Walk me through the cash flow statement: what does each of the three sections capture, and what's the overall purpose of the statement?
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The answer
- The cash flow statement reconciles accrual-based net income back to actual cash, and it separates every cash movement into operating, investing, and financing activities.
- Cash flow from operations starts with net income, adds back non-cash expenses like depreciation and stock-based compensation, then adjusts for changes in operating working capital. An increase in receivables or inventory is a use of cash, while an increase in payables is a source. CFO shows the cash generated by the core business.
- Cash flow from investing captures cash spent on long-term assets, primarily capital expenditures and acquisitions, and cash from asset sales. It is typically negative for a healthy, growing company because it is reinvesting.
- Cash flow from financing captures cash flows to and from lenders and shareholders: issuing or repaying debt, issuing or buying back equity, and paying dividends. Dividends are a financing outflow and never touch the income statement.
- The three sections sum to the net change in cash, which is added to beginning cash to get ending cash. Ending cash must tie to the cash line on the balance sheet.
- Free cash flow is CFO minus CapEx, the cash available after necessary reinvestment. It is the critical input for valuation because it represents cash that can actually be returned to capital providers.
Cash flow statement
| Operating activities | |
| Net income | 100 |
| + D&A | 40 |
| +/− Change in working capital | (20) |
| Cash from operations (CFO) | 120 |
| Investing activities | |
| Capital expenditures | (60) |
| Cash from investing (CFI) | (60) |
| Financing activities | |
| Debt repayment | (30) |
| Dividends paid | (10) |
| Cash from financing (CFF) | (40) |
| Net change in cash | 20 |
| Beginning cash | 130 |
| Ending cash | 150 |
Illustrative figures
Also asked as
- If accounts receivable increases by $15 during the year, what is the effect on cash flow from operations, and why?
- Why does CapEx appear in investing activities rather than operating activities, even though it's necessary to run the business?
- Explain why dividends paid never appear on the income statement, and where they do appear.
- Is negative cash flow from investing always a bad sign? Explain with an example of when it isn't.
- What's the difference between levered and unlevered free cash flow, and why does a DCF use one over the other?
- Name three ways a company could artificially inflate its reported cash flow from operations in a single period, and explain why each is unsustainable.
- A company reports net income of $70, D&A of $18, an increase in accounts receivable of $22, a decrease in inventory of $6, and an increase in accounts payable of $14. Compute CFO.
- A company has EBIT of $200, a 30% tax rate, D&A of $35, an increase in net working capital of $12, CapEx of $50, and $300 of debt at 5% interest. Compute both levered free cash flow (via net income) and unlevered free cash flow (via EBIT), and show that the difference equals after-tax interest expense.
- A company's CFO grew from $80 to $130 year over year while net income grew only from $75 to $85. The CFO build shows accounts payable contributed $45 of the increase versus $5 the prior year, with no other major changes. Assess whether this cash flow growth is sustainable and explain what you'd expect in the following year if it isn't.
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- Explain the three hard linkages between the three financial statements.
- What is the difference between COGS and SG&A? Give two examples of costs that belong in each for a manufacturing company.
- Why does cash increase, not decrease, when depreciation increases, assuming a positive tax rate?
- Guide: Accounting terms study guide
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