Statement of Cash Flows

Some subtractions on the income statement do not involve an outlay of cash.
Depreciation and amortization spread an asset's historical cost over an estimated useful life, but no cash is being spent when we record the expense on the income statement.

Therefore, since there's a difference between an accounting entry called "depreciation" and actual cash being spent, analysts ignore intangible expenses like that when focusing on cash flow, which is how much cash is being generated (or consumed) by a company. One way to estimate cash flow is to take the net income from the income statement and then add back two non-cash charges: depreciation and amortization.


Companies that invest in expensive factories, warehouses, and equipment can show quite different figures for net income on the one hand and cash flow from operations on the other. When they add back the depreciation that reduced their net income, their cash flow is a much higher amount.

In the issuer's 10-K, we also find a separate statement of cash flows that shows how much cash has been provided or used by the business over the reporting period. Net income and the cash generated by the business over the period are often quite different numbers. The accrual method of accounting is most widely used, and it involves the company booking revenue/sales before any cash has been exchanged. The statement of cash flows eliminates this sort of distortion, as well as intangible expenses like depreciation/amortization. A good fundamental analyst knows that some companies have been known to book "profits" when they are not generating enough cash to stay afloat.

The statement of cash flows is separated into three distinct ways in which a company can generate (or exhaust) cash: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Cash flows from operating activities are what that phrase sounds like: the company provided or exhausted this much cash through their core operations. For example, Starbucks generates most of its cash by operating thousands of successful coffee shops, but it can also generate cash through investing activities and through financing activities.

Cash flow from operations shows us the net income from the income statement, adds back depreciation/amortization, and then records the changes in working capital (from the balance sheet). After dealing with the change in the line items under current assets and current liabilities (working capital), the company can then calculate and re¬port the net cash provided/used by operating activities.

Cash flow from investing activities indicates how much cash was used or generated, usually from investing in capital equipment, and to some extent buying and selling securities, e.g. U.S. Treasuries. Capital equipment ("capex") can be thought of as all the hard, tangible infrastructure that brick-and-mortar companies have to invest in to operate, stay afloat and maybe make a profit (buying a printing press, remodeling existing stores, building new stores, etc.).

If a company is like MSFT or ORCL, they might go on a business buying binge, which is reflected in their cash used for acquisitions. Big increases in this number could indicate that the company is making strategic acquisitions of former competitors, or it could mean that they're generating too much of their returns by buying up smaller fish as opposed to operating successfully.

Cash flow from financing activities is the cash provided/used through any activity involving the shareholders (owners) or bondholders (creditors) of the company. If stock is issued, cash is generated, while if the company engages in share buyback programs, cash is used. If a company issues bonds, cash is generated, while when it finally redeems or calls those bonds, cash is used up.

Also, when the company pays dividends to shareholders, or interest payments to creditors, this is cash that is used by the company. Young, growing companies often issue stock to finance their operations. That may be fine, but new stock issues dilute the value of the existing shareholders' equity. More mature companies, with plenty of cash, often buy back their shares to make each existing share more valuable. Either way, we could track these activities under this section of the statement of cash flows.

The terms "cash flows from investing activities" and "cash flows from financing activities" could be potentially confusing. Remember that if a company buys Government securities or shares of a public company on the open market, we would see that under "cash flows from investing activities." And, if the company invests in a printing press,n that is under cash flows from investing activities, too.

Cash flow from financing activities includes the cash generated by issuing stocks or bonds and the cash used buying back stock and/or retiring bonds.

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