The Statement of Cash Flows

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The statement of cash flows seem similar to the income statement, which shows how much revenue came in and how much income went out. The difference lies in a concept called accrual accounting. Accrual accounting requires companies to record revenue and expenses when transactions occur, not when cash exhcanges hands. The principle is known as matching-- expenses must match revenues those expenses created whenever possible. While that explanation seems simple enough, it gets messy in practice, and the statement of cash flows help investors sort it out.

The statement of cash flows strips out all of the abstract, noncash revenues and expenses that are included in the income statement. Many companies have shown profits on the income statement but have stumbled because of insufficient cash flows. A good look at the statement of cash flows would have warned investors of rocky times ahead.

Because companies can generate cash in several different ways, the statement of cash flows is seperated into three segments: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

The cash flow from operating activities comes first and tells you how much cash the company generated from its core business, as opposed to peripheral activities such as borrowing and investing. This is the section you must pay close attention to. It paints the best picture of how well a company is producing cash that will ultimately benefit shareholders. Some of the main line items found in this section are: net income, depreciation and amortization, changes in working capital, and net cash provided by operating activities.

After all adjustments to net income are accounted for, whats left over is the net cash provided by operating activities, also know as operating cash flow. This number is not a replacement for net income, but does provide a great summary of how much cash a company's core business has generated.

Cash flows from investing activities shows the amount of cash a firm spends on investments. Investments are either classified as capital expenditures --money spent on items such as new equipment or anything else needed to keep the business running--or monetary investments such as the purchase or sale of government bonds. The most important part of this section for investors is the line items capital expenditures and acquisitions of other businesses.

The final section of the statement of cash flows is "cash from financing activities." This section includes any activities that involve the company's owners or creditors. For example, the issuance or purchase of common stock, the issuance or repayment of debt, and dividends paid to investors would be found in this section. Although these line items are pretty explanatory, we think investors should look carefully at how much stock a company is issuing or repurchasing.

The Financial Reality

Understanding how to read financial statements is a fundamental skill required to be a knowledgeable investor.

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