9.6 Three Sections of the Cash FLow

Hanumant Dhokle

FINANCIAL STATEMENT ANALYSIS

Companies produce and consume cash in different ways and so the cash flow statement is divided into three sections: cash flows from operations, financing and investing. Basically, the sections on operations and financing show how the company gets its cash, while the investing section shows how the company spends its cash:

Cash Flows From Operating Activities:

This section shows how much cash comes from the sales of the company's goods and services less the amount of cash needed to make and sell those goods and services. Investors tend to prefer companies that produce a net positive cash flow from operating activities. High growth companies, such as technology firms, tend to show negative cash flow from operations in their formative years. At the same time, changes in cash flow from operations typically offer a preview of changes in the net future income. Normally it’s a good sign when it goes up. Watch out for a widening gap between a company's reported earnings and its cash flow from operating activities. If the net income is much higher than cash flow, the company may be speeding or slowing its booking of income or costs.

Cash Flows From Investing Activities:

This section largely reflects the amount of cash the company has spent on capital expenditures, such as new equipment or anything else that is needed to keep the business going. It also includes acquisitions of other businesses and monetary investments such as money market funds. You want to see a company re-invest capital in its business by at least the rate of depreciation expenses each year. If it doesn’t re-invest, it might show artificially high cash inflows in the current year which may not be sustainable.

Cash Flow From Financing Activities:

This section describes the goings-on of cash associated with outside financing activities. Typical sources of cash inflow would be cash raised by selling stock and bonds or by bank borrowings. Likewise, paying back a bank loan would show up as a use of cash flow, as would dividend payments and common stock repurchases.

Relevance Of Cash Flow Statements:

A good investor is attracted to companies that produce plenty of free cash flow (FCF). Free cash flow signals a company’s ability to pay debt, pay dividends, buy back stock and facilitate the growth of business. Free cash flow, which is essentially the excess cash produced by the company, can be returned to shareholders or invested in new growth opportunities without hurting the existing operations. The most common method of calculating free cash flow is:

Net Income + Amortization / Depreciation – Changes In Working Capital – Capital expenditures = Free Cash Flow.

Ideally, investors would like to see that the company can pay for the investing figure out of operations without having to rely on outside financing to do so. A company’s ability to pay for its own operations and growth signals to investors that it has very strong fundamentals.

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