Now that income’s been and gone, let’s go with the flow. The cash flow statement explains a company’s sources and uses of cash across three main activities. Here’s a simple example:

As the presence of net income suggests, cash flow from operations (CFO) is the crucial amount of money generated from core business activities like making and selling products. It’s calculated by adding back any non-cash expenses that were previously deducted from net income (such as depreciation and amortization, which involve accounting for the declining value of assets over time) and factoring in any changes in working capital such as an increase in inventory (which represents a cash outflow).

Cash flow from investing (CFI), meanwhile, includes capital expenditures – the amount spent on building new factories and stores, purchasing equipment, and so on – as well as any money made (or lost) via other investing-type activities: acquisitions, asset sales, and so on. Finally, cash flow from financing (CFF) shows the amount of cash generated and jettisoned from dividend payments, share issues or repurchases, and taking out or paying off debt, i.e. bonds and loans 🔁

One of the first things to figure out when analyzing a cash flow statement is the firm’s cash conversion rate. Cash, as they say, is king – and this metric measures a firm’s ability to convert accounting profit (as shown on the income statement) into actual money in the bank. It’s calculated as CFO divided by net income, and – you guessed it – the higher the ratio the better. Once again, it’s even more informative if we compare the company’s cash conversion rate to its peers’.

Another very important thing investors like to look at is how much free cash flow (FCF) the company generates – and what it does with it. FCF represents the amount of cash generated after all necessary reinvestments back into the business; it’s calculated as CFO minus capital expenditures. What investors ideally want to see is positive and growing FCF which the company is using to pay down debt – and dishing out to shareholders through dividends and share buybacks, natch 😉

Negative FCF is common among young companies spending heavily to grow – and that’s fine, so long as you think the company’s growth strategy will eventually lead to positive FCF. But persistently negative FCF – especially at a more mature company with lots of competition – is never a good sign. Making matters worse, a company in this position will have to constantly finance itself by issuing new debt or shares – and the latter dilutes the value of existing shares.

To better illustrate these points, let’s once again compare two hypothetical companies in the same industry: GreatCo and AwfulCo.

Whaddaya know: GreatCo’s CFO is growing every year, and it’s got a very high cash conversion rate. It’s not only generating positive FCF, but that figure is growing every year. That allows the company to distribute an increasing amount of cash back to GreatCo’s shareholders. Finally, note the net increase in cash every year other than 2017, when the firm paid back lots of debt. That’s not a bad use of cash; it should lower interest expenses and reduce overall riskiness 👍

Now let’s look at AwfulCo’s cash flow statement:

Dear oh dear. AwfulCo’s CFO is shrinking every year – and its cash conversion rate, at less than 50%, is very poor. It’s also generating ever-more negative FCF. To make up for that shortfall, the firm has to constantly issue both new shares and debt – and despite that, its cash pile is still consistently decreasing… 🙀