What is the Cash Flow Statement?
The cash flow statement is one of four financial statements a company produces quarterly and annually and covers the entire reporting period.
The purpose of the cash flow statement is to show how much cash went into the company (e.g. through sales or financing activities), and how much cash left the company (e.g. through investments, dividend payments, or share buybacks).
Structure of the Cash Flow Statement
The cash flow statement is split into three sections, each representing a different type of cash source or use:
- Cash from operating activities: any cash accumulated by the company’s operations, summarized by net income, plus any non-cash items.
- Cash from investing activities: includes items related to long-term investments, such as capital expenditures (CapEx) and any other investing cash flow items.
- Cash from financing activities: cash in and outflows from financing related items, such as dividend payments, and share issuance and buybacks.
The sum of all three sections is the net change of cash.
Note that any cash inflows are positive, and any cash outflows are listed as negative numbers.
Section 1: Cash from Operating Activities
The first section of the cash flow statement is cash from operating activities. It contains the net income, and any non-cash items. Together, these reflect the total cash generated by the company’s operations.
Net Income
The net income reported on the cash flow statement is the same as the net income on the income statement.
Depreciation and Amortization
Depreciation and amortization are also reported on the income statement. These are non-cash expenses. While reported as expenses, no actual cash left the company. To reflect this non-cash nature, these are added back to the net income on the cash flow statement.
Deferred Taxes and Investment Tax Credit
Deferred taxes are taxes due in a future reporting period. Therefore, the deferred taxes don’t necessarily match the net income and tax rate of the current reporting period. However, deferred taxes result in cash in or outflows, and must be recorded on the cash flow statement.
An investment tax credit represents a tax incentive for business investments, allowing companies to deduct a certain percentage of investment costs from their taxes.
Other Non-Cash Items
Other non-cash items are cash in or outflows resulting from other non-cash items that reduce the net income on the income statement.
An example could be net interest income and expenses, incurred due to exchange rate variations.
Another example could be extraordinary income or losses, or stock-based compensation. For instance, when a company sells an asset, the difference in sales price and carrying value on the company’s books is either recorded as a gain or loss on the income statement. Because this difference doesn’t result in any cash in or outflows, it’s a non-cash item that needs to be added back to net income as part of the operating cash (the actual sale price, which does result in a cash inflow, is recorded in the cash from investing activities section).
Changes in Working Capital
Working capital is the difference between current assets and current liabilities, recorded on a company’s balance sheet, and an essential part in funding day to day operations. A positive working capital means the company can cover its current liabilities in full.
A change in working capital occurs if the difference between current assets and current liabilities increases or decreases from the previous reporting period to the current reporting period. This difference is then recorded on the cash flow statement, as it represents real cash in or outflows.
Total Cash from Operating Activities
Total cash from operating activities is the sum of all items of the first section.
Section 2: Cash from Investing Activities
The second section of the cash flow statement is cash from investing activities.
It lists cash used for long-term investments, which includes capital expenditures, and cash generated, for example by lending money or by selling investment securities.
Capital Expenditures (Cap Ex)
Capital expenditures are the costs related to acquiring or maintaining long-term assets, such as building a new factory, warehouse, a new server farm, or manufacturing equipment. This also include intangible assets such as patents.
In other words, CapEx is the cash spent on long-term investments that get depreciated or amortized over time. CapEx is often a necessary component of a company’s strategy to ensure the long-term health of the company.
Depending on the type of business and the competitive landscape, some companies require large investments. Large capital expenditures over many years can eat significantly into profits due to increasing depreciation and amortization, thus reducing net income and therefore the return in invested capital.
For this reason, in general, companies with a smaller portion of capital expenditures to earnings or capital expenditures to sales should be preferred.
Other Investing Cash Flow Items
Other investing cash flow items could include the purchase or sale of stock, or lending money.
Total Cash from Investing Activities
Total cash from investing activities is the sum of capital expenditures and other investing cash flow items.
Section 3: Cash from Financing Activities
The third section of the cash flow statement is cash from financing activities. It lists items related to how the company returns cash to shareholders, and how it finances its operations through equity or debt.
Cash Dividends Paid
When a company decides to pay its shareholders a cash dividend, the value is noted under cash dividends paid.
Repurchase of Common and Preferred Stock
When a company repurchases its own common or preferred stock, the dollar value of the shares is recorded under repurchase of common and preferred stock.
In contrast to paying dividends to shareholders, for which the shareholders have to pay income tax, share buybacks are a tax-free way for the company to increase the value for its shareholders.
A share repurchase reduces the number of outstanding shares and therefore increases the amount of partial ownership of each shareholder. This also leads to increased earnings and free cash flow per share.
Sale of Common and Preferred Stock
When a company issues new shares to the public, the corresponding value is recorded on the line item sale of common & preferred stock.
Selling new shares is a way for a company to raise capital. Companies with durable competitive advantages that generate sufficient free cash flow shouldn’t have much reason to issue new shares. From a shareholder’s perspective, issuance of new shares dilutes the ownership percentage of each shareholder.
Issuance (Retirement) of Debt
Issuance (retirement) of debt is a net account that shows the extent to which a company takes on debt compared to how much debt it pays down.
A positive number means more debt has been taken on than paid back, resulting in cash inflows. A negative number indicates cash outflows, meaning more debt has been paid back than taken on.
Total Cash from Financing Activities
Total cash from financing activities is the sum of cash dividends paid, repurchase and sale of common and preferred stock, as well as issuance/retirement of debt.
Net Change in Cash
Finally, combining the cash from operating, investing and financing activities either results in a positive or negative net change in cash. This is an important indicator that tells investors whether the company is able to bring in more cash than goes out, or vice versa.