $ |
| Net Income | $75,000 |
| Depreciation | $10,000 |
| Increase In Accounts Payable | $8,000 |
| Increase In Accounts Receivable | ($20,000) |
| Cash Flow From Operations (CFO) | +$73,000 |
| Cash Flow From Investing | $ |
| Purchase of New Equipment | ($12,000) |
| Cash Flow From Investing (CFI) | ($12,000) |
| Cash Flow From Financing | $ |
| Notes Payable Issued | $7,500 |
| Cash Flow From Financing (CFF) | +$7,500 |
| CFO | $73,000 |
| CFI | ($12,000) |
| CFF | $7,500 |
| Net Change In Cash | +$68,500 |
This above example illustrates a simplified cash flow statement calculation. The dentist's equipment depreciated by $10,000, but because depreciation doesn't actually decrease cash on hand, it is added back to the net income. Accounts Payable rose by $8,000, indicating that the company is holding extra cash beyond what is reflected by its net income statement. Accounts receivable rose $20,000, suggesting that the company is waiting for customers to make payment, which is a drag on cash.
The dentist has invested $12,000 in new equipment for the business, and sought additional financing in the amount of $7,500.
For the reporting period, the dentist has experiences positive cash from operations, as well as a positive overall change in cash flow.
Limitations of Cash Flow Statements
A company's cash flow statement can look quite a bit different than their income statement. In many cases, one is positive and the other is negative. Many investors subscribe to the notion that cash is king, and that cashflow is less exposed to the subjectivity of accounting mechanisms and assumptions.
However, in certain circumstances a company's cash flow statement may yield an incomplete picture of how the business is doing. For instance, consider a company whose primary manufacturing facility is outdated and in need of replacement within the next year. However, the company has not yet invested in the construction of a new facility. This company's net income might be low, due to depreciation expense of the old facility, while the cash flows may look impressive. What's missing from the picture is the fact that the company desperately needs to invest in a new facility to keep their business running efficiently, but has avoided to do so thus far. Thus, the impressive positive cash flow might be misrepresenting the true state of this company and their business.
On the flip side, having a negative cash flow may seem unfortunate, on the surface. But if the company's negative cash flow related to, for example, investments in new machinery to help the company grow, it may be justified to overlook the negative cash flow.
Bottom Line
Understanding the cash flow statement helps investors assess the cash entering and exiting the company. There are 3 components to the cash flow statement, each revealing different types of cash flows.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.