Cash flow statement is meant to record the cash flowing in and out of a company during a quarter or a financial year. In fact, it can seem a lot like income statement which keeps track of the revenues and expenses but there is a basic difference between the two. Usually, accrual accounting is employed while creating an income statement in which any expenses or earnings are recorded based on the date of transaction and does not necessarily mean that such and such cash inflows or outflows have taken place on a certain date. However, in a cash flow statement, the income and expenses are recorded based on the net cash inflow that has taken place.
This is why studying a cash flow statement in combination with the income statement can help investors get a better idea of how much income a company actually generates. There can be difference in the amount of income shown in income statement and on cash flow statement and the latter shows net cash from operations which can be considered as the actual cash profit generated by the company. A cash flow statement is divided into three sections:
This section shows any cash generated from operations including sales of goods and services after deducting the cash spent on production and sale of those goods and services which represents the net cash inflow for a specific period. Investors look for companies with the capability to produce net positive cash flow from its business operations. Any changes in cash flow from operations can indicate changes in net income in future.
This section of the cash flow statement shows how much the company re-invests for business growth and expansion. It includes the capital expenditures incurred by the company which can range from acquisition of other business operations, upgrading the equipment for operations and any market investments made on behalf of the company.
This section describes use of cash in financing activities which include cash inflows when it raises capital through sale of stocks or bonds and banking debts and cash outflows when it pays back some debts or pays dividends to the shareholders.
Free Cash Flow (FCF) is another important concept worth knowing to study the cash flow statement. It can be calculated in the following manner:
Net Income + Amortization/Depreciation – Changes in Working Capital – Capital Expenditures = Free Cash Flow
It represents the additional cash left with the company which can be paid back to shareholders in the form of dividends or can be used for business growth. The amortization/depreciation is added back to the net income while calculating free cash flow serves to adjust it for a more accurate measure of the current expenses. Usually, investors are attracted to stocks with high FCF but it must be kept in mind that it is not a foolproof method of assessing the growth potential of a company.
Still, growing FCF for a company can indicate growth in revenues, reduction in costs and share buybacks amongst other things which are considered good signs from the point of view of investment. This is why despite its limitations, FCF is considered a useful tool for measuring the true value of a company. On the other hand, a falling FCF is not considered a positive sign for the company because it can signal risk of incurring higher future debts, lower liquidity and unsustainable future earnings.
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