Cash Flow Statement: How to Read and Understand It

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.

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.

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.

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.