Reading a cash flow statement

In short

You have probably picked up an annual report and felt your eyes glaze over somewhere around page forty. I know that feeling well. A cash flow statement is just three questions dressed up in accounting clothes. Where did the money come from? Where did it go? How much is left? Read those three answers and you know something real about a company.

The whole of it

What it is

A friend of mine once called the cash flow statement the lie detector of finance. I thought that was a little harsh, but I understood what he meant. A company can report a profit on its income statement and still run out of money. Cash cannot be faked the way earnings sometimes can. The cash flow statement tracks actual dollars in and actual dollars out over a set period, usually one quarter or one full year. It does not care about estimates or accounting adjustments. It cares about what hit the bank. Think of it as the checkbook register for a business.

You have probably noticed that most financial documents seem to ask a dozen questions at once. This one really asks only three. The first question is how much cash the core business made or spent, which accountants call operating activities. The second question is how much the company spent buying equipment or other companies, or earned selling them, which goes under investing activities. The third question is how the company dealt with lenders and shareholders through borrowing, repaying, paying dividends, or buying back stock, which falls under financing activities. Those three answers add up to show the net change in cash for the period. Simple as that.

How it works

I once sat with a neighbor who ran a small hardware store. He showed me his books. His store looked profitable on paper every single month. But some months he had no money to pay suppliers. The timing was the problem. Cash flow tells you about timing. A company might sell a million dollars of goods and not collect the cash for ninety days. The income statement records the sale today. The cash flow statement records the cash when it actually arrives.

The operating section is prepared in one of two ways. Most companies you will read use what accountants call the indirect method. That method starts with net income, the profit figure from the income statement, and then works backward from there. A less common approach, called the direct method, lists actual cash receipts and payments instead and does not start with net income at all. The filing will tell you which method was used. Either way, the ending operating cash figure lands in the same place.

Under the indirect method, the statement adds back a charge called depreciation after it starts with net income. Depreciation is the accountant's way of spreading the cost of a big purchase, like a machine, over several years. It reduces reported profit but it is not a cash payment going out the door right now. So it gets added back. Then the statement adjusts for changes in working capital. Working capital is money tied up in things like inventory sitting on shelves or bills the company has not yet collected. If inventory grew, cash went out to buy it. If customer bills grew, cash is still out there waiting to come in. Those changes shrink or grow the operating cash figure.

The investing section is usually negative for a growing company. That is not automatically bad. It means the company is spending on equipment, buildings, or acquisitions. The specific line to watch is called capital expenditures, sometimes shortened to capex. Capex is money spent to maintain or grow the physical ability to do business. Some analysts subtract capex from operating cash to get a number called free cash flow. Free cash flow is what is left after the company keeps itself running. It is the money available for everything else.

The financing section shows how the company handles its relationship with lenders and shareholders. Borrowing money shows up as a cash inflow. Paying it back shows up as a cash outflow. Paying a dividend shows up as a cash outflow. Buying back its own stock shows up as a cash outflow. A company that consistently borrows just to cover basic operations is worth a longer look.

The numbers, and where to find yours

You have probably wondered where to actually read one of these statements. Every company that sells stock to the public in the United States must file financial statements with the Securities and Exchange Commission. The SEC's online database is called EDGAR. You can reach it at sec.gov/edgar. Search the company name and look for a filing called a 10 K, which is the annual report, or a 10 Q, which is the quarterly report. The cash flow statement is inside those filings. It is labeled Consolidated Statements of Cash Flows or something close to that.

Free cash flow is not a line the accounting rules require companies to report in a standard way. Companies calculate and present it differently. Always check how a specific company defines it before comparing two companies side by side. The SEC's EDGAR page is the primary source for the raw filings, and it costs nothing to use.

A worked example

Let me walk you through a made up company I will call Millbrook Printing. Millbrook reported a net income of 400,000 dollars for the year. The company uses the indirect method, so the operating section of its cash flow statement starts there and then adds back 80,000 dollars of depreciation, because that was an accounting charge, not a real cash payment leaving the building. Then it shows that accounts receivable, meaning money customers owe, grew by 60,000 dollars during the year. That growth means 60,000 dollars of sales were recorded but the cash has not arrived yet. So 60,000 dollars gets subtracted. Operating cash flow comes out to 420,000 dollars. That is 400,000 plus 80,000 minus 60,000.

The investing section shows Millbrook spent 150,000 dollars on new printing equipment. That is the capex figure. Subtract 150,000 from 420,000 and free cash flow is 270,000 dollars. Millbrook earned a profit and it has real cash left over after maintaining its equipment. That tells a calmer story than just reading the 400,000 dollar profit headline.

The financing section shows Millbrook paid 50,000 dollars in dividends and paid back 30,000 dollars on a small loan. That section reduced cash by 80,000 dollars in total. Now picture the three sections sitting side by side as three simple figures. Operating brought in 420,000 dollars, investing sent out 150,000 dollars, and financing sent out 80,000 dollars. Add those together and Millbrook ended the year with 190,000 more dollars in the bank than it started with. Every number in this example is mine, built to show the math. Your job with a real company is to find these same lines in the actual filing.

Where it goes wrong

I once heard a fellow say he trusted every number in a financial statement the way he trusted a weather forecast. I smiled at that. The cash flow statement is more reliable than the income statement, but it is not perfect. Companies can time large payments to fall just outside a reporting period. They can sell receivables, meaning they sell the right to collect customer bills to a third party, and record that as operating cash. Always read the footnotes. Footnotes are the small print sections after the main statements. They explain choices the company made. Ignoring them is like reading a contract and skipping the middle pages.

A company with strong operating cash flow but sharply rising capex every year may be running hard just to stay in place. A company with weak operating cash but claims of strong free cash flow may be defining free cash flow in a generous way. Compare the definition they use to what you see in the actual numbers. Let the SEC filing be your source, not the press release.

Questions to answer before you leave this page

Before you move on, sit with these for a moment and answer each one honestly, because your understanding of one real company is worth more than a perfect memory of this page. Is the operating cash flow positive, and has it been positive for several years in a row? Is free cash flow also positive after you subtract capex, and how does this company define free cash flow compared to the simple definition here? Did the company borrow money during the period, and if so, did the operating section show enough cash to cover the cost of paying it back? Are accounts receivable growing faster than revenue, which might mean customers are slow to pay or the company is being generous with credit to boost sales? Did you read at least one page of the footnotes to understand choices management made about how to classify certain cash flows, and did you also check which method, indirect or direct, the company used to prepare the operating section? And finally, does the story the cash flow statement tells match the story management tells in the letter to shareholders at the front of the annual report?