Cash Flow Statement Basics

The cash flow statement reveals the truth about a company's finances. While income statements can be manipulated through accounting choices, cash is cash—it either came in or it went out. [DEFINITION] Cash Flow Statement: A financial statement showing how cash moved in and out of a company during a specific period, categorized by operating, investing, and financing activities. ### Why Cash Flow Matters [KEY] A company can show profits on the income statement while actually burning cash. The cash flow statement exposes this disconnect. **Famous example:** Enron reported billions in profits but was hemorrhaging cash—a warning sign many ignored before its collapse. ### The Three Sections **1. Operating Cash Flow (OCF)** Cash generated from core business operations. Starts with net income, then adjusts for: - Non-cash items (depreciation, stock compensation) - Changes in working capital (inventory, receivables, payables) [TIP] Healthy companies generate more operating cash flow than net income. If net income consistently exceeds OCF, investigate why. **2. Investing Cash Flow** Cash used for or generated from investments. Includes: - Capital expenditures (buying equipment, property) - Acquisitions - Buying/selling investments - **Usually negative for growing companies** **3. Financing Cash Flow** Cash from financing activities. Includes: - Issuing or repaying debt - Issuing or buying back stock - Paying dividends [EXAMPLE] Apple Cash Flow (Simplified, Billions): | Activity | Amount | |----------|--------| | Operating Cash Flow | +$110B | | Investing Cash Flow | -$8B | | Financing Cash Flow | -$95B | | **Net Change in Cash** | +$7B | Apple generates massive operating cash, invests some in growth, and returns most to shareholders through buybacks and dividends. ### Free Cash Flow: The Key Metric [DEFINITION] Free Cash Flow (FCF): The cash left over after a company pays for operations and capital expenditures—available for dividends, buybacks, debt reduction, or investment. [FORMULA] Free Cash Flow = Operating Cash Flow - Capital Expenditures [EXAMPLE] Company generates $100M in operating cash flow and spends $30M on capital expenditures. FCF = $100M - $30M = $70M This $70M can be used to: - Pay dividends - Buy back shares - Pay down debt - Make acquisitions - Save for future opportunities ### Comparing Income to Cash Flow | Scenario | Net Income | Cash Flow | Interpretation | |----------|-----------|-----------|----------------| | Healthy | $100M | $120M | Real profits + good cash conversion | | Warning | $100M | $50M | Profits not converting to cash | | Red Flag | $100M | -$20M | Reported profits but burning cash | [WARNING] Red flags in cash flow: - OCF consistently below net income - FCF negative year after year - Heavy reliance on financing (issuing debt/stock) to fund operations - Working capital consuming increasing cash ### Cash Conversion Quality **Why OCF can exceed net income (good signs):** - Depreciation adds back (non-cash expense) - Accounts receivable declining (collecting faster) - Inventory declining (selling efficiently) **Why OCF can be below net income (concerning):** - Receivables ballooning (trouble collecting) - Inventory piling up (not selling) - Aggressive revenue recognition [EXERCISE] A company reports Net Income of $50M. Operating Cash Flow is $30M. Capital Expenditures are $40M. Calculate FCF and interpret the situation. |ANSWER| FCF = $30M - $40M = -$10M. Despite reporting $50M profit, the company is actually burning $10M in cash after necessary investments. This is unsustainable—they'll need to borrow or issue stock to continue. ### Cash Flow Trends Look at 3-5 years of data: - Is OCF growing over time? - Is FCF positive and growing? - Is the company self-funding or relying on external capital? [SCENARIO] Two tech companies: - **Company A:** $100M net income, $130M OCF, $80M FCF - **Company B:** $100M net income, $60M OCF, -$20M FCF Both report identical profits, but Company A generates real cash while Company B burns it. Company A is the stronger business. This is why cash flow analysis is essential for fundamental investors.