How to Analyze a Cash Flow Statement
What’s Included in a Cash Flow Statement
Before analyzing a cash flow statement, it’s important to understand that cash and profit are not the same thing.
Cash refers to the money a company has on hand, while profit is calculated by subtracting all expenses from revenue. A company can have positive cash flow but still be unprofitable, and vice versa.
Still confused? Here’s a quick accounting breakdown:
Revenues and expenses are not always tied to the timing of cash inflows and outflows because they are recorded differently. Revenue is recognized when it is earned, regardless of when the cash is received, and expenses are recognized when incurred, regardless of when the cash is paid.
For example:
A company may earn revenue by selling goods on credit. In this case, the revenue is recorded at the time of sale, but cash may be collected later.
On the other hand, a company may purchase goods on credit and pay for them later. In this case, the expense is recognized when the goods are received, but the cash will leave the company at a later date.
In addition, some expenses, such as depreciation, amortization, and deferred tax, are non-cash expenses. This means they do not result in a cash outflow at the time of recording but instead reduce net income (profit).
The cash flow statement shows actual cash inflows and outflows, whereas the income statement shows the company’s profits or losses.
The cash flow statement includes three sections: operating activities, investing activities, and financing activities:
Operating Activities – These are the day-to-day activities of the business. This section shows how much cash the company generates after selling products or services and paying operating expenses, from rent to salaries.
Investing Activities – These include the purchase or sale of long-term assets such as property and equipment or securities. This section shows how much cash the company uses to invest in its future growth.
Financing Activities – These include things like issuing new shares or taking on loans. This section shows how much cash the company raises from investors or borrows from creditors.
Operating Activities
The operating activities section shows the cash transactions for running day-to-day business. This is often the most important section to review.
A positive operating cash flow is a good sign because it means the company is generating cash from simply running its business. Conversely, negative operating cash flow can be a red flag because it means the company spends more cash on operations than it generates.
When analyzing the operating activities section of the cash flow statement, pay attention to a few key items:
Stock-Based Compensation (SBC):
SBC is a non-cash expense.
SBC is a type of employee benefit that gives employees the right to acquire company stock at a discount or for free. It’s a way for companies to attract and retain top talent and can be a tax-efficient way for employees to receive part of their compensation.
However, when a company grants stock options to employees, it must recognize an expense on the income statement at the estimated fair value of these options. The company incurs a cost by issuing shares to employees.
These expenses appear on the income statement as part of cost of revenue or operating expenses. They reduce net income but are added back when calculating operating cash flow. We’ll look at SBC in more detail in a moment.
Depreciation and Amortization (D&A):
These are non-cash expenses incurred as the company uses long-term assets like buildings, equipment, or patents. In the income statement, they may be allocated across COGS and other operating expenses. The cash flow statement is where you find the exact total depreciation and amortization for the period.
When evaluating overall company profitability, it’s important to focus on net income because it includes the effect of non-cash expenses like SBC. However, when we focus on the company’s ability to meet financial obligations over time, operating cash flow is the better indicator.
Negative operating cash flow should prompt you to check the balance sheet and evaluate the company’s cash and debt. Ask yourself how many years it can sustain a cash-burning business.
Investing Activities
The investing activities section shows cash the company uses to invest in its future growth, such as buying or selling long-term assets. This is where you can identify capital expenditures.
What the heck are capital expenditures, you ask?
Here’s a brief explanation:
Capital expenditures (Capex) refer to cash outflows from investing activities that the company incurs to acquire or upgrade long-term assets, such as property, plant, and equipment (PP&E), which are expected to have a useful life of more than one year. These purchases are considered investments in the company’s future growth and are typically funded through a mix of debt and equity.
It’s important to note that the cash flow statement records the actual cash spent during the period, whereas the balance sheet records the assets acquired. So if a company had significant Capex during the period, it will appear as a cash outflow on the cash flow statement, and the asset will be recorded on the balance sheet.
Note that to calculate free cash flow, we subtract capital expenditures from operating cash flow (more on that in a moment).
When analyzing the investing activities section of the cash flow statement, focus on two key points:
Purchase or sale of property, plant & equipment (PP&E): These are long-term assets the company uses to generate revenue. High PP&E purchases can be a good sign because the company is investing in future growth. Conversely, large sales can be a red flag if the company is offloading assets. Context is key.
Purchase or sale of investments: These are investments in other companies or assets the company uses to generate additional income.
Financing Activities
The financing activities section shows cash the company receives from investors or borrows from creditors.
When analyzing the financing section of the cash flow statement, watch for these key points:
Issuing or repaying debt: The company can borrow from creditors or repay borrowed funds. We want to watch whether the company is taking on too much debt, which requires checking the balance sheet.
Issuing or buying back shares: The company can sell new shares to raise cash. Alternatively, it can repurchase its own shares, which depletes cash but reduces the number of shares outstanding, making each share more valuable to existing shareholders.
Paying dividends: The company can distribute part of its profit to shareholders as a reward for investing.
To conclude this section, here’s an example of a cash flow statement from an annual 10-K or quarterly 10-Q. This is Apple’s fiscal year ending September 2022, summarized in the visualization discussed above. It also includes comparisons to FY21 and FY20.
Key Ratios and Metrics
When analyzing a cash flow statement, there are several key ratios and metrics to look for to better understand the company’s cash flow and liquidity.
Here are some of the most important:
Operating Cash Flow (OCF): Also called net cash from operating activities or net cash from operations. Calculated by subtracting cash outflows from cash inflows in the operating activities section of the cash flow statement. The operating cash flow margin is expressed as a percentage of revenue.
**Net Income
Non-Cash Expenses +/- Changes in Working Capital = Operating Cash Flow**
Free Cash Flow (FCF): Free cash flow is calculated by subtracting capital expenditures from operating cash flow. Free cash flow represents the cash the company has available to pay dividends, repurchase shares, repay debt, or make acquisitions. The free cash flow margin is expressed as a percentage of revenue.
Free Cash Flow = Operating Cash Flow – Capital Expenditures
Net Cash Flow: Calculated by adding net cash flow from operating, investing, and financing activities. It shows the net movement of cash over the period. It equals the difference between the beginning and ending cash balance for the period.
Operating Cash Flow
+/- Net Cash from Investing Activities
+/- Net Cash from Financing Activities
= Net Cash Flow
= Ending Cash Balance – Beginning Cash Balance (from the balance sheet)
Operating Cash Flow to Total Debt: As the name suggests, this ratio is calculated by dividing operating cash flow by total debt on the balance sheet. A higher ratio indicates that the company generates enough cash from operations to pay off its debt. As we explained in our balance sheet review, we want a company that could quickly pay down its debt.
Types of Analysis
Now that we’ve gone through each section of the cash flow statement, it’s time to put it all together and see the big picture.
Key Traits to Watch For
When I look at a cash flow statement, I immediately focus on a few things:
Positive/improving operating cash flow: Indicates the company brings in more cash from operations than it spends.
Positive/improving free cash flow: Indicates the company has enough cash to pay dividends, buy back shares, pay down debt, or make acquisitions.
Stock-Based Compensation (SBC): SBC is dilutive (more shares issued to employees). So it’s important to monitor SBC as a percentage of the company’s market cap. Ideally, we want free cash flow to offset SBC’s negative effect. It’s also useful to track SBC as a percentage of revenue. For young tech companies, we want SBC as a percentage of revenue to decline over time.
Share Buybacks: A company can return cash to shareholders via buybacks or dividends. Buybacks can be extremely beneficial for long-term shareholders. While dividends are taxable, buybacks return cash without generating short-term capital gains. However, a company using its cash for buybacks loses the chance to reinvest in growth initiatives. A company should only buy back aggressively when its stock price is considered attractive. If the company is still in a growth phase, buybacks may not be the best use of capital.
Remember that these positive traits are not the only things to look for when analyzing a cash flow statement. It’s also important to understand the context of the company’s overall financial health, business model, and industry.
For example:
Negative operating cash flow is not the end of the world if the company has a large net cash position on its balance sheet that can fund several years of runway.
Positive operating cash flow is insufficient if it still doesn’t cover the company’s obligations (interest and debt repayments).
It’s critical to think beyond historical data and anticipate how cash flow may evolve over time. In investing, the future matters more than the past. A company’s valuation is based on its future earnings and the cash it can return to shareholders. So you must keep that in mind. This is why the market always looks ahead.
A great example illustrating the importance of viewing the cash flow statement in context is Netflix (NFLX).
When the company shifted its strategy to original content in 2012 (remember “House of Cards”?), it significantly increased its spending.
Development and production expenses can be capitalized on the balance sheet and amortized over time on the income statement as content is released. However, the cash outflows for paying writers, creators, actors, crew salaries, and the costs of sets and costumes appear immediately on the cash flow statement. As a result, Netflix saw its operating cash flow turn negative and plummet from 2015 to 2019.
Another factor contributing to negative cash flow was the company’s international expansion. Netflix was rolling out services in new countries, which required significant investments in content localization, marketing, and infrastructure, all of which also pressured cash flow.
Although this approach hurt short-term cash flow, it was an impressive long-term strategy to attract and retain subscribers.
Before analyzing a cash flow statement, it’s important to understand that cash and profit are not the same thing.
Cash refers to the money a company has on hand, while profit is calculated by subtracting all expenses from revenue. A company can have positive cash flow but still be unprofitable, and vice versa.
Still confused? Here’s a quick accounting breakdown:
Revenues and expenses are not always tied to the timing of cash inflows and outflows because they are recorded differently. Revenue is recognized when it is earned, regardless of when the cash is received, and expenses are recognized when incurred, regardless of when the cash is paid.
For example:
A company may earn revenue by selling goods on credit. In this case, the revenue is recorded at the time of sale, but cash may be collected later.
On the other hand, a company may purchase goods on credit and pay for them later. In this case, the expense is recognized when the goods are received, but the cash will leave the company at a later date.
In addition, some expenses, such as depreciation, amortization, and deferred tax, are non-cash expenses. This means they do not result in a cash outflow at the time of recording but instead reduce net income (profit).
The cash flow statement shows actual cash inflows and outflows, whereas the income statement shows the company’s profits or losses.
The cash flow statement includes three sections: operating activities, investing activities, and financing activities:
Operating Activities – These are the day-to-day activities of the business. This section shows how much cash the company generates after selling products or services and paying operating expenses, from rent to salaries.
Investing Activities – These include the purchase or sale of long-term assets such as property and equipment or securities. This section shows how much cash the company uses to invest in its future growth.
Financing Activities – These include things like issuing new shares or taking on loans. This section shows how much cash the company raises from investors or borrows from creditors.
Operating Activities
The operating activities section shows the cash transactions for running day-to-day business. This is often the most important section to review.
A positive operating cash flow is a good sign because it means the company is generating cash from simply running its business. Conversely, negative operating cash flow can be a red flag because it means the company spends more cash on operations than it generates.
When analyzing the operating activities section of the cash flow statement, pay attention to a few key items:
Stock-Based Compensation (SBC):
SBC is a non-cash expense.
SBC is a type of employee benefit that gives employees the right to acquire company stock at a discount or for free. It’s a way for companies to attract and retain top talent and can be a tax-efficient way for employees to receive part of their compensation.
However, when a company grants stock options to employees, it must recognize an expense on the income statement at the estimated fair value of these options. The company incurs a cost by issuing shares to employees.
These expenses appear on the income statement as part of cost of revenue or operating expenses. They reduce net income but are added back when calculating operating cash flow. We’ll look at SBC in more detail in a moment.
Depreciation and Amortization (D&A):
These are non-cash expenses incurred as the company uses long-term assets like buildings, equipment, or patents. In the income statement, they may be allocated across COGS and other operating expenses. The cash flow statement is where you find the exact total depreciation and amortization for the period.
When evaluating overall company profitability, it’s important to focus on net income because it includes the effect of non-cash expenses like SBC. However, when we focus on the company’s ability to meet financial obligations over time, operating cash flow is the better indicator.
Negative operating cash flow should prompt you to check the balance sheet and evaluate the company’s cash and debt. Ask yourself how many years it can sustain a cash-burning business.
Investing Activities
The investing activities section shows cash the company uses to invest in its future growth, such as buying or selling long-term assets. This is where you can identify capital expenditures.
What the heck are capital expenditures, you ask?
Here’s a brief explanation:
Capital expenditures (Capex) refer to cash outflows from investing activities that the company incurs to acquire or upgrade long-term assets, such as property, plant, and equipment (PP&E), which are expected to have a useful life of more than one year. These purchases are considered investments in the company’s future growth and are typically funded through a mix of debt and equity.
It’s important to note that the cash flow statement records the actual cash spent during the period, whereas the balance sheet records the assets acquired. So if a company had significant Capex during the period, it will appear as a cash outflow on the cash flow statement, and the asset will be recorded on the balance sheet.
Note that to calculate free cash flow, we subtract capital expenditures from operating cash flow (more on that in a moment).
When analyzing the investing activities section of the cash flow statement, focus on two key points:
Purchase or sale of property, plant & equipment (PP&E): These are long-term assets the company uses to generate revenue. High PP&E purchases can be a good sign because the company is investing in future growth. Conversely, large sales can be a red flag if the company is offloading assets. Context is key.
Purchase or sale of investments: These are investments in other companies or assets the company uses to generate additional income.
Financing Activities
The financing activities section shows cash the company receives from investors or borrows from creditors.
When analyzing the financing section of the cash flow statement, watch for these key points:
Issuing or repaying debt: The company can borrow from creditors or repay borrowed funds. We want to watch whether the company is taking on too much debt, which requires checking the balance sheet.
Issuing or buying back shares: The company can sell new shares to raise cash. Alternatively, it can repurchase its own shares, which depletes cash but reduces the number of shares outstanding, making each share more valuable to existing shareholders.
Paying dividends: The company can distribute part of its profit to shareholders as a reward for investing.
To conclude this section, here’s an example of a cash flow statement from an annual 10-K or quarterly 10-Q. This is Apple’s fiscal year ending September 2022, summarized in the visualization discussed above. It also includes comparisons to FY21 and FY20.
Key Ratios and Metrics
When analyzing a cash flow statement, there are several key ratios and metrics to look for to better understand the company’s cash flow and liquidity.
Here are some of the most important:
Operating Cash Flow (OCF): Also called net cash from operating activities or net cash from operations. Calculated by subtracting cash outflows from cash inflows in the operating activities section of the cash flow statement. The operating cash flow margin is expressed as a percentage of revenue.
**Net Income
Non-Cash Expenses +/- Changes in Working Capital = Operating Cash Flow**
Free Cash Flow (FCF): Free cash flow is calculated by subtracting capital expenditures from operating cash flow. Free cash flow represents the cash the company has available to pay dividends, repurchase shares, repay debt, or make acquisitions. The free cash flow margin is expressed as a percentage of revenue.
Free Cash Flow = Operating Cash Flow – Capital Expenditures
Net Cash Flow: Calculated by adding net cash flow from operating, investing, and financing activities. It shows the net movement of cash over the period. It equals the difference between the beginning and ending cash balance for the period.
Operating Cash Flow
+/- Net Cash from Investing Activities
+/- Net Cash from Financing Activities
= Net Cash Flow
= Ending Cash Balance – Beginning Cash Balance (from the balance sheet)
Operating Cash Flow to Total Debt: As the name suggests, this ratio is calculated by dividing operating cash flow by total debt on the balance sheet. A higher ratio indicates that the company generates enough cash from operations to pay off its debt. As we explained in our balance sheet review, we want a company that could quickly pay down its debt.
Types of Analysis
Now that we’ve gone through each section of the cash flow statement, it’s time to put it all together and see the big picture.
Key Traits to Watch For
When I look at a cash flow statement, I immediately focus on a few things:
Positive/improving operating cash flow: Indicates the company brings in more cash from operations than it spends.
Positive/improving free cash flow: Indicates the company has enough cash to pay dividends, buy back shares, pay down debt, or make acquisitions.
Stock-Based Compensation (SBC): SBC is dilutive (more shares issued to employees). So it’s important to monitor SBC as a percentage of the company’s market cap. Ideally, we want free cash flow to offset SBC’s negative effect. It’s also useful to track SBC as a percentage of revenue. For young tech companies, we want SBC as a percentage of revenue to decline over time.
Share Buybacks: A company can return cash to shareholders via buybacks or dividends. Buybacks can be extremely beneficial for long-term shareholders. While dividends are taxable, buybacks return cash without generating short-term capital gains. However, a company using its cash for buybacks loses the chance to reinvest in growth initiatives. A company should only buy back aggressively when its stock price is considered attractive. If the company is still in a growth phase, buybacks may not be the best use of capital.
Remember that these positive traits are not the only things to look for when analyzing a cash flow statement. It’s also important to understand the context of the company’s overall financial health, business model, and industry.
For example:
Negative operating cash flow is not the end of the world if the company has a large net cash position on its balance sheet that can fund several years of runway.
Positive operating cash flow is insufficient if it still doesn’t cover the company’s obligations (interest and debt repayments).
It’s critical to think beyond historical data and anticipate how cash flow may evolve over time. In investing, the future matters more than the past. A company’s valuation is based on its future earnings and the cash it can return to shareholders. So you must keep that in mind. This is why the market always looks ahead.
A great example illustrating the importance of viewing the cash flow statement in context is Netflix (NFLX).
When the company shifted its strategy to original content in 2012 (remember “House of Cards”?), it significantly increased its spending.
Development and production expenses can be capitalized on the balance sheet and amortized over time on the income statement as content is released. However, the cash outflows for paying writers, creators, actors, crew salaries, and the costs of sets and costumes appear immediately on the cash flow statement. As a result, Netflix saw its operating cash flow turn negative and plummet from 2015 to 2019.
Another factor contributing to negative cash flow was the company’s international expansion. Netflix was rolling out services in new countries, which required significant investments in content localization, marketing, and infrastructure, all of which also pressured cash flow.
Although this approach hurt short-term cash flow, it was an impressive long-term strategy to attract and retain subscribers.
Thanks to its massive content library, Netflix drew in new subscribers by the millions. The success of this strategy became evident in the company’s financial results.
Today, Netflix has moved past the most cash-intensive part of its original content transition. The company has significantly increased subscription revenue through new paid memberships and price hikes. Netflix has generated positive cash flow since 2020 and has grown its revenue eightfold over the last decade.
Today, Netflix has moved past the most cash-intensive part of its original content transition. The company has significantly increased subscription revenue through new paid memberships and price hikes. Netflix has generated positive cash flow since 2020 and has grown its revenue eightfold over the last decade.
If you had invested in Netflix when it released the first season of “Stranger Things” in 2016 (when operating cash flow was negative and worsening), your money would have more than tripled today (even considering the current bear market).
Hopefully, this serves as a reminder of the importance of zooming out and thinking about how a business may evolve over time.
Remember that the cash flow statement is only one piece of the puzzle in understanding a company’s financial health. Be sure to also analyze the income statement and balance sheet to get the full picture.
Financial statements can tell you a lot about the past but not much about the future. That’s why we must connect the dots and go beyond the ratios and table metrics to make the right investment decisions.
Andrew Wilkinson has spoken about the danger of being a “spreadsheet investor.”
Brad Gerstner of Altimeter Capital has emphasized avoiding “accounting thinking.” Instead, he wants to adopt “investor thinking.” One that looks forward, not backward.
Hopefully, this serves as a reminder of the importance of zooming out and thinking about how a business may evolve over time.
Remember that the cash flow statement is only one piece of the puzzle in understanding a company’s financial health. Be sure to also analyze the income statement and balance sheet to get the full picture.
Financial statements can tell you a lot about the past but not much about the future. That’s why we must connect the dots and go beyond the ratios and table metrics to make the right investment decisions.
Andrew Wilkinson has spoken about the danger of being a “spreadsheet investor.”
Brad Gerstner of Altimeter Capital has emphasized avoiding “accounting thinking.” Instead, he wants to adopt “investor thinking.” One that looks forward, not backward.