What Is The Cash Flow Statement And How To Analyze It?

What is a cash flow statement?


A cash flow statement is a financial statement that summarizes all cash inflows received by a company from continuing operations and external investment sources during a specific period of time. It also comprises all cash outflows used to fund the company’s operations and investments over a certain time period. The financial statements of a firm provide investors and analysts with a picture of all the transactions that occur within the organization, where each transaction adds to its growth. In simple words, cash flow is the movement of cash in and out of the company’s account.

The cash flow statement reconciles both the income statement and the balance sheet, and they complete each other in which the first line in the cash flow statement, "consolidated net income," is the same as the bottom line, "income from continuing operations" on the income statement, and the last line in the cash flow statement, "cash and cash equivalents at end of the year" is the same as "cash and cash equivalents” which is the first line under current assets in the balance sheet.

Example of a cash flow statement

Example of a cash flow statement| Source: Harvard Business School Online
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How do we calculate the cash flow statement?

There are 3 types of cashflows; cash flow from operations (CFO), cash flow from investing (CFI), and cash flow from financing (CFF).

Cash flow from operations:

It is the money generated from the core business activities, calculated using two methods:

Direct Method:

The direct method is used by the Financial Accounting Standards Board (FASB), but it is less preferred by companies because it needs more time and details to calculate. it shows more details on the movement of cash in the business. A business keeps a cash record of all transactions and shows the cash flow statement with actual cash flow from the accounting period. it calculates the net cash flows from operations more "directly”. It uses a simple income statement style approach by adding up the income and subtracting the expenses.

It groups cash transactions into major classes; cash receipts and cash payments.

Cash Received from customers = Sales + Decrease (or - Incease) in Account Receivable

Cash Paid for opetating expenses (including research and development)=operating expenses+increase (or−decrease)inprepaid expenses+decrease (or−increas)in accrued liabilities. Cash Payments Made to Employees = Beginning Salaries Payable - Ending Salaries Payable + Salaries Expense

Cash Payments for Prepaid Assets = + Ending Prepaid Rent, Prepaid Insurance etc. - Expired Rent, Expired Insurance etc - Beginning Prepaid Rent, Prepaid Insurance etc.
Interest Payments = Beginning Interest Payable - Ending Interest Payable + Interest Expense.
Income Tax Payments = Beginning Income Tax Payable - Ending Income Tax Payable + Income Tax Expense

Indirect Method:

The indirect method starts with the net income from the income statement and adds back all of the non-cash activities to arrive at the ending net cash from operating activities.

The indirect method differs from one company to another;

CFO=(Net income+Depreciation, Depletion and Amortization
+Deferred Taxes & Investment Tax Credit+Other Funds)
+Changes in Working Capital


CFO=net income depreciation, depletion and amortization
+adjustments to net income+changes in accounts recievables
+changes in liabilities+changes in inventories
+changes in other operating activities

Cash flow from investing:

It shows the cash flow from acquisitions and selling of long-term assets and other investments not included in cash equivalents.

Cash flow from financing:

It shows the cash flow that causes changes in the size and composition of the shareholder’s equity and borrowings of the entity such as bonds, stocks, and cash dividends.


What are some important financial ratios calculated from the cash flow statement?

Free Cash Flow=Operating Cash Flow−Capital Expenditure

One ratio is the free cash flow (FCF) which is used to determine a company's genuine profitability. FCF is a very important indicator of financial performance that tells a better narrative than net income since it reveals how much money the firm has left over after paying dividends, buying back shares, or paying down debt to develop the business or return to shareholders. A ratio of less than 1% indicates that the company is not making enough cash flow from its sales to meet its expenses, while a ratio of greater than 1% indicates that the company has more cash available than it spends on capital expenditures.

Cash Flow coverage ratio=
Operating Cash flows
Total Debt

Another ratio is the CF Coverage ratio which shows whether the firm has the sufficient cash flow to pay for scheduled principal and interest payments on its debt. The ratio should be at greater than 1 to 1. For example, if the ratio is 1.6 means that there is at least $1.60 in operating cash flows to pay off every $1 of interest payments.

Cash Flow Margin Ratio=
Operating Cash flows

It shows the company’s efficiency in converting sales to cash. The higher the percentage, the more cash is available from the sale, and a margin ratio of 60% indicates goodness and that the company has a high level of profitability.

Current Liability Coverage Ratio=
Operating Cash flows
Current Liabilities

It shows the company’s ability to pay off its debts. If this ratio is less than 1:1, a business is not generating enough cash to pay for its current debt, and so maybe at major risk.

Price to Cash Flow Ratio=
Share Price
Operating Cash Flow per share

It is a stock valuation indicator where it measures the value of the price of the stock compared to its operating cash flow per share. A ratio of less than 15 to 20 is considered a good ratio. The P/ CF is sometimes preferred over the Price to earnings (P/E) ratio because the net income of the Cash Flow takes into account the depreciation and amortization in the addition equation since these are not cash expenditures. While the net income that goes into the Earnings of the P/E ratio does not add these in, hence underestimating the income and skewing the ratio.

What are the limitations of the cash flow statement?

A negative cash flow does not necessarily mean that the company is bankrupt, rather it might be part of a growth strategy. Therefore, it is crucial to do a vertical financial analysis where an analyst compares the company's results over a certain period of time to make sense of the figures, as well as analyzing the balance sheet and the income statement in parallel for a holistic view of the health of the company. Also, it is important to compare the figures to the company’s specific industry to know more about the competitiveness of the company among its counterparts.

The content published above has been prepared by CFI for informational purposes only and should not be considered as investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.