What is cash flow (short definition)
– Cash flow is the movement of cash into and out of a business over a specific period. Inflows include collections from customers, interest, investment proceeds and other cash receipts. Outflows are payments for operating expenses, investing purchases and financing obligations. Net cash flow = total inflows − total outflows.
Why cash flow matters (brief)
– Positive net cash flow increases a company’s liquid resources, enabling it to meet bills, invest, return capital to owners, and build a buffer against downturns. Negative net cash flow means the business used more cash than it generated in the period and may need to draw on reserves or external financing.
Core components and where they appear
– Cash flow statement: A required financial statement for public companies that shows cash movements for a reporting period and reconciles the income statement and balance sheet. Its bottom line is the net increase (or decrease) in cash and cash equivalents.
Three standard sections of the cash flow statement
1. Cash flow from operations (CFO / operating cash flow)
– Cash generated or used by the company’s normal business activities (receipts from customers minus cash payments for operating expenses). It indicates whether the company’s core business generates sufficient cash to cover ongoing obligations.
2. Cash flow from investing (CFI)
– Cash used for or provided by investing actions such as buying or selling property, equipment, acquisitions, or financial investments. Large negative investing cash flow can reflect growth investments (not necessarily bad).
3. Cash flow from financing (CFF)
– Cash received from or paid to providers of capital, including issuing or repaying debt, issuing stock, and paying dividends. This shows how the business funds itself and returns capital to owners.
Key distinctions (short)
– Cash flow vs. revenue: Revenue is sales earned (may include credit sales); cash flow measures actual cash received and paid.
– Cash flow vs. profit: Profit (net income) is revenue minus expenses (including non-cash items such as depreciation). Cash flow focuses on actual cash movements.
– Free cash flow (FCF): Cash remaining after paying operating expenses and capital expenditures (capex). FCF shows the cash a company can use at management’s discretion.
Useful formulas
– Net cash flow = Cash inflows − Cash outflows
– Operating cash flow (simplified) = Cash received from sales − Cash paid for operating expenses
– Free cash flow (common measure) = Operating cash flow − Capital expenditures
– Price-to-cash-flow (P/CF) = Market price per share ÷ operating cash flow per share
How to analyze cash flows — practical checklist
– Confirm operating cash flow is positive and trending with or above net income over time.
– Compare CFO to net income to identify large non-cash adjustments (e.g., depreciation, changes in working capital).
– Inspect investing cash flow: negative values may indicate reinvestment for growth; large one-time asset sales produce positive CFI.
– Review financing cash flow for signs of new debt issuance, large repayments, stock issuance, or dividend policy changes.
– Calculate free cash flow to assess discretionary cash available for dividends, buybacks, debt reduction or reinvestment.
– Check the bottom line: net change in cash and cash equivalents and the ending cash balance on the balance sheet.
– Use the P/CF ratio for valuation comparisons when earnings are distorted by non-cash charges.
Small worked examples
1) Net cash flow example
– Cash received from customers: $1,200
– Cash paid for operating expenses: $700
– Cash paid for capital equipment: $150
– Debt proceeds received: $100
Net cash flow = (1,200 inflows) − (700 + 150 + 0 outflows from operations & investing) + 100 financing inflow = 1,200 − 850 + 100 = $450 net increase in cash.
2) Free cash flow and P/CF example
– Operating cash flow (CFO) = $400
– Capital expenditures (capex) = $150
Free cash flow = 400 − 150 = $250
– If a company’s share price = $20 and operating cash flow per share = $4, then:
P/CF = 20 ÷ 4 = 5
Practical notes and caveats
– A single period of negative cash flow in investing may reflect long-term investment rather than weakness; context and trends matter.
– Cash flow metrics are most informative when used alongside the income statement and balance sheet.
– Public companies must present a cash flow statement; accounting standards set the reporting rules.
Selected reputable references
– Investopedia — Cash Flow overview: https://www.investopedia.com/terms/c/cashflow.asp
– Financial Accounting Standards Board (FASB): https://www.fasb.org
– U.S. Securities and Exchange Commission (SEC) — Financial reporting and filings: https://www.sec.gov
– International Accounting Standards — IAS 7 Statement of Cash Flows: https://www.ifrs.org/issued-standards/list-of-standards/ias-7-statement-of-cash-flows/
Educational disclaimer
This explainer is for educational purposes and does not constitute personalized investment advice, recommendations, or forecasts. Always verify financial information
and consider consulting a licensed financial professional before acting on any analysis.
Quick checklist — how to analyze a company’s cash flow
– Obtain the three core statements: income statement, balance sheet, cash flow statement.
– Reconcile net income to cash from operations (CFO) using the indirect method: start with net income, add non-cash charges (e.g., depreciation), and adjust for changes in working capital.
– Pull capital expenditures (CapEx) from investing cash flows (usually a cash outflow).
– Compute free cash flow (FCF) and key ratios (see formulas below).
– Compare trends (several years and quarters) and peer companies; one negative period can be a purposeful investment.
– Scan for red flags (see list below) and read the footnotes for nonrecurring items and accounting policy changes.
Core formulas (definitions and signs)
– Cash from Operations (CFO), indirect method:
CFO = Net income + Non-cash expenses (depreciation, amortization, stock-based comp) ± Changes in working capital
– Increase in current assets (e.g., accounts receivable, inventory) → subtract
– Increase in current liabilities (e.g., accounts payable) → add
– Free Cash Flow (FCF), simple operating definition:
FCF = CFO − Capital expenditures (CapEx)
– Operating Cash Flow Margin:
OCF margin = CFO / Revenue
– Accruals indicator (measures earnings quality):
Total accruals = Net income − CFO
Accruals ratio = (Net income − CFO) / Average total assets
High positive accruals (net income > CFO) may indicate earnings are less backed by cash.
Worked numeric example
Assume:
– Net income = $100 million
– Depreciation = $20 million
– Accounts receivable increased by $10 million (use + for increase but it reduces cash)
– Inventory increased by $5 million
– Accounts payable increased by $7 million
– CapEx = $30 million
Step 1 — compute CFO:
CFO = 100 + 20 − 10 − 5 + 7 = $112 million
Step 2 — compute FCF:
FCF = CFO − CapEx = 112 − 30 = $82 million
Interpretation: The company generated $112m in operating cash, and after reinvesting $30m in fixed assets, it has $82m of free cash to pay debt, dividends, or fund growth.
Common signs of cash-flow manipulation and things to watch
– Growing net income but flat or falling CFO over multiple periods.
– Large increases in accounts receivable relative to revenue growth (sales booked but not collected).
– Frequent one-time gains in investing cash flows (asset sales) used to mask weak operations.
– Repeated changes in working capital classification or accounting policies without clear justification.
– Unusual related-party transactions or off-balance-sheet financing disclosed in notes.
Practical analysis steps (step-by-step)
1. Collect 3–5 years of financial statements, plus the latest interim filings.
2. Recompute CFO using the indirect method from the cash flow statement to verify company math.
3. Extract CapEx from investing activities (look for “purchase of property, plant and equipment”).
4. Calculate FCF and OCF margin; compare to peers and sector medians.
5. Compute accr
ruals and accruals ratios to gauge earnings quality:
– Accruals = Net income − Cash flow from operations (CFO).
– Accruals ratio = Accruals / Average total assets (or use average revenues if you prefer scaling to sales).
– CFO conversion ratio = CFO / Net income (also called cash conversion ratio).
Interpretation tips:
– Large positive accruals (Net income > CFO) over several periods can signal low-quality or “paper” earnings because profits are not being converted into cash.
– Large negative accruals (CFO > Net income) can indicate cash-heavy performance (possibly one-off cash items) or aggressive non-cash charges; check sustainability.
6. Compare to peers and sector medians. Normalize for capital intensity (CapEx-heavy industries naturally show lower FCF margins). Use 3–5 comparable companies or industry averages and note structural differences (e.g., software vs. utilities).
Worked numeric example (step-by-step)
Assume a single-year snapshot for a company:
– Revenue = 1,000
– Net income = 80
– Depreciation & amortization (non-cash) = 30
– Increase in accounts receivable = 20 (an increase in AR reduces cash)
– Increase in accounts payable = 0
– CapEx (purchase of PP&E) = 40
– Average total assets = 500
Compute CFO (indirect method):
– CFO = Net income + non-cash charges − increase in working capital
– CFO = 80 + 30 − 20 = 90
Compute FCF (simple definition):
– FCF = CFO − CapEx = 90 − 40 = 50
Compute margins and ratios:
– OCF margin = CFO / Revenue = 90 / 1,000 = 9.0%
– FCF margin = FCF / Revenue = 50 / 1,000 = 5.0%
– Accruals = Net income − CFO = 80 − 90 = −10
– Accruals ratio = −10 / 500 = −0.02 (−2.0%)
– CFO conversion ratio = CFO / Net income = 90 / 80 = 1.125 (112.5%)
Interpretation of the example:
– CFO > Net income (negative accruals) suggests cash is stronger than reported earnings; investigate whether cash came from sustainable operations (repeatable sales collections) or one-offs (tax refunds, asset sales).
– FCF positive (50) is good in isolation; check trend and whether CapEx is maintenance or growth-related.
– OCF margin of 9% should be benchmarked to peers; in some industries that’s low, in others acceptable.
Checklist: where to look in filings and what to ask next
– Statement of cash flows: confirm classification of items (
operating, investing, financing). Check whether items that look like operations (e.g., proceeds from legal settlements, government grants, tax refunds) were placed in operating activities or shifted to investing/financing. Note non‑cash adjustments (depreciation, stock‑based comp) and whether any significant cash items were excluded as non‑cash.
– Balance sheet: trace the working‑capital changes that drove CFO. Reconcile year‑over‑year movements in:
– Accounts receivable (rising receivables can inflate sales without cash),
– Inventory (builds may tie up cash),
– Accounts payable (stretching payables can boost CFO short term),
– Other current assets/liabilities (deferred revenue, accrued expenses).
Ask whether the company is lengthening supplier terms, accelerating collections, or using inventory financing.
– Footnotes and MD&A (Management Discussion & Analysis): read footnotes for descriptions of:
– Large asset sales, insurance recoveries, tax refunds,
– One‑time restructuring or litigation cash flows,
– Cash effects of acquisitions/disposals and how purchase price was paid,
– Capital expenditure plans (maintenance vs. growth CapEx).
In MD&A, look for management’s explanation of cash flow drivers and sustainability.
– Auditor and accounting policy notes: watch for going‑concern language, changes in accounting policy (affecting classification), or qualification that could affect cash reporting.
– Ratio and trend checks (quick list):
– Accruals = Net income − CFO. Accruals ratio = Accruals / (chosen denominator; common choices: average total assets or sales). State your denominator when you use this.
– CFO conversion ratio = CFO / Net income. Values 1 indicate cash > reported earnings.
– Free cash flow (FCF) = CFO − CapEx. FCF margin = FCF / Sales.
– Operating cash flow (OCF) margin = CFO / Sales.
– CapEx intensity = CapEx / Sales.
– Debt service check: compare CFO or FCF to interest and principal payments (if publicly available).
Compute these over multiple years and versus peers.
– Red flags to investigate:
– Large positive NI with negative or declining CFO (possible aggressive accruals or revenue recognition).
– Large one‑time cash inflows classified as operating (e.g., proceeds from asset sale).
– Persistent growth in receivables or inventory relative to sales.
– Repeated reclassification of cash items between operating and investing/financing.
– Rising CapEx that is not matched by operating cash or financing capacity.
– CFO that is highly volatile vs. stable reported earnings.
Step‑by
Step‑by‑step cash‑flow analysis checklist
1) Pull the documents
– Required: cash‑flow statement, income statement, balance sheet for several years, and the 10‑K/10‑Q notes.
– Optional but useful: MD&A (management discussion & analysis) and segment disclosures.
2) Reconstruct operating cash flow (CFO)
– Basic formula (indirect method): CFO = Net income + Noncash charges (depreciation, amortization, stock‑based comp, impairments) − ΔWorking capital + Other operating adjustments (deferred taxes, noncash gains/losses).
– Worked example:
– Net income = 80
– Depreciation = 30
– ΔAccounts receivable = +10 (an increase uses cash)
– ΔInventory = +5
– ΔAccounts payable = +8 (an increase provides cash)
– CFO = 80 + 30 − 10 − 5 + 8 = 103
3) Compute free cash flow (FCF) measures
– Common definitions:
– FCF to equity (simple): FCF = CFO − Capital expenditures (CapEx).
– Free cash flow to firm (FCFF) (useful for valuation): FCFF = EBIT × (1 − t) + Depreciation − CapEx − ΔWorking capital. (EBIT = earnings before interest & taxes; t = tax rate.)
– Using numbers above and assuming CapEx = 50:
– FCF (CFO − CapEx) = 103 − 50 = 53
– If instead EBIT = 120 and tax rate = 25%, Depreciation = 30, ΔWC = +7:
– FCFF = 120×(1−0.25) + 30 − 50 − 7 = 90 + 30 − 50 − 7 = 63
4) Calculate helpful ratios (with formulas)
– Operating cash flow margin = CFO / Sales. (Shows cash conversion of revenue.)
– CapEx intensity = CapEx / Sales. (Shows how capital‑intensive the business is.)
– Cash conversion (quality) check = CFO / Net income. (Above 1 suggests conservative accounting; well below 1 warrants investigation.)
– Interest coverage (cash basis) = CFO / Interest paid
– Interest coverage (cash basis) = CFO / Interest paid
Other useful ratios and variants
– Price-to-cash-flow (P/CF) = Market capitalization / CFO
– Interprets company value relative to operating cash generation. Lower = cheaper on a cash basis.
– Cash flow per share = CFO / Shares outstanding
– Useful for per‑share comparisons when earnings per share are volatile.
– Free cash flow yield (equity basis) = Free cash flow to equity / Market capitalization
– Free cash flow to equity (FCFE) = CFO − CapEx + Net borrowing (net debt issued)
– Example: If CFO = 103, CapEx = 50, net borrowing = 0 → FCFE = 53. If market cap = 1,000 → FCF yield = 53 / 1,000 = 5.3%.
– Free cash flow yield (firm basis) = FCFF / Enterprise value
– FCFF (free cash flow to the firm) is the pre‑debt cash flow available to all capital providers (see formulas below).
– Dividend coverage (cash basis) = CFO / Dividends paid
– Or payout ratio (cash basis) = Dividends paid / Free cash flow (FCFE preferable)
– Cash conversion cycle metrics (for working capital): Days Sales Outstanding, Days Inventory, Days Payable Outstanding — these explain timing of cash inflows and outflows.
Quick worked examples (using earlier numbers)
– CFO = 103, CapEx = 50, Net income = 80, Interest paid = 10, Shares = 50, Market cap = 1,000, Dividends paid = 20
– FCF (CFO − CapEx) = 103 − 50 = 53
– Cash conversion (quality) = CFO / Net income = 103 / 80 = 1.287 → cash > accounting earnings
– P/CF = Market cap / CFO = 1,000 / 103 ≈ 9.71
– Cash flow per share = CFO / Shares = 103 / 50 = 2.06 per share
– Dividend payout (cash basis) = Dividends / FCFE = 20 / 53 ≈ 37.7%
– Interest coverage (cash) = CFO / Interest paid = 103 / 10 = 10.3x
FCFF vs. FCFE — formulas and when to use each
– FCFF (free cash flow to the firm): cash generated by operations available to all capital providers (debt and equity).
– Common formula: FCFF = EBIT × (1 − tax rate) + Depreciation & amortization − CapEx − ΔWorking capital