Corporate Cash Flow: Understanding the Essentials (2024)

If a company reports earnings of $1 billion, it does not necessarily mean it has that much cash in the bank. Financial statements are based on accrual accounting, which takes into account non-cash items. Financial statements consider non-cash items to reflect the financial health of a company more accurately.

However, accrual accounting may create accounting noise that is often best tuned out for a more precise determination of the cash a company is generating. The statement of cash flow provides clarity. Here's how to interpret the cash flow statement.

What Are Cash Flows?

Business is all about trade, the exchange of value between two or more parties, and cash is the asset needed to participate in the economic system. Although some industries are more cash-intensive than others, no business can survive in the long run without generating positive cash flow per share for its shareholders. For positive cash flow, a company's long-term cash inflows must exceed its long-term cash outflows.

An outflow of cash occurs when a company transfers funds to another party (either physically or electronically). A transfer could be made to pay for employees, suppliers, and creditors; to purchase long-term assets and investments; or pay for legal expenses and lawsuit settlements. It is important to note that legal transfers of value through debt—a purchase made on credit—is not recorded as a cash outflow until the money actually leaves the company's hands.

A cash inflow is the opposite; it is any transfer of money that comes into the company's possession. Typically, the majority of a company's cash inflows are from customers, lenders (such as banks or bondholders), and investors who purchase equity from the company. Occasionally, cash flows come from legal settlements or the sale of company real estate or equipment.

Cash Flows vs.Income

There is a distinction between being profitable and having positive cash flow transactions. Just because a company is bringing in cash does not mean it is making a profit (and vice versa).

For example, if a manufacturing company is experiencing low product demand and, therefore, decides to sell off half its factory equipment at liquidation prices. The company will receive cash from the buyer for the used equipment, but it is losing money on the sale: the company would prefer to use the equipment to manufacture products and earn an operating profit.

Because low demand precludes additional manufacturing, the next best option is to sell off the equipment at prices much lower than the company paid for the equipment. In the year that the equipment is sold, the company would show significant positive cash flow, but it's current and future earnings potential would be bleak. Because cash flow can be positive while profitability is negative, investors should analyze income statements in conjunction with the cash flow statement.

What Is the Cash Flow Statement?

There are three critical parts of a company's financial statements: the balance sheet, the income statement, and the cash flow statement. The balance sheet gives a one-time snapshot of a company's assets and liabilities. The income statement indicates the business's profitability during a certain period.

The cash flow statement differs from the other financial statements because it acts as a corporate checkbook that reconciles the other two statements. The cash flow statement records the company's cash transactions (the inflows and outflows) during the given period. It shows whether all of the revenues booked on the income statement have been collected.

At the same time, however, the cash flow does not necessarily show all the company's expenses because not all expenses the company accrues are paid right away. Although the company may have incurred liabilities, any payments towards these liabilities are not recorded as a cash outflow until the transaction occurs (see the section "What Cash Flow Doesn't Tell Us" below).

The following is a list of the various areas of the cash flow statement and what they mean:

• Cash flow from operating activities.This section measures the cash used or provided by a company's normal operations. It shows the company's ability to generate consistent positive cash flow from operations. Think of normal operations as the core business. For example, Microsoft's normal operating activity is selling software.
• Cash flows from investing activities.This area lists all the cash used or provided by the purchase and sale of income-producing assets. If Microsoft buys or sells companies for a profit or loss, the resulting figures would be included in this section of the cash flow statement.
• Cash flows from financing activities.This section measures the flow of cash between a firm and its owners and creditors. Negative numbers can mean the company is servicing debt, but they can also mean the company is making dividend payments and stock repurchases, which will satisfy investors.

The Important Items on the Cash Flow Statement

The first item to note on the cash flow statement is the bottom line item. This is likely to be the "net increase/decrease in cash and cash equivalents." The bottom line reports the overall change in the company's cash and its equivalents (the assets that can be immediately converted into cash) over the last period. If you check under current assets on the balance sheet, you will find cash and cash equivalents (CCE or CC&E). If you take the difference between the current CCE and that of the previous year or the previous quarter, you should have the same number as the number at the bottom of the statement of cash flows.

In the sample Microsoft annual cash flow statement from June 2004(shown below), the statement shows approximately $9.5 billion more cash at the end of the 2003/04 fiscal year than at the beginning (see "Net Change in Cash and Equivalents"). On closer inspection, it's clear that the company had a negative cash outflow of $2.7 billion from investment activities during the year (see "Net Cash from Investing Activities").This negative cash flow is likely due to the purchase of long-term investments, which have the potential to generate a profit in the future.

It is difficult to determine if negative cash flow from investing activities is a positive or negative indicator—these cash outflows are investments in the future operations of the company (or another company), and the outcome plays out over the long term.

Net Cash from Operating Activities reveals that Microsoft generated $14.6 billion in positive cash flow from its usual business operations—a good sign. Note that the company has had similar levels of positive operating cash flow for several years. If this number were to increase or decrease significantly in the upcoming year, it would indicate an underlying change in the company's ability to generate cash.

Digging Deeper Into Cash Flows

All companies provide cash flow statements as part of their financial statements, but cash flow (net change in cash and equivalents) can also be calculated as net income plus depreciation and other non-cash items.

A company's primary industry typically determines the level of cash flow that would be considered adequate. Comparing a company's cash flow against its industry peers, or benchmarking, is a good way to gauge the health of cash flow. A company not generating the same amount of cash as its competitors is at a disadvantage of the economy takes a downturn.

Even a company considered profitable according to accounting standards can fail if there is insufficient cash on hand to pay bills. Comparing the amount of cash generated to outstanding debt, known as the operating cash flow ratio, reveals the company's ability to service its loans and interest payments. If a slight drop in a company's quarterly cash flow would jeopardize its loan payments, the company carries more risk than a company with stronger cash flow levels.

Unlike reported earnings, there is little room for cash manipulation. Every company that files reports with the Securities and Exchange Commission (SEC) must include a cash flow statement with its quarterly and annual reports.

What the Cash Flow Statement Does Not Tell Us

The cash flow statement does not tell us the profit earned or lost during a particular period: profitability is composed of cash earned but also of non-cash items. This is true even for items on the cash flow statement such as "cash increase from sales minus expenses." This item is not an indicator of profit.

The cash flow statement does not tell the whole profitability story, and it is not a reliable indicator of the overall financial well-being of the company. While a company's cash situation is significant, it is not reflective of the company's entire financial condition. The cash flow statement does not account for liabilities and assets, which are recorded on the balance sheet. Furthermore, accounts receivable and accounts payable, each of which can be sizeable, are also not reflected in the cash flow statement.

In other words, the cash flow statement is a compressed version of the company's checkbook that includes a few other items that affect cash. For example, the financing section shows how much the company spent or collected from the repurchase or sale of stock, the amount of issuance or retirement of debt, and the amount the company paid out in dividends.

The Bottom Line

The cash flow statement is not straightforward. Those who pay attention to the cash flow statement should understand the extent to which a company relies on the capital markets and the extent to which it relies on the cash it has generated. No matter how profitable a company may be, if it lacks the cash to pay bills, it is likely to fail.

Investing in a company that shows positive cash flow is wise, but there are also opportunities in companies that aren't yet cash-flow positive. The cash flow statement is simply a piece of the puzzle. Analyzing the cash flow statement together with the other statements gives a more accurate representation of a company's financial health. Knowing what to look for on a cash flow statement will help an investor avoid holding stock that suffers from a cash flow crunch.