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Steve Bauer

Investment Basics

This is a Course called "Investment Basics" - created by Professor Steven Bauer, a retired university professor and still active asset manager and consultant /…

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Investment Basics - Course 303 - The Statement of Cash Flows

This is the eighteenth Course in a series of 38 called "Investment Basics" - created by Professor Steven Bauer, a retired university professor and still active asset manager and consultant / mentor.


Course 303 - The Statement of Cash Flows


Now that we've run through the income statement and balance sheet, it's time to take a look at arguably the most important as well as the most complex of the three major types of financial statements, the statement of cash flows. The statement of cash flows tells you how much cash went into and out of a company during a specific time frame like a quarter or a year. In other words, it shows how much cash a company is generating from one period to the next -- and cash is what matters most.

What It Tells You

The statement of cash flows seems similar to the income statement, which shows how much revenue came in and how many expenses went out. The difference lies in a concept called accrual accounting. As discussed in Course 301, accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. The principle is known as matching -- expenses must match the revenues those expenses created whenever possible. While that explanation seems simple enough, it gets messy in practice, and the statement of cash flows helps investors sort it out.

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

Cash Flows from Operating Activities

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

The cash flows from operating activities section comes first and tells you how much cash the company generated from its core business, as opposed to peripheral activities such as investing or borrowing. This is the area you should focus most of your attention on because it paints the best picture of how well a firm's business operations are producing cash that will ultimately benefit shareholders. Some of the main line items found in this section are described below:

Net Income. This figure is taken directly from a company's income statement. Net income is the starting point of how much cash a company provides from its operations. However, there are plenty of items on the income statement that affect income but don't affect cash flow, so all the remaining items are adjustments to net income that help you reconstruct how much actual cash was generated by the business.

Depreciation and Amortization. As we mentioned in Course 301, depreciation is accounting's way to record wear and tear on a company's property, plant, and equipment (PP&E). Even though it's an expense on the income statement, depreciation is not a cash charge, so it's added back to net income.

Changes in Working Capital. Working capital is calculated as current assets minus current liabilities on the balance sheet (see Course 302). Just as the name suggests, working capital is the money that the business needs to "work." Therefore, any cash used in or provided by working capital is included in the "cash flows from operating activities" section.

Any change in the balances of each line item of working capital from one period to another will affect a firm's cash flows. For example, Harley-Davidson's accounts receivable increased at the end of 2004. This means that the firm collected less money from its customers than it recorded in sales during 2004 on its income statement. This is a negative event for cash flow and is one of the reasons Harley's "Net changes in current assets and current liabilities" on its 2004 cash flow statement is negative. However, if accounts payable were also to increase, it means a firm is able to pay its suppliers more slowly, which is a positive for cash flow.

We're all about shortcuts to make financial statement analysis easier, so here's a little secret that's all you really need to remember regarding changes in working capital:

  • If balance of an asset increases, cash flow from operations will decrease.
  • If balance of an asset decreases, cash flow from operations will increase.

  • If balance of a liability increases, cash flow from operations will increase.
  • If balance of a liability decreases, cash flow from operations will decrease.

Current assets may include things like inventories and accounts receivable, while current liabilities would include short-term debt and accounts payable.

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

Cash Flows from Investing Activities

This section of the cash flow statement shows the amount of cash firms spend on investments. Investments are usually classified as either 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 parts of this section for investors are typically the capital expenditures line item and the line item for acquisitions of other businesses.

Capital Expenditures. This figure represents the amount of cash a company spent on items that last a long time, such as property, plant, and equipment (PP&E). Basically, capital expenditures -- often referred to as "capex" -- are brick-and-mortar types of investments that are necessary to keep the company running and growing in its current form. For example, in order for a supermarket to keep operating and growing, it will typically need to remodel its existing stores, replace its equipment, and build new stores. These expenditures will show up in the capex line item in the "cash flows from investing activities" section.

One of the most important terms and figures you should become familiar with is free cash flow. Free cash flow is calculated as net cash from operating activities minus capital expenditures. This figure represents the amount of excess cash a company generated, which can be used to enrich shareholders or invest in new opportunities for the business without hurting the existing operations.

Prof's. Guidance: I can't emphasize enough that this figure -- free cash flow -- is one of the most important foundations in determining a company's ability to enrich its shareholders. It get permits doing some wonderful fundamental valuations which separates the positive companies from those that are not so positive. Remember, fundamentally companies rotate into favor and then perhaps back out of favor and maybe back into favor over time. This is a wonderful thing to remember.

Cash Used for Acquisitions. The acquisitions line item refers to how much cash a company paid to acquire another. Because companies tend to overpay for acquisitions, it's a good idea to keep an eye on this line item to see how much cash a company is spending on acquisitions. This line item will also give you a good sense of how much of a company's growth is coming from internal sources versus acquisitions.

Cash Flows from Financing Activities

The final section of the statement of cash flows is "cash flows 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 self-explanatory -- dividends paid is exactly what it says -- I think investors should look carefully at how much stock a company is issuing or repurchasing.

Issuance/Purchase of Common Stock. This is an important number to look at because it shows how a company is financing its business. Newer companies and rapidly growing companies often need to issue lots of new stock to fund their growth. New stock issuance typically dilutes existing shareholders' ownership -- they own a smaller piece of the whole pie -- but it also gives the company cash to expand.

Meanwhile, mature companies that have ample free cash flow often will buy back their own stock, which has the effect of increasing the value of existing shares -- existing shareholders own a bigger piece of the pie. Share repurchases and dividend payments are typically the only two ways a company can enrich its shareholders with its cash flows.

The Bottom Line

Congratulations! You've made it through three lessons of pretty in-depth coverage of the three most important financial statements. While this knowledge may not make you the life of your next party, understanding how to read financial statements is a fundamental skill required to be a knowledgeable investor.

Quiz 303
There is only one correct answer to each question.

  1. Which of the following will decrease a company's net cash provided by operating activities (operating cash flow)?
    1. A decrease in inventories.
    2. A decrease in accounts receivable.
    3. A decrease in accounts payable.
  1. Which of the following is not true about operating cash flow?
    1. It is always greater than net income.
    2. It's a useful measure for companies with lots of depreciation and other noncash items.
    3. It doesn't include cash flows from buying or selling investments.
  1. All else being equal, when a company's capital expenditures increase:
    1. Net income decreases by the amount of the expenditures.
    2. Free cash flow decreases.
    3. Free cash flow increases.
  1. Which of the following is not one of the three major sections of the statement of cash flows?
    1. Cash flows from operating activities.
    2. Cash flows from acquisition activities.
    3. Cash flows from financing activities.
  1. The total amount of shares issued or repurchased is found in which of the following sections of the statement of cash flows?
    1. Cash flows from operating activities.
    2. Cash flows from investing activities.
    3. Cash flows from financing activities.

Thanks for attending class this week - and - don't put off doing some extra homework (using Google - for information and answers to your questions) and perhaps sharing with the Prof. your questions and concerns.


Investment Basics (a 38 Week - Comprehensive Course)
By: Professor Steven Bauer

Text: Google has the answers to most all of your questions, after exploring Google if you still have thoughts or questions my Email is open 24/7.

Each week you will receive your Course Materials. There will be two kinds of highlights: a) Prof's Guidance, and b) Italic within the text material. You should consider printing the Course Materials and making notes of those areas of questions and perhaps the highlights and go to Google to see what is available to supplement those highlights. I'm here to help.

Freshman Year

Course 101 - Stock Versus Other Investments
Course 102 - The Magic of Compounding
Course 103 - Investing for the Long Run
Course 104 - What Matters & What Doesn't
Course 105 - The Purpose of a Company
Course 106 - Gathering Information
Course 107 - Introduction to Financial Statements
Course 108 - Learn the Lingo & Some Basic Ratios

Sophomore Year

Course 201 - Stocks & Taxes
Course 202 - Using Financial Services Wisely
Course 203 - Understanding the News
Course 204 - Start Thinking Like an Analyst
Course 205 - Economic Moats
Course 206 - More on Competitive Positioning
Course 207 - Weighting Management Quality

Junor Year

Course 301 - The Income Statement
Course 302 - The Balance Sheet
Course 303 - The Statement of Cash Flows
Course 304 - Interpreting the Numbers
Course 305 - Quantifying Competitive Advantages

Senor Year

Course 401 - Understanding Value
Course 402 - Using Ratios and Multiples
Course 403 - Introduction to Discounted Cash Flow
Course 404 - Putting OCF into Action
Course 405 - The Fat-Pitch Strategy
Course 406 - Using Morningstar as a Reference
Course 407 - Psychology and Investing
Course 408 - The Case for Dividends
Course 409 - The Dividend Drill

Graduate School

Course 501 - Constructing a Portfolio
Course 502 - Introduction to Options
Course 503 - Unconventional Equities
Course 504 - Wise Analysts: Benjamin Graham
Course 505 - Wise Analysts: Philip Fisher
Course 506 - Wise Analysts: Warren Buffett
Course 507 - Wise Analysts: Peter Lynch
Course 508 - Wise Analysts: Others
Course 509 - 20 Stock & Investing Tips

This Completes the List of Courses.

Wishing you a wonderful learning experience and the continued desire to grow your knowledge. Education is an essential part of living wisely and the experiences of life, I hope you make it fun.

Learning how to consistently profit in the Stock Market, in good times and in not so good times requires time and unfortunately mistakes which are called losses. Why not be profitable while you are learning? Let me know if I can help.


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