Cash Flow Statement–Top Secrets to Investing Success

Did you ever hear the sentence “Cash is King”? It is indeed true as cash is the lifeblood of any business. If you don’t have cash, you can’t pay bills, pay your employees or expand your business by acquiring assets. Even you can’t pay for yourself! That’s why understanding the cash flow statement of your stocks  is very critical for your long-term investing in stocks.

When you think about financial statements, you usually think of the income statement and the balance sheet. Thus you may overlook to pay much importance to the cash flow statement. Let me explain this by a simple example. If are looking at the balance sheet of your targeted company, you may discover that the cash balance is increasing. Does this mean that your potential company is earning more money? If this is true then you’re lucky enough. But this may not be the case always. This increase may happen due to taking out a loan or issuance of more shares by diluting equity.    

What is Cash Flow Statement (CFS)?

The cash flow statement, in a nutshell, is the net amount of cash and cash equivalents coming in and leaving a company. CFS points out how well a company manages its cash position and generates cash to pay its debt obligations and fund its operating expenses.

Why Cash Flow Statement Is So Important

In an accrual accounting system, listed companies need to report revenue income and incurred expenses during the past accounting period. It’s like your checking account at the bank. Deposits are the cash inflow into your account and withdrawals are the cash outflows from your account. The balance in your checking account is what you end up with your net cash flow at a given point in time. The cash flow statement will indicate the net increase (or decrease) in cash. If a company is having negative in cash, it will have issues paying its short-term debts and have difficulty continuing to do business.

Understanding of the cash flow statement

The cash flow statement is a very important financial statement that you need to familiar with. The cash flows are boiled down into three parts: operating activities, investing activities, and financing activities. The changes in cash flow statement are very important for knowing financial health of the firm.

Cash Flow from Operating Activities

The cash received from daily operations is the heart of any company. Cash receivable from a client and cash payable to a supplier of raw materials etc will be recorded as cash from operations or operating cash flow.  Day-to-day operating activities of the firm are the production, sales, and delivery of the company’s products. This will also include items like depreciation, taxes, and amortization of intangible assets like a brand-name patents, etc.

You might have noticed that the cash flow statement starts with the income statement (net income) and ends up with the balance sheet (cash and cash equivalents). In the case of operating cash flow, we want cash flow to be negative. Cash generated from operations manifests the ability of the company to generate cash from its core business operations. This is why we want the cash flow from operations to be as high as possible.

The figure for cash flow is derived from the income statement. The net income shown in the income statement is money (not the cash) that a company has made during a year or quarter. This may not always be the pure cash that a company generally earns. If any deal takes place with a supplier without an actual inflow of cash, then you can’t take it for your cash flow calculation. Hence, an adjustment is necessary for all non-cash items such as depreciation for tangible assets and amortization for intangible assets, changes in working capital, etc in the net income.

So, Cash Flow from Operating Activities = Net income + Non-cash Expenses + Changes in Working Capital.

Cash Flow from Investing Activity

This type of activity records the cash flow from sales and purchases of long-term fixed assets like land and building and other tangible assets like plant or machinery/equipment for production, vehicles, furniture, etc.

Typically, investing activities end up with cash outflows as capital expenditures for plant & machinery, properties, business acquisitions and so on. Cash inflows often result in the sale of assets, businesses, and securities. As an investor, you need to analyze how the company best utilize its capital expenditures in a prudent way.

Cash Flow from Financing Activity

This category reveals many of the secrets for changing cash balance. You’ll find figures for debt and equity transactions. Any cash flows (outflows as well inflows) such as payment of dividends, the repurchase or sale of stocks, bonds and so on would be considered cash flow for financing activities.

Exemplary Implication and Brief Analysis of CFS

Now, that you have learned three categories of cash flow in a cash flow statement. How do you simplify this by a real- life example? Well, if you have to determine your sister Alice’s earning capacity each year, you need to look at the money she made from the work she performed. That’s what cash flow from three activities represents.

Let’s say your sister made $50,000 annually from the job. And, let’s say your sister sold her house with a one-time gain of $40,000 during that same year. To make things more interesting, let’s say your sister purchased a new car and took a bank loan for $20, 000. Now, your sister’s cash flow statement would look like this:

  1. Cash flow from operating activities or operating cash flow: $50,000
  2. Investing Cash Flow or Cash Flow from investing activities: $40,000
  3. Financing Cash flow or Cash Flow from financing activities: $20,000

From this above example, you can see (No.1) that the only inflow of cash representing a stable and predictable earnings capacity is the one obtained from the job or from operating activities. The other two cash flow increase involves selling an asset (the house) and taking on debt (the car loan). This is extremely important. You need to look at the cash flow from operating activities and make sure it’s the primary source for the company’s cash flow. When you look at the five-year trends on the company’s cash flow statement, nothing spells trouble faster outside of the company’s operating activities.

Investing activities(No.2) result in capital expenditure such as newly purchased assets, acquisition of good businesses, investing in shares and bonds, etc that increase the outflow of cash (negative figure). The disposals of long-term assets beyond 12 months period or non-current assets that increase the inflow of cash (positive figure) are frequent. You would like to see the net value of cash flow (difference of cash outflow and inflow) to be negative for a growing company. This is because of the purchase of more investing assets (tangible as well as intangible in nature) would produce a larger operating cash flow.

As a value investor, you need to dig deep into this section before taking any investment decision. This is because the company might have acquired new debts or dividends have not been paid to the shareholders. This is the area where you will often see big inflows and outflows of cash. Like cash flows of operating and investing activities, you will also want to find the financing cash flow to be negative. Cash flows from financing activities are extremely important for you as a shareholder.

A company can raise capital for funding its investing activities by issuing common stock. When this figure is a positive number that means the company has issued more common stock to raise money and often as an existing shareholder you would end up with diluted ownership in the company. And a negative figure would mean the company is buying back its own shares from the open market. When a company is buying back its own shares, the existing shareholders will be in a position to increase their relative ownership in that company.

Borrowing money for the initial fund required by a company through financing route is common. But too much borrowing can be disastrous for a company.

Why Cash Flow Ratios are Important?

Before going into the cash flow ratios, let me introduce some of the important terms briefly to make things clearer. Among them, free cash flow is an extremely important calculation because many value investors believe this figure holds the key to determine the intrinsic value of a business. Free Cash Flow is the Operating Cash Flow plus Property, Plant and Equipment, Net (investing nature).

Free cash flow shows how efficient a company in generating cash. Investors use free cash flow to measure whether a company has enough cash, after funding operations and capital expenditures (CAPEX), to pay investors through dividends and share buybacks.

As a practical matter, if a company has a history of dividend payments, it cannot easily suspend or roll back from it.  It’s important to monitor free cash flow over several years and compare the figures to companies within the same industry. If free cash flow is positive, it indicates that the company is able to meet its obligations including funding its operating activities and paying dividends.

While cash flow analysis can include several ratios, the following ratio analysis provides a starting point for an investor to measure the investment quality of a company’s cash flow. Among them, Free Cash Flow to Revenue Ratio and   Investing Cash Flow to Operating Cash Flow are very critical.

Free Cash Flow to Revenue Ratio

From the Cash Flow Statement, you can define it as Operating Cash Flow + Property, Plant and Equipment, Net divided by Revenue or Sales of a company. This ratio is expressed as a percentage of a company’s net operating cash flow to its net sales or revenue, tells us how many dollars of cash are generated for every dollar of sales. There is no exact percentage to look for, but the higher the percentage, the better.


For instance, if operating cash flow, investing cash flow, net and revenue of any ABC company are 3000,(-1300) and 13000 respectively, then you will end up with Free Cash Flow to Revenue ratio as [3000+(-1300)]/13000=13% approximately.

What does this 13% mean? It would mean that every time the ABC sells of its product for $100, $13 will be available as cash or dividend for shareholders. Although the company may offer a portion of this available cash to shareholders as dividend and remaining cash will likely to be reinvested in future acquisitions or growth opportunities. As an investor, you should be looking for companies that have a consistent free-cash-flow to revenue ratio of at least 5%

Investing Cash Flow to Operating Cash Flow Ratio:

Investing-cash-flow to Operating-cash-flow ratio is defined by dividing Investing Cash Flow with its Operating Cash Flow. Again let’s suppose, if investing cash flow and operating cash flow of ABC Company are 1600 and 3000 respectively, the ratio comes around 53%. What does this mean? It means that for every $100 the company earns in cash, $53 cash are meant for maintaining and investing in the company’s growth. This ratio should be as low as possible without hurting the company’s growth prospect.

The Final Take Away from Cash Flow Analysis

A company’s operating cash flow from its core business activities that appears in the cash flow statement is extremely crucial. Many financial professionals consider a company’s cash flow to be the sum of its net income and depreciation (a non-cash item).  The operating cash flow is a measure of how well current liabilities are covered by the cash flows generated from a company’s operations. The ratio can help gauge a company’s liquidity in the short term.

When analyzing the cash flow statement, you need to be very careful. This is because of the fact that any increase in cash flow due to financing activities other than cash flows from the operating and investing activities may not result in the true growth of the company. You need to investigate in details to see whether the company land in a debt trap and how well that company manages its debt to participate in its ongoing growth story.

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