Cash Flow Statement

The cash flow statement tracks actual cash moving in and out of a company over a period. It is divided into three parts: cash from operations, cash from investing and cash from financing. Because profit on the income statement includes estimates and timing differences, cash flow is often a more reliable picture of a company's health. A saying among analysts is that "profit is opinion, cash is fact". Many accounting problems first show up as a gap between earnings and cash.

The three sections#

Cash from operations (indirect method)#

Most companies start with net income and adjust:

operating cash flow = net income + non cash charges ± changes in working capital

• Add back non cash charges: depreciation, amortisation, stock based compensation, impairments.
• Adjust for working capital: an increase in receivables or inventory uses cash; an increase in payables provides cash. See Working Capital.

Reading the patterns#

Why traders watch cash flow#

• Earnings quality: if net income rises but operating cash flow falls for several periods, profits may be inflated. See Earnings Quality and Cash Conversion.
• Funding needs: companies burning cash may need to issue shares or debt, diluting or burdening shareholders. See Secondary Offerings and Rights Offerings.
• Capital returns: dividends and buybacks must be funded by cash. See Dividends and Buybacks.
• Valuation: many valuation methods use free cash flow. See DCF Valuation.

Common adjustments to watch#

• Stock based compensation: added back as non cash, but it is a real cost to shareholders through dilution.
• Working capital swings: one good quarter can come from delaying supplier payments.
• Capitalised costs: costs moved into capex make operating cash flow look higher.
• Leases: under current rules, lease principal payments often appear in financing, flattering operating cash flow.

Direct vs indirect method#

A few companies use the direct method, listing actual cash received from customers and paid to suppliers and employees. It is easier to read but less common. The indirect method, which starts from net income, is used by most companies because it reconciles profit with cash and shows exactly which accounting items explain the difference. Either way, the total cash from operations is the same.

Example of a warning sign#

Before its collapse in 2001, Enron reported rising profits, but its operating cash flow was boosted by complex transactions that were later found to be financing disguised as operating cash. Many later frauds also showed large, persistent gaps between reported profits and real cash generation.

Frequently asked questions#

What is a cash flow statement?#

A financial statement showing cash coming in and going out of a company over a period, split into operating, investing and financing activities.

Why is cash flow important?#

Because it shows whether a company actually generates cash from its business, which profit alone can hide.

What is the difference between operating cash flow and free cash flow?#

Operating cash flow is cash from running the business; free cash flow subtracts capital expenditures, showing cash available for debt repayment, dividends and buybacks.

Next, look closely at the top line in Revenue and Gross Profit.