The statement of cash flows is crucial to any business. Understanding this statement will set you apart as both an investor and business owner. As the saying goes, "cash is king." By mastering the nuances of the statement of cash flows, you’ll gain deeper insights into a business's strengths and weaknesses. I highly recommend analyzing the statement of cash flows alongside the income statement and balance sheet while also considering both the business’s historical performance and future prospects. If you’re curious about these financial statements, you’re in luck—I’ve previously written about both. Check them out below:
In its simplest form, the statement of cash flows describes the cash inflows and outflows of a business. It is divided into three main sections: 1) Operating Activities, 2) Investing Activities, and 3) Financing Activities.
1. Cash from Operating Activities
This section details the cash inflows and outflows from a company’s core operations. Items such as payroll, rent, payments for inventory, and sales receipts are included here. Pay close attention to this section, as it reveals how successful the business model is. For instance, if a company has negative cash flow from operations, it’s a major red flag and may indicate the need for additional financing to stay afloat. And so begins a vicious cycle of either giving up ownership of the company or incurring additional interest bearing debt. It's also crucial to analyze a company's operating cash flow over time. For start-ups, negative cash flow from operations is not unhear of. However, if you examine the trend over time—such as a 5-year, 10-year, or even 30-year period—and the pattern remains negative, run away.
2. Cash from Investing Activities
This section describes the cash inflows and outflows from a company’s investment activities, including the acquisition and disposal of long-term assets like property, plant, and equipment. These capital expenditures represent investments made to support operations and are expected to generate returns over time. A critical question to ask here is how well the company is positioning itself for long-term growth. Are they investing in assets that will sustain their competitive advantage? One key metric to focus on is free cash flow (FCF), which you can calculate by subtracting a company’s capital expenditures from its operating cash flow. This metric shows how much cash is available for discretionary uses, such as paying dividends to shareholders, reducing debt, or investing in future growth initiatives.
3. Cash from Financing Activities
This section addresses how the company is financed and, essentially, who owns it. Financing activities reveal whether the company is funded through equity or debt. Equity represents ownership in the company, where investors buy shares and become part-owners, while debt involves borrowing money that must be repaid, usually with interest. Both equity and debt have advantages and disadvantages—there’s no "right" way to finance a company. You’ll also find any cash dividends paid to shareholders within this section. Dividends are a portion of the company’s profits distributed to its owners. Companies have two options: they can either retain earnings to reinvest in growth or distribute them as dividends. Again, there’s no “right” answer, as both choices have their pros and cons. However, as a business owner or investor, the key takeaway is understanding the company’s reasoning behind its decisions. If they are retaining the profits for future growth, are they doing a decent job? You can revisit the Cash from Investing Activities to find out.
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