The cash flow statement helps investors answer questions like: Is the company generating enough cash needed to fund growth? Is growth outpacing cash generation, requiring additional financing? Is the company generating enough cash to cover its short-term needs?
In times of easy credit, companies may be able to patch over cash flow interruptions with interim financing; during tighter credit markets, though, such financing may not be as readily available. In those situations, steady cash-flow generated by the company's operations becomes especially important.There are three big categories of cash flow to pay attention to here. Word of warning: it's not always crystal-clear from just glancing at a cash flow statement which line items represent cash flowing IN versus cash flowing OUT. Cash generated by and used by the company's operations is summarized in the Net Cash Flow — Operating Activities line. That line includes cash flowing in as well as cash-out.
The company's long-term investing of cash is detailed in the Net Cash Flow — Investing line. That consists of cash flowing out. The third and last part, the Net Cash Flow — Financing line, shows the cash a company raised through from financing activities. That's cash that came in.
The very bottom line shows the net change in the company's cash position. If you add the line to the cash on the balance sheet from the previous year, you'll get the current cash position on the current year's balance sheet.
Reading a cash flow statement: Operating Cash Flows
That's the top level of categories, so let's dig into the specifics a bit. The cash flow statement starts with Net Income, a figure which comes from the income statement. You'll notice next Depreciation, Depletion & Amortization is added back in. These costs impact the company's profitability but aren't, literally speaking, cash flows out of the company. You could safely call these paper losses.
Depreciation is deducted when determining a company's net profit, because it's assumed that the things being depreciated have lost value. The rest of the top of the statement provides a more detailed explanation as to where cash came from and was used in operations.
Things like a change in Accounts Payable and Inventory can change the company's cash position. For example, this line item would include things like bills the company hasn't yet paid — that's cash the company still technically has on hand. Another item you might note in this section is increases in inventory, which costs the company some cash. The subtotal for Net Cash Flow — Operating Activities will usually be a positive figure, indicating cash flowing in.
Reading a Cash Flow Statement: Investing and Financing Cash Flows
If the company takes on new fixed assets like equipment or additional plants, that's an example of investing-based cash flows. The investing section of a cash flow statement may also include new assets acquired during a merger, disposal of fixed assets that were previously on the books, and other items.
The Net Cash Flow — Investing line will be either positive or negative, indicating whether net cash flowed out or in due to investing activities.
When we talk about cash flows from financing, keep in mind that financing might mean cash is coming in, if the company takes on new debt, or flowing out, if they choose to pay down debts. The financing section of the statement may also include cash dividends paid out to common or preferred stockholders, purchases or conversions of the company buying its own stock on the open market, the effects of foreign currency fluctuations and other items. Again, the Net Cash Flow — Financing line is either a positive or negative number, telling you whether net cash flowed out or in due to financing.
A cash flow statement may feel like a dry record of cash shunting from the plus to the minus columns and back again. It's only in closer inspection and comparison of statements over time that interesting discrepancies can reveal themselves. For example, say while comparing cash flow statements for a company over several years, you notice a sizeable jump in a company's Receivables item. This may simply be an accounting change and not mean much in real terms. However, if that's not the case, a jump in Accounts Receivables might mean the company is having a harder time collecting from its customers — an important shift that the company will naturally not seek to advertise. It's nuggets like these that reward the patient work of an investor willing to dig through financial statements to find potential red flags or opportunities unseen by the less-observant eye.