What is a cash flow statement?
– Definition: A cash flow statement is a financial report that summarizes the actual cash a company received and paid during a given period. It reconciles noncash accounting entries to real cash movements and groups cash flows into three separate categories: operations, investing, and financing.
– Why it matters: Unlike the income statement (which can show profit under accrual accounting before cash arrives), the cash flow statement shows whether a company actually has cash to operate, invest, pay creditors, and return capital to shareholders.
How the cash flow statement is organized
A cash flow statement is split into three main sections. The sum of these three sections equals the net change in a company’s cash balance for the period.
1) Cash flows from operating activities (CFO or CFI in some texts)
– What it shows: Cash generated or used by the company’s core business. It starts from net income and adjusts for items that affected profit but did not change cash (noncash items) and for changes in working capital (short-term current assets and liabilities).
– Typical adjustments: add back depreciation and amortization (noncash expenses); subtract increases in accounts receivable (AR) because sales were recognized but not collected; add increases in accounts payable (AP) because expenses were incurred but cash has not been paid yet.
– Why look here first: Investors and creditors generally prefer companies to generate most cash from operating activities; ongoing operations are the primary, sustainable cash source.
2) Cash flows from investing activities (CFI)
– What it shows: Cash paid or received for long-term assets and investments. Examples include purchases or sales of property, plant, and equipment (PPE), and proceeds from selling investments or fixed assets
Examples include purchases or sales of property, plant, and equipment (PPE), proceeds from selling investments or fixed assets, payments for business acquisitions, and cash loans the company makes to others. Typical CFI items:
– Cash outflows to acquire fixed assets (capital expenditures, or CapEx). These reduce cash and are usually long‑lived.
– Cash inflows from selling PPE or investments (asset disposals).
– Cash paid or received on acquisitions or divestitures of businesses.
– Loans made to third parties (outflow) and collections on those loans (inflow).
Why it matters: investing cash flows show how a company is deploying capital for future growth. Large, recurring CapEx indicates capital intensity; one‑time asset sales can temporarily boost cash but may not be sustainable.
3) Cash flows from financing activities (CFF)
– What it shows: Cash flows between the company and its capital providers (equity holders and creditors).
– Typical items: proceeds from issuing stock or debt (inflows); cash used to repurchase shares or repay debt (outflows); dividends and other distributions to owners (outflows); principal repayments on leases or borrowings.
– Why it matters: CFF reveals how a company finances operations and growth—whether it relies on retained earnings, borrowing, or new equity. Heavy, persistent reliance on financing to fund operations can be a red flag.
Reconciliation and totals
– Basic identities:
– Net change in cash = Cash flow from operations (CFO) + Cash flow from investing (CFI) + Cash flow from financing (CFF)
– Ending cash balance = Beginning cash balance + Net change in cash
– The cash flow statement must reconcile to the period’s change in the cash line on the balance sheet, and it distinguishes cash and cash equivalents from noncash financing or investing transactions (those are disclosed elsewhere).
Direct vs. indirect method (operating section)
– Direct method: reports major classes of gross cash receipts and payments (cash received from customers, cash paid to suppliers, etc.). It’s conceptually straightforward but less commonly used.
– Indirect method: starts with net income and adjusts for noncash items (depreciation, amortization, stock‑based comp), gains/losses on disposals, and changes in working capital (AR, inventory, AP). Most companies use the indirect method for the operating section.
– Accounting framework: IFRS and US
– Accounting framework: IFRS and US GAAP — Differences and typical choices
– Classification of interest and dividends. Under IFRS (IAS 7), companies may classify interest received and paid and dividends received as either operating or investing/financing cash flows (but must be consistent and disclose policy). Under US GAAP (ASC 230), interest paid, interest received, and dividends received are usually classified as operating cash flows; dividends paid are classified as financing cash flows. Expect disclosure of any alternative policy.
– Income taxes. Cash paid for income taxes is generally reported as an operating cash outflow under both frameworks, but if tax cash flows can be specifically identified with financing or investing activities (rare), IFRS permits
IFRS permits that cash flows for income taxes be classified as investing or financing activities when they can be specifically identified with those activities; otherwise they are reported as operating cash outflows. Both IFRS (IAS 7) and US GAAP require disclosure of significant cash payments for interest and income taxes.
Noncash investing and financing activities
– What they are: transactions that affect assets and liabilities but do not involve cash (examples: acquiring an asset by issuing debt or equity, conversion of debt to equity, stock dividends, exchanges of nonmonetary assets).
– Reporting requirement: these must be disclosed in a separate schedule or in the notes to the financial statements so users can see material noncash events even though they are not on the cash flow statement itself.
Direct vs. indirect method for operating cash flows
– Direct method: lists major classes of cash receipts and cash payments (cash collected from customers, cash paid to suppliers, cash paid to employees, etc.). It shows actual cash inflows and outflows. Preparation can require reconstructing accrual accounting records into cash flows.
– Indirect method: starts with net income and adjusts for noncash items (depreciation, amortization, stock‑based compensation), nonoperating gains and losses (subtract gains, add losses), and changes in working capital (current assets and current liabilities).
– Presentation: both methods produce the same total cash flow from operating activities. Under US GAAP, if the direct method is used the entity must still provide a reconciliation that mirrors the indirect method. IFRS prefers the direct method but allows either.
Worked example — indirect method (numbers in thousands)
Assumptions for a period:
– Net income: 1,000
– Depreciation expense: 200 (noncash expense → add back)
– Gain on sale of equipment: 80 (nonoperating gain → subtract)
– Accounts receivable: increase 150 (use of cash → subtract)
– Inventory: decrease 50 (source of cash → add)
– Accounts payable: increase 120 (source of cash → add)
Reconciliation to cash flow from operating activities:
CFO = Net income
+ Depreciation
– Gain on sale
– Increase in accounts receivable
+ Decrease in inventory
+ Increase in accounts payable
CFO = 1,000 + 200 – 80 – 150 + 50 + 120 = 1,140
Checklist to prepare CFO using the indirect method
1. Start with net income from the income statement.
2. Add back noncash expenses (depreciation, amortization, impairment, stock compensation).
3. Subtract noncash gains and add noncash losses (e.g., gains on asset sales).
4. Adjust for changes in working capital (Δcurrent assets = subtract increases, add decreases; Δcurrent liabilities = add increases, subtract decreases).
5. Reconcile to any items classified as investing/financing that affected net income (e.g., interest income that was classified to investing).
6. Compare result to bank cash movement and note material reconciling items.
Free cash flow (FCF) variants — simple formulas and example
– Common operating-based FCF: FCF = Cash flow from operations − Capital expenditures (CapEx).
Example: Using the CFO above 1,140 less CapEx 300 → FCF = 840.
– Free cash flow to the
firm (FCFF): the cash available to all capital providers (both debt and equity holders) after the company pays operating expenses, taxes, and required reinvestment in working capital and fixed assets. Common formulas (choose one consistent with your inputs):
– FCFF = Cash flow from operations + Interest × (1 − tax rate) − Capital expenditures (CapEx).
– Alternate (income-statement based): FCFF = EBIT × (1 − tax rate) + Depreciation & amortization − ΔWorking capital − CapEx.
Worked numeric example (continuing the numbers above):
– Cash flow from operations (CFO) = 1,140
– Interest expense = 100
– Assumed tax rate = 25%
– CapEx = 300
Compute interest after tax = 100 × (1 − 0.25) = 75
FCFF = 1,140 + 75 − 300 = 915
Notes:
– Use FCFF when valuing the entire firm (discount rate = WACC, weighted average cost of capital).
– Make sure interest is treated consistently: if CFO already includes interest paid, add back the after-tax interest when calculating FCFF.
– Free cash flow to equity (FCFE): the cash available to equity holders after all expenses, reinvestment, and net debt repayments/issuances. Common formulas:
– FCFE = Cash flow from operations − CapEx + Net borrowing (net debt issued = debt issued − debt repaid).
– Alternate: FCFE = Net income + Depreciation & amortization − ΔWorking capital − CapEx + Net borrowing.
Worked numeric example (using CFO-based formula and continuing numbers):
– CFO = 1,140
– CapEx = 300
– Net borrowing (new debt issued minus repayments) = 50
FCFE = 1,140 − 300 + 50 = 890
Notes:
– Use FCFE when valuing only the equity claim (discount rate = required return on equity).
– If the company has preferred dividends, subtract them for FCFE.
Practical checklist when computing any FCF variant
1. Decide which FCF you need (simple FCF, FCFF, FC
FF?E, etc.) — pick FCFF (free cash flow to the firm), FCFE (free cash flow to equity), or a simple operating free cash flow.
2. Choose the base statement
– CFO (cash flow from operations) gives a cash-based starting point.
– Net income gives an accrual-based starting point (adjust for non-cash items and interest tax effects).
– Be consistent with your valuation approach (use CFO when you want pure cash movements; use net income when you will add back interest*(1−tax) for FCFF).
3. Use the correct formula (pick and stick)
– FCFF (common variants):
– From EBIT: FCFF = EBIT × (1 − tax rate) + Depreciation & amortization − ΔWorking capital − CapEx
– From net income: FCFF = Net income + Non-cash charges + Interest*(1 − tax rate) − ΔWorking capital − CapEx
– FCFE:
– FCFE = CFO − CapEx + Net borrowing
– Or: FCFE = Net income + Depreciation & amortization − ΔWorking capital − CapEx + Net borrowing
– Document which version you used and why (tax treatment of interest, treatment of minority interest, preferred dividends).
4. Measure each component carefully
– Depreciation & amortization: use the non-cash expense from the income statement. If forecasting, tie to historical capex and useful lives.
– ΔWorking capital: use change in (current assets − current liabilities), excluding cash & short-term debt if you prefer. Define which line items you include (inventory, receivables, payables).
– CapEx: use cash paid for purchase of PP&E from the cash flow statement (not the accrual of capital commitments). For forecasts, express as % of revenue or as a function of growth and depreciation.
– Net borrowing: use net cash from financing for debt issuance minus repayments; treat preferred dividends as a reduction to FCFE.
5. Check timing and consistency
– Compute FCF on the same period basis (annual vs quarterly). For multi-year forecasts, ensure working-capital changes align with revenue timing.
– When moving from annual to perpetual-growth terminal values, convert one-off items and normalize seasonality.
6. Forecast practicalities (step-by-step)
– Step A — Project revenue growth for each forecast year.
– Step B — Project operating margin (or EBIT margin) and derive EBIT.
– Step C — Estimate D&A as a function of prior capex schedules or as a % of revenue.
– Step D — Forecast ΔWorking capital using working-capital ratios (days receivable, days inventory, days payable). Convert days → levels: WC = (Days × Revenue)/365 etc.
– Step E — Forecast CapEx (either absolute values tied to growth or as % of revenue).
– Step F — Compute FCFF or FCFE using your chosen formula.
– Step G — Discount FCF series using the appropriate discount rate (WACC for FCFF; cost of equity for FCFE).
7. Reconcile with reported cash flows
– After calculating FCF for a historical period, reconcile to the cash flow statement: CFO − CapEx should be close to operating free cash flow; differences often stem from classification (e.g., asset sales included in investing cash flow).
– Investigate large reconciling items: asset sales, acquisitions, large non-cash charges, one-time tax items.
8. Common pitfalls and adjustments
– Don’t double-count non-recurring items (restructuring, impairment). Treat them separately or normalize earnings.
– Watch lease accounting (IFRS 16 / ASC 842): right-of-use asset rules affect capex and interest. Decide whether to adjust reported capex or interest for comparability.
– Working-capital swings can dominate short-term FCF — check seasonality and business model (subscriptions vs inventory-heavy retail).
– Interest: for FCFF use after-tax interest (or start from EBIT to avoid mixing capital structures); for FCFE include actual interest and net borrowing.
Worked forecasting example (concise)
– Assumptions for Year