Cash Flow Statement

What is the Cash Flow Statement?

The cash flow statement is the third of three financial statements a company generates each quarter and year (after the income statement and the balance sheet).

Because of the way accrual accounting works, companies record sales on the income statement, even though their customers may pay on credit. This means that no cash actually comes in at the point of sale.

To reflect this fact, the cash flow statement was created. From it, we can see how much cash went in and how much cash left the company during the quarter or year.


Cash from Operating, Investing and Financing Activities

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.

A positive number means more cash was generated than used, which is good. A negative number means more cash was used than actually came in. Not so good.

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, Depreciation, Amortization

Net income, depreciation, and amortization. They are the exact same numbers as reported on the income statement.

Depreciation and amortization are non-cash items. This means that no actual cash left the company. Instead, due to accounting rules, the values of certain assets were simply, resulting in a decrease in earnings. To reflect the non-cash nature, these are added back to the net income on the cash flow statement.

Deferred Taxes & Investment Tax Credit

Deferred taxes are taxes that are due in another fiscal year as the current 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.

Investment tax credit represents tax incentives for business investments, allowing companies to deduct a certain percentage of investment costs from their taxes.

Other Non-Cash Items

Other non-cash items lists any cash in or outflows resulting from non-cash items that reduce the net income on the income statement.

An example of such a non-cash item 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 to fund 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. This difference is then recorded on the cash flow statement, as it represents real cash in or outflows.

Total Cash from Operating Activities

Summing up all the components of the operating activities results in the total cash from operating activities.

Cash from Investing Activities

The second part of the cash flow statement is cash from investing activities. It summarizes cash generated (positive number) from or used for (negative number) long-term investments. This includes capital expenditures, as well as other investing cash flow items such as lending money, or sale of investment securities.

Capital Expenditures (CapEx)

Capital expenditures, often abbreviated as CapEx, are the costs related to acquiring or maintaining long-term assets, such as building a new factory, warehouse, a new server farm, equipment, and more. They 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 (averaged over 5-10 years).

Other Investing Cash Flow Items

This line might include purchase or sale of stock, or lending money.

Total Cash from Investing Activities

As one might expect, total cash from investing activities is the sum of capital expenditures and other investing cash flow items.

Cash from Financing Activities

Cash Dividends Paid

When a company decides to pay its shareholders a cash dividend, the value is noted under cash dividends paid. It is always a negative number because it represents a cash outflow.

Repurchase of Common & Preferred Stock

When a company repurchases its own common or preferred stock, the dollar value of the shares is recorded under repurchase of common & 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. The share repurchase reduces the number of outstanding shares, thereby increase each shareholder’s interest in the company, and at the same time increasing the earnings and cash flow per share.

Sale of Common & 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. Sale of 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 each shareholder’s interest, thus diluting value.

Issuance (retirement) of debt, net

Similar to repurchase and sale of stock, the cash flow statement contains a line item for issuance (retirement) of debt, net. 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

Summing up the cash dividends paidrepurchase and sale of common & preferred stock, as well as issuance/retirement of debt, gives us the total cash from financing activities.

Net Change of Cash

Finally, combining the cash from operating, investing and financing activities either results in a positive or negative net change of 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.

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