Cash Flow Statement: How to Read and Understand It

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Natalya Yashina is a CPA, DASM with over 12 years of experience in accounting including public accounting, financial reporting, and accounting policies.

Introduction to Company Valuation

1. Business Valuation: 6 Methods for Valuing a Company
2. Valuation
3. Valuation Analysis

1. Financial Statements
2. Balance Sheet
3. Cash Flow Statement

1. 6 Basic Financial Ratios
2. 5 Must-Have Metrics for Value Investors
3. Earnings Per Share (EPS)
4. Price-to-Earnings Ratio (P/E Ratio)
5. Price-To-Book Ratio (P/B Ratio)
6. Price/Earnings-to-Growth (PEG Ratio)

Fundamental Analysis Basics

1. Fundamental Analysis
2. Absolute Value
3. Relative Valuation
4. Intrinsic Value of a Stock
5. Intrinsic Value vs. Current Market Value
6. Equity Valuation: The Comparables Approach
7. 4 Basic Elements of Stock Value
8. How to Become Your Own Stock Analyst
9. Due Diligence in 10 Easy Steps
10. Determining the Value of a Preferred Stock
11. Qualitative Analysis

Fundamental Analysis Tools and Methods

1. Stock Valuation Methods
2. Bottom-Up Investing
3. Ratio Analysis
4. What Book Value Means to Investors
5. Liquidation Value
6. Market Capitalization
7. Discounted Cash Flow (DCF)
8. Enterprise Value (EV)
9. How to Use Enterprise Value to Compare Companies
10. How to Analyze Corporate Profit Margins
11. Return on Equity (ROE)
12. Decoding DuPont Analysis

Valuing Non-Public Companies

1. How to Value Private Companies
2. Valuing Startup Ventures

What Is a Cash Flow Statement?

A cash flow statement is a financial statement that provides aggregate data regarding all cash inflows that a company receives from its ongoing operations and external investment sources. It also includes all cash outflows that pay for business activities and investments during a given period.

A company’s financial statements offer investors and analysts a portrait of all the transactions that go through the business, where every transaction contributes to its success. The cash flow statement is believed to be the most intuitive of all the financial statements because it follows the cash made by the business in three main ways:

• Operating activities: These include revenue and expenses derived from regular goods and services.
• Investment activities: These involve purchasing or selling assets—anything from real estate to patents—using free cash, not debt. They include both gains and losses.
• Financing activities: These involve debt and equity financing.

The sum of the cash generated by these three segments is called “net cash flow.” Each has its own section of the cash flow statement, which helps investors determine the value of a company’s stock or the company as a whole.

Key Takeaways

• A cash flow statement provides data regarding all cash inflows that a company receives from its ongoing operations and external investment sources.
• It includes cash made by the business through operations, investment, and financing—the sum of which is called “net cash flow.”
• The first section of the cash flow statement is cash flow from operations (CFO), which includes transactions from all operational business activities.
• Cash flow from investment (CFI) is the second section and the result of investment gains and losses.
• Cash flow from financing (CFF) is the final section, which provides an overview of cash used from debt and equity.

How Cash Flow Statements Work

Every company that sells and offers its stock to the public must file financial reports and statements with the U.S. Securities and Exchange Commission (SEC). The four main financial statements are:

• Balance sheet: This shows detailed information about a company’s assets, liabilities, and shareholders’ equity.
• Income statement: This shows a company’s revenue earned during a set time period, usually one year or less, plus the costs and expenses that went into earning the revenue.
• Cash flow statement: This shows all the inflows and outflows of the company’s cash. It helps interested parties gain insight into all the transactions that go through a company.
• Statement of shareholders’ equity: This shows changes in the interests of the company’s shareholders over time.

There are two different methods of accounting. They are:

• Accrual accounting: This method recognizes income when it’s earned, not when it’s received, and expenses when they are incurred, not when they are paid. It means that the income statement is not the same as the company’s cash position. Most public companies use accrual accounting.
• Cash accounting: This method recognizes income when the cash is actually received and expenses when they are paid. The cash flow statement is focused on cash accounting.

Profitable companies can fail to adequately manage cash flow, which is why the statement is so important for prospective investors and business analysts. Let’s consider a company that sells a product and extends credit for the sale to its customer. Even though it recognizes that sale as revenue, the company doesn’t yet have the cash. Nevertheless, it earns a profit on the income statement and pays income taxes on that profit. If it does this too often, it faces the danger of running out of cash despite technically being profitable.

Investors and analysts should use good judgment when evaluating changes to working capital, as some companies may try to boost their cash flow before reporting periods.

How a Cash Flow Statement Is Organized

As stated above, a cash flow statement is divided into three main parts: operations, investing, and financing. These break down as follows:

Cash Flows From Operations (CFO)

The first section of the cash flow statement covers cash flows from operating activities (CFO) and includes transactions from all operational business activities. The CFO section begins with net income, then reconciles all noncash items to cash items involving operational activities. In other words, it is the company’s net income, but in a cash version.

This section reports cash inflows and outflows that stem directly from a company’s main business activities. These activities may include buying and selling inventory and supplies and paying employee salaries. Any other forms of inflows and outflows, such as investments, debts, and dividends, are not included.

Companies must be able to generate sufficient positive cash flow for operational growth. If not enough is generated, they may need to secure financing for external growth to expand.

For example, accounts receivable is a noncash account. If accounts receivable go up during a period, it means sales are up, but no cash was received at the time of sale. The cash flow statement deducts these receivables from net income because they are not cash. The CFO section can also include accounts payable (debts that are incurred but not yet paid), depreciation, amortization, and numerous prepaid items that are booked as revenue or expenses but have no associated cash flow.

Cash Flows From Investing (CFI)

This is the second section of the cash flow statement. It looks at cash flows from investing (CFI) and is the result of investment gains and losses. It also includes cash spent on property, plants, and equipment. It is where analysts look to find changes in capital expenditures.

When capital expenditures increase, it generally reduces the cash flow. However, that’s not always a bad thing, as it may indicate that a company is making investments in its future operations. Companies with high capital expenditures tend to be those that are growing.

Positive cash flows within the CFI section, which can be generated in such ways as selling equipment or property, can be considered good. However, investors usually prefer that companies generate their cash flow primarily from business operations.

Cash Flows From Financing (CFF)

Cash flows from financing (CFF) is the last section of the cash flow statement. It provides an overview of cash used in business financing and measures cash flow between a company and its owners and creditors. The cash normally comes from debt or equity, such as selling stocks and bonds or borrowing from a bank. These figures are generally reported annually on a company’s 10-K report to shareholders.

Analysts use the CFF section to determine how much money the company has paid out via dividends or share buybacks. It’s also useful to help determine how a company raises cash for operational growth. Cash obtained or paid back from capital fundraising efforts and loans is listed here.

When the cash flow from financing is a positive number, it means there is more money coming into the company than flowing out. When the number is negative, it may mean the company is paying off debt or making dividend payments and/or stock buybacks.

Which Kinds of Cash Flows Show Up in Operations?

Cash inflows and outflows from business activities, such as buying and selling inventory and supplies, paying salaries, accounts payable, depreciation, amortization, and prepaid items booked as revenues and expenses, all show up in operations.

When Capital Expenditures Increase, What Happens to Cash Flow?

Generally, cash flow is reduced when capital expenditures increase, as the cash has been used to invest in future operations, thus promoting the company’s growth.

What Does a Negative Cash Flow From Financing Mean?

A negative number can show that a company is paying off debt, making dividend payments, or buying back its stock.

The Bottom Line

The cash flow statement has three key sections: operations, investments, and financing. Even if the business uses accrual accounting as its main reporting system, the cash flow statement is focused on cash accounting, allowing managers, analysts, and investors to assess how well a company is doing. Investors generally prefer that companies generate the bulk of their cash flow from operations rather than investing and financing. After all, operations are what a company is created to do.