The Statement of Cash Flows is a vital financial report that shows a company's cash inflows and outflows. It's split into three sections: operating, investing, and financing activities. This breakdown helps investors and managers understand where money is coming from and going.
By analyzing cash flows, you can gauge a company's financial health and flexibility. Key metrics like Operating Cash Flow and Free Cash Flow reveal if a business can sustain itself, grow, and handle unexpected challenges. Understanding cash flows is crucial for making smart financial decisions.
The Statement of Cash Flows
Purpose of cash flow statement
- Provides information about a company's cash inflows and outflows during a specific period (quarterly or annually)
- Helps stakeholders assess the company's liquidity measures its ability to meet short-term obligations (accounts payable)
- Demonstrates the company's solvency evaluates its ability to meet long-term debt obligations (bonds)
- Showcases the company's financial flexibility indicates its ability to adapt to changing economic conditions (recession)
Structure of cash flow statement
- Divided into three main sections: operating activities, investing activities, and financing activities
- Operating activities section reports cash flows related to the company's core business operations (sales of goods or services)
- Investing activities section presents cash flows related to the acquisition and disposal of long-term assets (equipment purchases)
- Financing activities section displays cash flows related to the company's financing activities, such as issuing or repaying debt and equity (bank loans or stock issuance)
Types of cash flow activities
- Operating activities
- Include cash inflows and outflows from the company's primary revenue-generating activities
- Cash inflows examples: cash received from customers (product sales), interest income earned (investments)
- Cash outflows examples: cash paid to suppliers (inventory purchases), employees (salaries), interest expense (loans), taxes paid (income taxes)
- Adjustments to net income: non-cash expenses like depreciation (equipment wear and tear), amortization (intangible assets), and changes in working capital (accounts receivable and inventory)
- Investing activities
- Include cash flows related to the purchase and sale of long-term assets
- Cash outflows examples: purchase of property, plant, and equipment (factories), acquisition of other companies (mergers), purchase of long-term investments (stocks or bonds)
- Cash inflows examples: proceeds from the sale of long-term investments (stocks or bonds), sale of property, plant, and equipment (land or buildings)
- Financing activities
- Include cash flows related to the company's financing activities
- Cash inflows examples: issuing long-term debt (bonds), issuing stock (IPO or secondary offering)
- Cash outflows examples: repaying long-term debt (loan payments), repurchasing stock (share buybacks), paying dividends to shareholders (quarterly or annual distributions)
Key cash flow metrics
- Operating cash flow (OCF)
- Represents the cash generated from a company's core business operations
- Calculation: $Net\ income + Non\text{-}cash\ expenses\ (depreciation,\ amortization) \pm Changes\ in\ working\ capital$
- A positive OCF indicates the company is generating sufficient cash from its operations to sustain and grow its business (expanding production)
- Free cash flow (FCF)
- Represents the cash available to the company after accounting for capital expenditures
- Calculation: $Operating\ cash\ flow - Capital\ expenditures$
- A positive FCF indicates the company has excess cash available for discretionary purposes, such as paying dividends (to shareholders), repurchasing shares (stock buybacks), or investing in growth opportunities (research and development)
- Interpreting cash flow metrics
- Higher OCF and FCF generally indicate a healthier financial position and greater financial flexibility (weathering economic downturns)
- Comparing a company's cash flow metrics to its industry peers provides insights into its relative financial performance and liquidity (benchmarking against competitors)
- Analyzing trends in cash flow metrics over time helps assess the company's ability to generate and sustain cash flows (long-term financial stability)
Accounting methods and additional considerations
- Accrual accounting vs. cash basis accounting
- Accrual accounting records revenues and expenses when they are earned or incurred, regardless of when cash is received or paid
- Cash basis accounting records transactions only when cash is received or paid
- Direct and indirect methods for preparing the statement of cash flows
- Direct method reports major classes of operating cash receipts and payments
- Indirect method starts with net income and adjusts for non-cash transactions and changes in working capital
- Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash
- Non-cash transactions, such as equipment purchases through lease agreements, are typically disclosed in footnotes to the cash flow statement