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If a company reports earnings of $1 billion, does this mean it has this amount
of cash in the bank? Not necessarily. Financial statements are based on accrual
accounting, which takes into account non-cash items. It does this in an effort
to best reflect the financial health of a company. However, accrual accounting
may create accounting noise, which sometimes needs to be tuned out so that it's
clear how much actual cash a company is generating. The statement of cash flow
provides this information, and here we look at what cash flow is and how to
read the cash flow statement.
What Is Cash Flow?
Business is all about trade, the exchange of value between two or more parties,
and cash is the asset needed for participation in the economic system. For this
reason - while some industries are more cash intensive than others - no
business can survive in the long run without generating positive cash flow per
share for its shareholders. To have a positive cash flow, the company's
long-term cash inflows need to exceed its long-term cash outflows. (For more,
see What Is Money?)
An outflow of cash occurs when a company transfers funds to another party
(either physically or electronically). Such a transfer could be made to pay for
employees, suppliers and creditors, or to purchase long-term assets and
investments, or even pay for legal expenses and lawsuit settlements. It is
important to note that legal transfers of value through debt - a purchase made
on credit - is not recorded as a cash outflow until the money actually leaves
the company's hands.
A cash inflow is of course the exact opposite; it is any transfer of money that
comes into the company's possession. Typically, the majority of a company's
cash inflows are from customers, lenders (such as banks or bondholders) and
investors who purchase company equity from the company. Occasionally cash flows
come from sources like legal settlements or the sale of company real estate or
equipment.
Cash Flow vs Income
It is important to note the distinction between being profitable and having
positive cash flow transactions: just because a company is bringing in cash
does not mean it is making a profit (and vice versa).
For example, say a manufacturing company is experiencing low product demand and
therefore decides to sell off half its factory equipment at liquidation prices.
It will receive cash from the buyer for the used equipment, but the
manufacturing company is definitely losing money on the sale: it would prefer
to use the equipment to manufacture products and earn an operating profit. But
since it cannot, the next best option is to sell off the equipment at prices
much lower than the company paid for it. In the year that it sold the
equipment, the company would end up with a strong positive cash flow, but its
current and future earnings potential would be fairly bleak. Because cash flow
can be positive while profitability is negative, investors should analyze
income statements as well as cash flow statements, not just one or the other.
What Is the Cash Flow Statement?
There are three important parts of a company's financial statements: the
balance sheet, the income statement and the cash flow statement. The balance
sheet gives a one-time snapshot of a company's assets and liabilities (see
Reading the Balance Sheet). And the income statement indicates the business's
profitability during a certain period (see Understanding The Income Statement).
The cash flow statement differs from these other financial statements because
it acts as a kind of corporate checkbook that reconciles the other two
statements. Simply put, the cash flow statement records the company's cash
transactions (the inflows and outflows) during the given period. It shows
whether all those lovely revenues booked on the income statement have actually
been collected. At the same time, however, remember that the cash flow does not
necessarily show all the company's expenses: not all expenses the company
accrues have to be paid right away. So even though the company may have
incurred liabilities it must eventually pay, expenses are not recorded as a
cash outflow until they are paid (see the section "What Cash Flow Doesn't Tell
Us" below).
The following is a list of the various areas of the cash flow statement and
what they mean:
Cash flow from operating activities - This section measures the cash used or
provided by a company's normal operations. It shows the company's ability to
generate consistently positive cash flow from operations. Think of "normal
operations" as the core business of the company. For example, Microsoft's
normal operating activity is selling software.
Cash flows from investing activities - This area lists all the cash used or
provided by the purchase and sale of income-producing assets. If Microsoft,
again our example, bought or sold companies for a profit or loss, the resulting
figures would be included in this section of the cash flow statement.
Cash flows from financing activities - This section measures the flow of cash
between a firm and its owners and creditors. Negative numbers can mean the
company is servicing debt but can also mean the company is making dividend
payments and stock repurchases, which investors might be glad to see.
When you look at a cash flow statement, the first thing you should look at is
the bottom line item that says something like "net increase/decrease in cash
and cash equivalents", since this line reports the overall change in the
company's cash and its equivalents (the assets that can be immediately
converted into cash) over the last period. If you check under current assets on
the balance sheet, you will find cash and cash equivalents (CCE or CC&E). If
you take the difference between the current CCE and last year's or last
quarter's, you'll get this same number found at the bottom of the statement of
cash flows.
In the sample Microsoft annual cash flow statement (from June 2004) shown
below, we can see that the company ended up with about $9.5 billion more cash
at the end of its 2003/04 fiscal year than it had at the beginning of that
fiscal year (see "Net Change in Cash and Equivalents"). Digging a little
deeper, we see that the company had a negative cash outflow of $2.7 billion
from investment activities during the year (see "Net Cash from Investing
Activities"); this is likely from the purchase of long-term investments, which
have the potential to generate a profit in the future.Generally, a negative
cash flow from investing activities are difficult to judge as either good or
bad - these cash outflows are investments in future operations of the company
(or another company); the outcome plays out over the long term.
The "Net Cash from Operating Activities" reveals that Microsoft generated $14.6
billion in positive cash flow from its usual business operations - a good sign.
Notice the company has had similar levels of positive operating cash flow for
several years. If this number were to increase or decrease significantly in the
upcoming year, it would be a signal of some underlying change in the company's
ability to generate cash.
Digging Deeper into Cash Flow
All companies provide cash flow statements as part of their financial
statements, but cash flow (net change in cash and equivalents) can also be
calculated as net income plus depreciation and other non-cash items.
Generally, a company's principal industry of operation determine what is
considered proper cash flow levels; comparing a company's cash flow against its
industry peers is a good way to gauge the health of its cash flow situation. A
company not generating the same amount of cash as competitors is bound to lose
out when times get rough.
Even a company that is shown to be profitable according to accounting standards
can go under if there isn't enough cash on hand to pay bills. Comparing amount
of cash generated to outstanding debt, known as the operating cash flow ratio,
illustrates the company's ability to service its loans and interest payments.
If a slight drop in a company's quarterly cash flow would jeopardize its loan
payments, that company carries more risk than a company with stronger cash flow
levels.
Unlike reported earnings, cash flow allows little room for manipulation. Every
company filing reports with the Securities and Exchange Commission (SEC) is
required to include a cash flow statement with its quarterly and annual
reports. Unless tainted by outright fraud, this statement tells the whole story
of cash flow: either the company has cash or it doesn't.
What Cash Flow Doesn't Tell Us
Cash is one of the major lubricants of business activity, but there are certain
things that cash flow doesn't shed light on. For example, as we explained
above, it doesn't tell us the profit earned or lost during a particular period:
profitability is composed also of things that are not cash based. This is true
even for numbers on the cash flow statement like "cash increase from sales
minus expenses", which may sound like they are indication of profit but are
not.
As it doesn't tell the whole profitability story, cash flow doesn't do a very
good job of indicating the overall financial well-being of the company. Sure,
the statement of cash flow indicates what the company is doing with its cash
and where cash is being generated, but these do not reflect the company's
entire financial condition. The cash flow statement does not account for
liabilities and assets, which are recorded on the balance sheet. Furthermore
accounts receivable and accounts payable, each of which can be very large for a
company, are also not reflected in the cash flow statement.
In other words, the cash flow statement is a compressed version of the
company's checkbook that includes a few other items that affect cash, like the
financing section, which shows how much the company spent or collected from the
repurchase or sale of stock, the amount of issuance or retirement of debt and
the amount the company paid out in dividends.
The Bottom Line
Like so much in the world of finance, the cash flow statement is not
straightforward. You must understand the extent to which a company relies on
the capital markets and the extent to which it relies on the cash it has itself
generated. No matter how profitable a company may be, if it doesn't have the
cash to pay its bills, it will be in serious trouble.
At the same time, while investing in a company that shows positive cash flow is
desirable, there are also opportunities in companies that aren't yet cash-flow
positive. The cash flow statement is simply a piece of the puzzle. So,
analyzing it together with the other statements can give you a more overall
look at a company' financial health. Remain diligent in your analysis of a
company's cash flow statement and you will be well on your way to removing the
risk of one of your stocks falling victim to a cash flow crunch.
by Investopedia Staff
Investopedia.com believes that individuals can excel at managing their
financial affairs. As such, we strive to provide free educational content and
tools to empower individual investors, including thousands of original and
objective articles and tutorials on a wide variety of financial topics.