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2.05 The Cash Flow Statement Explained

The Cash Flow Statement is one of the three main financial statements, along with the Income Statement and the Balance Sheet (there are also Statements of Comprehensive Income and Statement of Stockholders’ Equity).  In the example below you can see a cash flow statement example from Microsoft.  This is just a reference for now, we will get into the details as we go through this material.

Cash Flow Statement Explained

Why do we care about the Cash Flow Statement?

Most large companies use accrual accounting.  When accrual accounting is used so revenue does not necessarily equal the cash that’s coming in and expenses do not necessarily show you the cash going out.  An example of this working would be a capitalized asset.  If a company buys a dump truck that is an expensive capital expenditure.  The company will actually have cash going out the door but if they use accrual accounting, they may only take one-fifth or one-seventh or one-tenth of the that amount as an expense in the year they purchase it.  The remaining expense they will amortize over the life of that asset (some number of years).  Similarly, on the revenue side a company like an airline may sell an airplane ticket to a passenger today and they charge that customer’s credit card (and get cash). 

However, the airline doesn’t actually earn that revenue until the passenger takes their flight.

The cash flow statement will help us understand the health of the company’s profit.  Does the company have enough cash coming along with their revenues?  It will also help reads of the cash flow statement understand if a company is liquid enough to meet its obligations can it pay for pay its creditors.  The cash flow statement will also give the information of a company has cash to grow and develop and if they have cash to invest (or if they already are investing) in new products and new business.

Indirect Cash Flow Statement vs. Direct Cash Flow Statement

Companies have two options for how to show their cash flows, the indirect method or the direct method. 

The direct method is a slightly simpler approach as it looks at

  • cash coming in cash (i.e. the cash collect from your customers)
  • +/- cash paid to suppliers/vendors
  • +/- cash paid for expenses
  • The sum of those is the cash flow from operating activities (CFOA)

The indirect method effectively backs into the cash flow number.

To get to a cash flow from operations number using the indirect method the starting point is net income and then you make adjustments.

  • Net Income
  • +/- Adjustment for depreciation
  • +/- adjustments for working capital and other accounts

The Sum of these is the Cash Flow from Operating Activates (CFOA)

The vast majority of public companies and most large private companies use in the indirect method.  The direct is simpler and frankly easier to understand.  It is what you would use for your own personal cash inflows and outflows as CFO of your personal life.  You know how much money you make, you know how much you spend, you know all the ins and the outs.  But with the volume and complexity of transactions for a big corporate it’s often much harder for a company to do the direct method and most companies use the Indirect method… which basically scraps the actual inflows and outflows in favor of backing into the number using the income statement and balance sheet.

Because the indirect cash flow statement is the prevailing statement used, we will concentrate on that for most of this.

Sources and Uses of Cash

Before getting into the details here, let’s take a minute to think through logically what happens in a business transaction and what is an accounts receivable when a person or company buys something from a company

A person or company purchases something and they then owe the company money.  The have a legal obligation to pay the company.  For this example, let’s say the company had zero dollars of sales and zero dollars of receivables January and February, but then in March the company sells (and ships) $1,000 of product all due to be paid by the customer in April. 

The accounts receivable at the beginning of the quarter was zero in the beginning of the first quarter, but at the end of the first quarter it is $1,000 end of the first quarter.

How much cash did the company collect?  The answer is $0.  The company sold something, but did not get paid.  That is a USE of cash for the company.  When looking at the statement of cash flows it’s important (and helpful) to think about sources and uses of cash (or inflows and outflows of cash). 

Staying with accounts receivable, If accounts receivable goes down that means more people paid the company money (reducing the AR balance).  The company got their cash, that’s an inflow or source of cash.  On the flip side, if AR goes up, that means more people owe the company money.  The company sold something and didn’t get paid (it is an outflow or use of cash). 

If inventory goes down that means a company sold more inventory than they built.  The company has less cash tied up in that inventory, meaning the company received cash for that inventory.  This is a source of cash (or cash inflow).  If inventory goes up that means they’re spending money to make stuff that they’re not selling that’s a use of cash.

If Accounts Payable goes up that means a company received supplies, but did not pay money for them (hence having a payable).  That’s a good thing for cash, the company is holding the cash instead of paying the supplier.  This is a source of cash (or inflow of cash).  If AP goes down that means the company has been paying suppliers, reducing that AP balance and having cash go out the door.  This is a use or cash or cash outflow. 

If Plant and Equipment down the company is probably spending less on new P&E, so you have less money going out the door.  This is a source (or cash inflow).  If P&E goes up that means the company is buying new machines or equipment and money is going out the door to pay for it, this is a use of cash (or cash outflow).

When a company takes out a new loan, that means the lender is giving the company cash.  This is money coming in the door, so it is a source of cash (or cash inflow).  On the flip side, if a company pays back a loan they’re giving cash back to that bank / lender.  This is a use of cash (or cash outflow). 

Source and Uses of Cash

It’s helpful to always think about the actual money and whether the account you are looking at results in cash coming in the door (getting a loan, collecting cash from customer, etc) or cash going out the door (paying suppliers, buying equipment, etc).  If you can get this concept to make sense in your head, I the rest of the indirect cash flow statement will make sense

The three types of cash flows … operating, investing, and financing

Tehre are three types of cash flows broken out on cash flow statement, operating, investing, and financing.  Let’s dig into each. 

Cash Flow from Operating Activities (CFOA)

Cash Flow from Operating Activities relate to cash that is coming in or going out for things that a business normally does.  This would be things like getting paid for selling a product or service, paying employees, paying your rent for a building, buying supplies needed to make a product, and more.  Put very simply, a company wants to collect more cash than they pay out.  Almost everything in the income statement that is revenue or expense is included in an indirect CFOA except for depreciation. 

Cash Flow from Operations

This is a great transition into how we walk CFOA.  As mentioned above, almost everything on the P&L that is a revenue or an expense is part of CFOA, so you start with revenue minus expense which equals net income.  However, depreciation is non-cash.  Recall from earlier, if you buy a capitalized asset it will depreciate over time, which disconnects the expense form the cash flow.  Depreciation is reducing net income on the income statement even though there’s no change in cash associated with the depreciation so we add depreciation back to Net Income on the CFOA walk. 

Next you have working capital.  This goes back to our sources and uses (inflows and outflows) discussion.   if accounts receivable goes down, that means more people paid cash, so that would be positive number.  See the image below for a full working capital example.   Once you work through the working capital accounts you arrive at the CFOA result.

Working Capital CFOA

A few final thoughts on CFOA

When you look at CFOA you’re trying to see if a company is generating cash flow from its normal operations or does it need to go get it somewhere else.  One thing that investors look at is if CFOA is in line with operating income.  As those approach equal, that is typically a signal of high quality earnings where sales are converting to cash.

It’s also important to consider that CFOA expectations should be different  for companies at different stages of the business life cycle. Companies that are early in their life are going to have a hard time generating CFOA in line with their income

A bank can also use CFOA combined with CFFA to derive if a company can generate enough cash to pay its obligations

Cash Flow from Investing Activities (CFIA)

Moving on to cash flow from investing activities.  CFIA is cash that’s coming in or going out related to investing back in the business.  This would cover things like a company buying or selling their building or land, purchasing or selling machines or equipment or other assets, it could also be buying or selling investments in other companies.

Thinking back to CFOA and how we add back depreciation to get to CFOA… In CFIA this is where you see the outflows for the purchases of assets.  As mentioned above, this coulc also relate to selling assets and the number shown CFIA is typically shown as one net amount. 

If a company is spending more than it is generating, cash flow for investing will be negative on the cash flow statement

Cash Flow from Financing Activities (CFFA)

Cash flow from financing activities is related to financing the business.  It’s aptly named as this part of the cash flow statement shows things like borrowing or repaying loans, getting capital from a bank, getting cash from an investor, or paying dividends out to your investors.  It could also include stock buybacks.  Public companies will sometimes do stock buybacks and this would be a financing activity.  The movement of cash and financing activities is typically between a company and a bank owner shareholder when a company takes out a loan or gets funding from its owners the cash is coming that’s

When a company takes out a loan, or gets funding from owners … cash is coming IN (positive on CFFA).  When a company pays back loans, buys back stock, or pays a dividend…cash is going OUT (negative on CFFA)

A few examples,

  • Debt… If a company borrows money from a bank that is a source of cash or inflow.  If they repay a loan it is a use or outflow
  • Stock … If a company issues common stock that is a source of cash or inflow.  If a company buys back stock that is a use of cash or outflow
  • Dividends… If a company pays dividends to shareholders that is a use of cash or outflow. 

Cash is still King

It’s important to understand the different pieces of the cash flow statement and start to get a feel for what trends are good and bad depending on the business, and how to look at the cash flow statement in conjunction with the other financial statement.  If cash isn’t managed well, there could be a profitable business with revenue > expenses, but is mismanaged on the cash front and they could go bankrupt!  At the end of the day cash is king, it is imperative to the long term success of a company

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