How do I read and interpret a company’s cash flow statement?

A cash flow statement shows the money that flows in and out of a business. Once you can interpret it, you see into a company’s financial condition - invaluable knowledge to employees, managers, owners, investors, and everyone else.

For instance, an investor can decide whether to buy in to a company. An owner can revise strategy and initiatives. And a manager can run budgets and teams, build ties with leadership, and gain standing.

Naturally, getting all this is hard without a financial background. The wording can confuse people who didn’t study finance.

You’ll learn what these statements are, how they’re structured, and what to look for next time you read one.

How Cash Changed over the Accounting Period

A cash flow statement shows how cash changed over the accounting period. It details how much cash came in and how much went out, from what sources and for what uses. It shows if a firm is raising money, what it uses the money for, and if it has enough to cover its needs now and in the future.

The cash flow statement usually covers three main parts.

• Cash flow from operations
• Cash flow from investing
• Cash flow from financing

The Operating section shows cash from usual activities, like selling goods and services. Investing covers buying or selling assets, like real estate, vehicles or patents. These purchases are paid with free cash, not loans. Financing deals with debt and equity from shares or loans.

This three-part breakdown also lets you easily see how much cash each kind of activity brings in. That then helps you base decisions on concrete information, since now you know how much money is being made and what is using it.

Ultimately, you’re looking to see if operational cash flow reliably comes in ahead of net income. That positive cash flow means the firm can cover its debts and keep growing.

But don’t mistake cash flow for profit. It’s just one part of the whole picture. To see all of it, you need to read a cash flow statement together with the balance sheet and income statement. That way you get a full understanding of how well a business is really doing financially.

By closely analyzing what has been going on in the three primary activities - operating, investing, and financing - you can make strategic decisions about how you want to continue spending and growing in the future.

Two Options for Calculating Cash Flow

To create the cash flow statement, you have two options for calculating cash flow from operations. They’re called the direct method and the indirect method.

The direct method is based on records of transactions that affected cash over the time frame you’re interested in. It subtracts operating cash disbursements from operating cash collections. These collections and disbursements come from the regular course of business, like paying bills or receiving payments.

With the indirect method, you use accrual accounting, where you record revenue and expenses at times other than when cash changes hands. This means that operating cash flow differs from net income. For instance, you might book a sale as a profit on one day, but not get paid until later, perhaps due to invoicing practices.

Start by using net income from the income statement and then reverse all the accruals made during the period by making additional adjustments. This includes adjusting for income and expenses recorded when money didn’t actually change hands.

To turn your net income into cash flow, look for non-cash expenses on your income statement. The two most consistent ones are depreciation and amortization. Depreciation means an asset is losing value over time. Amortization means payments are spread over several periods.

Whichever method you use, always read any financial statement like a business manager would. The reason you read the documents is to learn about the company’s financial health and status.

A company’s cash flow statement can tell you a lot about where they are in their business lifecycle. A fast-growing startup’s is likely to look nothing like a mature profitable company’s. If you see a sudden gap or dramatic change it might mean the firm is in transition or decline.

Investors use cash flow statements to understand how an investment or company might do in the future. They avoid companies with erratic cash flows and prefer those that reliably generate positive cash. Financial statements also let department heads see how their area contributes to the company’s total. They can then adjust their activities to help the business reach its goals. This understanding is vital when they craft budgets, hire or fire people, and pitch ideas to decision-makers.

You can also tell about a company’s financial health and stability by whether it’s got a positive or negative cash flow. A firm with a positive cash flow took in more than it spent, while a negative cash flow means the opposite: more went out than came in.

Having a positive cash flow is the ideal situation to be in. This extra cash can be reinvested in the company and its shareholders, paying off debts and finding ways to grow.

Remember, positive cash flow still isn’t the same as a profit. It is possible to be profitable but have no cash flow, or even negative cash flow. And conversely, you could be generating positive cash flow but be making no profit, or even a loss.

Negative cash flow doesn’t necessarily mean a loss in profit, though. It could happen because of a timing mismatch between spending and income. However, if the timing keeps working against you, you should find a way to fix it quickly.

Negative cash flow can also come from a decision to expand the company and invest in future growth. Before you decide whether it’s in decline, it helps to compare periods.

To see how this works in practice, here is a sample cash flow statement for Company A. It is a fictitious company for learning purposes only. This statement is just an example, you may find cash flow statements structured differently.

The beginning balance is the first line to read. Company A started the year with about $10.75 billion in its cash and cash equivalents accounts.

The year brought in $53.66 billion from operating activities. On the other side, about $33.77 billion went toward investing activities, another $16.3 billion went to financing ones, and the total outflow came to about $50.1 billion.

Company A finished the year with positive cash flow of $3.5 billion. It had a total of $14.26 billion in cash and cash equivalents by year end.

Cash flow statements are among the most essential documents in finance. Learn to understand them, and you get a vital tool for every financial decision you make - whether it’s for your job, your next deal or the next big investment you’re thinking about making.