What is a cash flow statement?

The cash flow statement is one of the three essential financial statements investors must understand to analyze businesses.

The purpose of the cash flow statement statement is to track cash movement. It shows how cash moves through a company over a period of time, such as a quarter or year.

A company’s cash flow statement can be compared to your personal checking account. It doesn’t care about transactions of goods and services being sold or when sales contracts are signed. It only tracks when money is deposited or withdrawn from a company’s bank accounts.

Unlike the income statement and balance sheet, cash flow statements use cash accounting, not accrual accounting.

What the cash flow statement looks like

Here is a typical layout for the cash flow statement and an explanation of each row. Just remember, management has some discretion over the terms and categories used, and individual companies might use slight variations.

The cash flow statement's operating activities

Operating activities are equivalent to the money needed to run your household. This section begins with the net income, but then non-cash charges are added back. These are charges that were accounted for on the income statement but where no cash exchanged hands.

This commonly includes four things:

1) Amortization - The gradual writing off of an intangible asset, similar to paying more interest at the start of a mortgage.

2) Depreciation - The gradual writing off of a tangible asset, such as the value of your car decreasing over time.

3) Stock-based compensation - Compensating employees with stock instead of cash.

4) Asset impairment - When the market value of an asset is less than previously stated and is written down, such as a company admitting it paid too much for an acquisition.

All of these charges are accounted for on the income statement (though they are not always broken out), but none of them actually involve cash leaving a company’s bank account.

Continuing with operating activities, changes in working capital are the difference between current assets and current liabilities (both from the balance sheet). This can include accounts receivable (e.g., when someone pays for a good or service using credit), inventory that has yet to be sold, or prepaid expenses.

This brings us to operating cash flow. It is the cash generated from normal business operations, similar to net income from the income statement on a cash basis.

The cash flow statement's investing activities

Investing activities are funds used to invest back in the business, either for growth or to maintain assets. This is cash used beyond the scope of a company’s daily operations, such as building a new factory or acquiring another business.

It’s similar to remodeling your kitchen or painting your house. That’s not running your household; that’s maintaining and investing in your home.

The cash flow statement's financing activities

Financing activities are cash flows in and out based on financial activity. For public companies, this includes issuing bonds or new stock (producing positive cash flow), paying dividends, or buying back shares (generating negative cash flow).

What is free cash flow?

Investors should pay attention to one additional metric: free cash flow. It's one of the most essential numbers a business generates, but it isn't always shown on the cash flow statement.

Free cash flow results from subtracting capital expenditures (CapEx) from operating cash flow. CapEx are funds a company uses to build new or maintain existing physical assets, such as factories, equipment, and machinery.

How the cash flow statement connects to the other financial statements

Lastly, the bottom section of the cash flow statement shows the cash the company started with at the beginning of the quarter or year and compares it with the money it ended the period with.

The cash the company ends with is also shown on top of the balance sheet’s assets section in the cash and cash equivalents line.

So, the cash flow statement begins with net income from the bottom of the income statement and ends with cash and cash equivalents at the top of the balance sheet. This is how all three financial statements connect to show a complete 360 view of a company's financial performance.

Key Takeaway

So why do investors say that "cash is king"?

Many companies can appear profitable on their income statements despite never generating positive free cash flow.

Positive free cash flow gives companies vital flexibility, allowing them to invest for growth, make long-term strategic moves, and reward shareholders.

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