Cash Flow Statement

Mastering the cash flow statement is crucial for understanding the financial health of a business. A cash flow statement tracks the flow of cash into and out of a company over a specific period. It is divided into three key sections:

1. Cash Flow from Operating Activities (CFO)

This section deals with the core operations of the business. It includes cash inflows from sales of goods or services and cash outflows related to operating expenses like salaries, rent, and inventory purchases.

• Key inflows: Receipts from customers, dividends, and interest received.
• Key outflows: Payments to suppliers, employees, taxes, and interest.

Common adjustments:

Operating cash flow starts with net income and adjusts for non-cash items like depreciation and changes in working capital (e.g., changes in accounts receivable, inventory, and accounts payable).

2. Cash Flow from Investing Activities (CFI)

This section shows cash spent on and received from investments. It's related to the purchase and sale of long-term assets like property, equipment, and investments.

• Key outflows: Purchase of property, plant, and equipment (PPE), acquisitions.
• Key inflows: Proceeds from the sale of assets, dividends from investments, interest received.

3. Cash Flow from Financing Activities (CFF)

This section focuses on transactions with the company's owners and creditors. It includes cash inflows from raising capital and cash outflows from paying back debt or distributing dividends to shareholders.

• Key inflows: Proceeds from issuing stock or taking on debt.
• Key outflows: Repayment of loans, dividends paid, repurchase of stock.

Steps to Analyze a Cash Flow Statement:

1. Understand Cash Flow Trends: Is the company generating positive cash from its operations? This is critical because, regardless of profitability, if a company runs out of cash, it can face liquidity issues.
2. Look at Operating Cash Flow: Strong positive operating cash flow suggests the company’s core business is healthy and can sustain itself.
3. Examine Capital Expenditures: Large negative cash flow in investing activities could indicate the company is investing in growth. However, too much spending without enough operational cash flow might signal overextension.
4. Assess Financing Activities: Understand how the company is financing its operations. If it's relying heavily on debt or equity issuance, evaluate the sustainability of this approach.
5. Free Cash Flow (FCF): Calculated as Operating Cash Flow - Capital Expenditures, free cash flow represents the cash a company can generate after spending money to maintain or expand its asset base. Positive free cash flow is a sign of financial flexibility.

Mastery Tips:

• Regular Analysis: Track cash flows over multiple periods to identify trends, rather than relying on a single period.
• Contextual Understanding: Always analyze the cash flow statement alongside the income statement and balance sheet for a fuller picture of the business’s financial condition.
• Cash Flow vs. Profit: Don’t confuse profitability with cash generation. A company can be profitable on paper but struggle with cash flow.

Understanding cash flow is essential for business solvency, managing growth, and making informed investment decisions.

Examples of CFO adjustments?

Adjustments to Cash Flow from Operating Activities (CFO) are made to reconcile net income (from the income statement) with actual cash generated from or used in operations. Since net income is calculated using the accrual basis of accounting, adjustments are necessary to reflect the true cash position. Below are some common examples of these adjustments:

1. Non-Cash Items

Non-cash items are included in net income but do not involve actual cash movement, so they need to be added back (if expenses) or subtracted (if income).

• Depreciation and Amortization: These are non-cash expenses that reduce net income but don’t affect cash. They are added back to CFO.
• Stock-Based Compensation: While stock options or grants affect earnings, they do not result in a cash outflow, so they are added back to CFO.
• Unrealized Gains/Losses: Gains or losses from investments that haven’t been sold (i.e., no cash has changed hands) are adjusted. Unrealized gains are subtracted, while unrealized losses are added back.

2. Changes in Working Capital

Working capital items affect cash, so changes in these accounts need to be adjusted for.

• Accounts Receivable (A/R): If accounts receivable increases, it means the company sold goods on credit but hasn’t collected the cash yet, so it's subtracted from CFO. If A/R decreases, the company has collected cash, so it's added to CFO.
• Inventory: If inventory increases, the company has spent cash to buy more inventory, which reduces cash flow. A decrease in inventory adds cash back.
• Accounts Payable (A/P): If accounts payable increases, the company has deferred payment to suppliers (kept cash), so it's added to CFO. If A/P decreases, the company has paid suppliers, so it's subtracted.
• Accrued Expenses: Similar to accounts payable, an increase in accrued expenses (such as unpaid wages or taxes) means cash has not been spent yet, so it is added back.

3. Deferred Income Taxes

Deferred taxes arise from differences between accounting income and taxable income. Since they do not represent current cash outflows, they are added back to CFO.

• Example: A company has $7,000 in deferred tax liabilities, which is added back to CFO.

4. Gains and Losses on Sale of Assets

Gains and losses from the sale of assets are not part of operating activities but may still affect net income. These need to be adjusted because the cash flow from selling an asset is captured in investing activities, not operating activities.

• Gains on Sale of Assets: Subtracted from CFO because they inflate net income without reflecting cash from core operations.Example: A $10,000 gain on the sale of equipment is subtracted from CFO.
• Losses on Sale of Assets: Added back because they reduce net income but don’t represent cash outflows related to operating activities.Example: A $5,000 loss on the sale of equipment is added back to CFO.

Summary of Common CFO Adjustments:

1. Non-cash adjustments:
2. Working capital changes:
3. Deferred income taxes: Add deferred tax liabilities to CFO.
4. Gains/Losses on asset sales:

Mastering these adjustments helps in understanding how net income translates to actual cash generated by a company’s operations, crucial for analyzing a business's liquidity and operational efficiency.