cash flow statementHow to read a statement of cash flows.

A more advanced reader might want to check out this excellent book (which the author is currently reading), Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance.

Cash is King

After a firm sells a product and then after deducting the cost of providing the product including raw material, labor cost and other expenses from the revenue the firm’s earning or net income can be ascertained. If the firm was paid in cash for the sales then the earnings and cash flow would be the same, however in the real world earnings and cash flow vary because of the way the accrual accounting treats the timing difference between recognizing revenues and expenses, versus when the firm actually receives and pays out cash. Sometimes a company will make a sale on credit to its customers and not receive immediate cash. In such cases the company will show positive earnings but has not produced any cash, and this will inaccurately misguide investor’s perception of the profitability of the firm.

Free Cash flow can be calculated by starting with net income and adding back non-cash expenses like depreciation and amortization. Afterwards you subtract working capital and capital expenditures from it. Capital outlays in the form of capital expenditures should be taken into account while calculating free cash flow as a firm will require replacing its fixed investments as they depreciate over time.

Free cash flow will gives a more accurate picture of how much the company is really earning and can return to its shareholders.  Warren Buffett utilized the cash flow concept of owner earnings, years before the SEC required cash flow statement to be filled by companies.

Free cash flow is a commonly used metrics by investors today.

The Cash flow statement shows the investor how much cash flow in or out of the business, and it also reconciles the income statement and the balance sheet. The balance sheet gives a snapshot of a company’s assets and liabilities, and the income statement shows the profitability of the business during a certain period. The cash flow statement records the inflow and outflow of cash transactions during the given period.

Cash flow statements are categorized into three sections.

The first Cash flow from Operating activities- this section measures the cash produced and used by the company’s operations. It shows whether the company is producing consistent cash flow and accounts for sales made on credit to customers and also purchases made on credit from suppliers. It also includes non-cash expenses like depreciation and amortization.

The second section is Cash flow from Investing activities– this section includes items like capital expenditures, acquisition of businesses, and purchase and sale of investment securities by the company.

The third is Cash flow from financing activities- this section measures the cash flow between a firm and its owner and creditors and includes items such as Proceeds from sale of share, proceeds from issuance of debt, stock repurchases and dividend payments.

Consider the cash flow statement of Microsoft Inc from 2010

CASH FLOWS STATEMENTS

(In millions)


Year Ended June 30, 2010 2009 2008
Operations
Net income $ 18,760 $ 14,569 $ 17,681
Adjustments to reconcile net income to net cash from operations:
Depreciation, amortization, and other noncash items 2,673 2,562 2,056
Stock-based compensation 1,891 1,708 1,479
Net recognized losses (gains) on investments and derivatives (208 ) 683 (572 )
Excess tax benefits from stock-based compensation (45 ) (52 ) (120 )
Deferred income taxes (220 ) 762 935
Deferral of unearned revenue 29,374 24,409 24,532
Recognition of unearned revenue (28,813 ) (25,426 ) (21,944 )
Changes in operating assets

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