Investing Classroom: Reading cash flow statements

Now that we've run through the income statement and balance sheet, it's time to take a look at arguably the most important as well as the most complex of the three major types of financial statements, the statement of cash flows. The statement of cash flows tells you how much cash went into and out of a company during a specific time frame, such as a quarter or a year. In other words, it shows how much cash a company is generating from one period to the next--and cash is what matters most.

What it tells you
The statement of cash flows seems similar to the income statement, which shows how much revenue came in and how many expenses went out. The difference lies in a concept called accrual accounting. As we’ve discussed, accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. The principle is known as matching--expenses must match the revenues those expenses created whenever possible. While that explanation seems simple enough, it gets messy in practice, and the statement of cash flows helps investors sort it out.

The statement of cash flows strips out all the abstract, noncash revenues and expenses that are included in the income statement. Many companies have shown profits on the income statement but have stumbled later because of insufficient cash flows. A good look at the statement of cash flows for those companies may have warned investors that rocky times were ahead.

Cash flows from operating activities
Because companies can generate cash in several different ways, the statement of cash flows is separated into three sections: cash flows from operating activities, from investing activities, and from financing activities.

The cash flows from operating activities section comes first and tells you how much cash the company generated from its core business, as opposed to peripheral activities such as investing or borrowing. This is the area you should focus most of your attention on because it paints the best picture of how well a firm's business operations are producing cash that will ultimately benefit shareholders. Some of the main line items found in this section are described below:

Net income: This figure is taken directly from a company's income statement. Net income is the starting point of how much cash a company provides from its operations. However, there are plenty of items on the income statement that affect income but don't affect cash flow, so all the remaining items are adjustments to net income that help you reconstruct how much actual cash was generated by the business.

Depreciation and amortisation: As we’ve mentioned, depreciation is accounting's way to record wear and tear on a company's property, plant, and equipment (PP&E). Even though it's an expense on the income statement, depreciation is not a cash charge, so it's added back to net income.

Changes in working capital: Working capital is calculated as current assets minus current liabilities on the balance sheet. Just as the name suggests, working capital is the money that the business needs to "work." Therefore, any cash used in or provided by working capital is included in the "cash flows from operating activities" section.

Any change in the balances of each line item of working capital from one period to another will affect a firm's cash flows. For example, if Company X's accounts receivable increased at the end of 2009, this means that the firm collected less money from its customers than it recorded in sales during that year on its income statement. This is a negative event for cash flow and is one of the reasons Company X's "net changes in current assets and current liabilities" on its 2009 cash flow statement would be negative. However, if accounts payable were also to increase, it means a firm is able to pay its suppliers more slowly, which is a positive for cash flow.

We're all about shortcuts to make financial statement analysis easier, so here's a little secret that's all you really need to remember regarding changes in working capital:

- If balance of an asset increases, cash flow from operations will decrease

- If balance of an asset decreases, cash flow from operations will increase

- If balance of a liability increases, cash flow from operations will increase

- If balance of a liability decreases, cash flow from operations will decrease

Current assets may include things like inventories and accounts receivable, while current liabilities would include short-term debt and accounts payable.

Net cash provided by operating activities: After all adjustments to net income are accounted for, what's left over is the net cash provided by operating activities, also known as operating cash flow. This number is not a replacement for net income, but it does provide a great summary of how much cash a company's core business has generated.

Cash flows from investing activities
This section of the cash flow statement shows the amount of cash firms spend on investments. Investments are usually classified as either capital expenditures--money spent on items such as new equipment or anything else needed to keep the business running--or monetary investments such as the purchase or sale of government bonds. The most important parts of this section for investors are typically the capital expenditures line item and the line item for acquisitions of other businesses.

Capital expenditures: This figure represents the amount of cash a company spent on items that last a long time, such as property, plant, and equipment (PP&E). Basically, capital expenditures--often referred to as "capex"--are brick-and-mortar types of investments that are necessary to keep the company running and growing in its current form. For example, in order for a supermarket to keep operating and growing, it will typically need to remodel its existing stores, replace its equipment, and build new stores. These expenditures will show up in the capex line item in the "cash flows from investing activities" section.

One of the most important terms and figures you should become familiar with is free cash flow. Free cash flow is calculated as net cash from operating activities minus capital expenditures. This figure represents the amount of excess cash a company generated, which can be used to enrich shareholders or invest in new opportunities for the business without hurting the existing operations. We can't emphasise enough that this figure--free cash flow--is one of the most important foundations in determining a company's ability to enrich its shareholders.

Cash used for acquisitions: The acquisitions line item refers to how much cash a company paid to acquire another. Because companies tend to overpay for acquisitions, it's a good idea to keep an eye on this line item to see how much cash a company is spending on acquisitions. This line item will also give you a good sense of how much of a company's growth is coming from internal sources versus acquisitions.

Cash flows from financing activities
The final section of the statement of cash flows is "cash flows from financing activities." This section includes any activities that involve the company's owners or creditors. For example, the issuance or purchase of common stock, the issuance or repayment of debt, and dividends paid to investors would be found in this section. Although these line items are pretty self-explanatory--dividends paid is exactly what it says--we think investors should look carefully at how much stock a company is issuing or repurchasing.

Issuance/purchase of common stock: This is an important number to look at because it shows how a company is financing its business. Newer companies and rapidly growing companies often need to issue lots of new stock to fund their growth. New stock issuance typically dilutes existing shareholders' ownership--they own a smaller piece of the whole pie--but it also gives the company cash to expand.

Meanwhile, mature companies that have ample free cash flow often will buy back their own stock, which has the effect of increasing the value of existing shares--existing shareholders own a bigger piece of the pie. Share repurchases and dividend payments are typically the only two ways a company can enrich its shareholders with its cash flows.

The bottom line
Congratulations! You've made it through some pretty in-depth coverage of the three most important financial statements. While this knowledge may not make you the life and soul of your next party, understanding how to read financial statements is a fundamental skill required to be a knowledgeable investor.

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