Just about everyone has heard the phrase “cash is king” in investing. That’s true for business finances, too.
Cash flow is how businesses pay their employees, buy materials and cover basic expenses. Companies need cash to pay down debt, invest in the business and pay shareholder dividends.
A cash flow statement shows businesses and investors the financial state of a company, says Dan White, founder of the financial planning firm Daniel A. White & Associates. Part of the mandatory financial quarterly reports that companies release, cash flow statements are just as important for investors to evaluate as balance sheets.
“Over the long term, stock price is closely tied to cash flow from operations,” says Rob Stevens, a financial planning strategist at TIAA. To stay solvent and attract investors, companies must generate more cash than they pay out for expenses and debt repayments.
“Companies with stable increasing cash flows from operations are in a better position to weather economic downturns than those with volatile or decreasing cash flows,” he says. “Investors looking to compare companies within a particular industry can gain a better understanding of each company’s financial strength by comparing cash flow statements.”
With this in mind, here is what investors should understand about cash flow statements:
— What is a cash flow statement?
— The structure of a cash flow statement.
— How a cash flow statement is prepared.
— Using cash flow metrics.
What Is a Cash Flow Statement?
A simple definition of a cash flow statement is how money, that is cash and cash equivalents, enters and exits a company.
“A company’s cash flow statement ultimately looks at how well a company manages the cash they have,” says Hollina Wadsworth, a CFP and assistant vice president at Baker Boyer. It can reveal how liquid a company is, “meaning how much cash is available to pay for any debts or operating expenses.”
A company with strong free cash flow is like a person with an emergency fund — it is money firms can rely on during economic downturns.
The Structure of a Cash Flow Statement
Three of the main components of a cash flow statement are cash from operating activities, cash from investing activities and cash from financing activities.
Cash From Operating Activities
The operating section shows how much cash a business has coming in and going out as part of its daily operations, says Daniel Rodriguez, director of operations at Hill Wealth Strategies. It will include cash received from customers or other operating activities and cash outflows for operations such as payroll, inventory purchases, rent, interest payments, and research and development.
Operating cash flow is where the detailed adjustments occur to reflect swings in a company’s working capital, which can positively or negatively impact actual cash flow.
Cash From Investing Activities
Cash flows that are not for daily operations often fall under the cash flow from investing activities section. “These may include the purchase or sale of assets, such as property, plant and equipment,” White says. When a company buys or sells a long-term asset, it gets recorded under cash from investing activities.
Cash flow generated from the sale of securities, such as stocks and bonds, is also included in this section. It essentially “recognizes any source or use of cash from a company’s investments,” Stevens says. “Purchases or sales of assets, loans made to investors or received from customers, or payments tied to a merger or acquisition all fit in this category.”
Net cash flow from investing activities can sometimes be negative if a company is investing in long-term assets, which can be a good sign.
Cash From Financing Activities
“Financing activities shows how a business raises its capital and pays back its debts,” Rodriguez says. This includes cash outflows for stock buybacks, dividend payments or to repay debt. It also includes cash received from loans or issuing stock.
“If a company issues bonds to the public the company receives cash financing, but when interest is paid to bondholders the company’s cash is reduced,” Stevens says.
A large, positive net cash flow from financing activities can mean a company is accumulating a lot of debt or is using debt to grow.
How a Cash Flow Statement Is Prepared
Companies are required to produce cash flow statements along with their other financial reports. They may be prepared monthly, quarterly or annually.
A cash flow statement starts with net income from the income statement and adds in depreciation and amortization, which are recognized as noncash expenses. The company then works through all the adjustments made throughout the quarter to come to the actual cash flow.
“These adjustments are made because noncash items are included on the income statement and impact total assets and liabilities on the balance sheet,” Stevens says.
He says there are two ways to calculate cash flow: the direct cash flow method and the indirect cash flow method.
“The direct method adds up cash payments and receipts from various business accounts within the company based on beginning and ending balances, and determines the net increase or decrease in the accounts,” according to Stevens.
The indirect method starts with net income as reported on the income statement and subtracts nonoperating activities such as sale of a property, he says. “It also adjusts for the fact that the income statement only recognizes revenue when it is earned rather than received.” Then depreciation is added back to calculate the final cash flow.
Using Cash Flow Metrics
Cash flow metrics help value a company’s financial health, especially as accounting practices for recognizing earnings and assets have morphed over the years.
Useful cash flow metrics include free cash flow. To get from operating cash flow to free cash flow, subtract the company’s capital expenditures from the cash received from operations. The leftover money is the free cash flow.
High free cash flow is usually a positive sign, but it can be a red flag if the firm’s capital expenditures are consistently below asset depreciation and amortization. This could mean a company is potentially underinvesting in its business over the long term, and the cash flow its reporting is overstated and unsustainable.
Cash flow yield, which is free cash flow divided by a company’s enterprise value — the stock’s market capitalization minus net debt — can often be more helpful than a price-to-earnings ratio because of the practice of some companies to smooth out earnings to meet or exceed previously given guidance. Cash flow analysis can help confirm or refute what’s being reported as earnings.
Investors may look at a company’s balance sheet and its profit and loss statement, which lists the accounting entries that show the net income of the operating business. But that doesn’t show how much cash the firm has to pay down debt or to buy raw materials, and it doesn’t show how efficiently a company collects its accounts receivable. Those details are on the cash flow statement.
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Update 03/29/21: This story was published at an earlier date and has been updated with new information.