Lesson 26

What is a Cash Flow Statement

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Lesson 26 Objectives


Lesson Objective 1: What is a Cash Flow Statement

Lesson Objective 2: How to use a cash flow statement to identify strong versus risky companies


Lesson 26 Executive Summary


In this lesson we learn that the cash flow statement is the third of the three financial statements. The other two are the Income Statement and the Balance Sheet., which has been discussed in earlier lessons. The reason why companies today are required to disclose the cash flow statement is to give a deeper insight to outsiders of the details of the business.


The income statement is disclosing for the investor the amount of revenue that the company is producing, but as we learn in this lesson it does not disclose funds poured into the business from the issue from stocks and bonds. The cash flow statement shows us that. The same is the case if the company starts to buy listed stocks or paying out dividend. This would immediately have no influence on the income statement, but the cash flow statement shows that the company now possesses less cash.


The cash flow statement can be broken down into three components:


  • 1) Operating Activities (Look for a high positive number)

  • This is the most important number to look for. This is the cash that is produced by the company’s operations, and without that, the cash flow from investing and financing activities cannot be healthy. While the net income is a key number and is also included in the calculation of operating activities, many other factors influence how much cash the company is actually making. If you see a high positive cash flow from you operating cash it is typically a positive of a healthy business.


  • 2) Investing Activities (Look for a negative number

  • All companies need cash to reinvest in the business. It might be for new machines, cars or property. Often companies also invest in common stock or bonds, and all of that is too finance by the investing activities. If you see that the cash flow from investing activities is positive, this would imply that the company has sold income producing assets. While that may nice in the short run to obtain more cash, this would most often be followed by a decline in in later earnings. Therefore you want investing activities to show a negative cash flow.


  • 3) Financing Activities (Look for a negative number)

  • Financing activities includes handling of debt and relationship to the investors, and is a neat number to investigate for management’s financial discipline. If you see that this number is positive it would typically imply that the company has obtained more debt, or in some cases that it has issued more shares. While tis extra cash can be very useful in some cases, it can also be a sign of trouble. An increase in debt means higher interest payment in the long run, and common stock issue dilute the investor’s ownership of the company. A negative number on the other hand indicate that debt has been repaid, common stock has been bought back (increasing investors’ ownership of the company), or dividend has been paid out to the shareholders.


    In this lesson we also become familiar with the net change of cash. It is simply a summation of operating, investing, and financing activities for a given period. While a company should have sufficient amount of cash, it is not always positive if there is more cash at the end of the period. It all depends on how the cash has been used.


    Imagine a company who has taken on a ton of debt for no apparent reason. In that situation the net change in cash would be positive, but the implication is not good for the company. A company might also invest in great equipment that can be expected to yield high earnings in the years to come. By only looking at the net change in cash one might think be skeptical although the implications are good for the company.

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    New Vocabulary


    Cash Flow Statement

    A financial statement that is showing the flow of cash in the company. The cash flow statement can be broken down into three components showing the cash from: operating, investing and financing activities.


    Operating Activities

    This is the most important source of cash for the company, and that cash is basically paying for all activities that is reinvested or distributed back to the investors. You want the cash flow from operating activities to be high and positive.


    Investing Activities

    Companies that is growing or even just to sustain their earnings needs to reinvest. You will therefore often see that investing activities represents a negative cash flow. As long as the investments made are profitable you should feel comfortable with a negative cash flow from this component in the cash flow statement. 


    Financing Activities

    Cash flows from financing activities tell the investor if the management show financial discipline. In other words the information about handling of debt and financing of the company can be found under this component. You want this cash flow to be negative as it represent dividend paid out to the shareholders or repayment of debt.


    Net Change in Cash

    Summing up operating, investing, and financing activities for a given period shows the net change in cash.


    Free Cash Flow

    Often referred to as “owner’s earnings”.

    Cash Flow Statement - Lesson Transcript


    In course 1 unit 1, we discussed income statements and balance sheet with Nancy’s ice cream stand. The cash flow statement was briefly mentioned there, so this lesson is about it.


    Before 1987, a cash flow Statement was not even required. However, in order to provide more fidelity as to what's happening inside of a publicly traded company, cash flow statement is now required.


    Dan has a basic candy store. The income statement demonstrates the amount of money being generated on the operating activities of his business. This report will show how much money is flowing in and out of the company based off of that product. This would be the sale of Dan’s candy store. If Dan sold enough candy to generate enough net income of $100, it would be recorded off of that income statement.


    At the top is the revenue and at the bottom is the net income or the profit. The profit of $100 flows in Dan’s candy store and the income statement would capture that. The money could be paid to the owner through a dividend, listed as an asset on his balance sheet, or used to pay off debts. Paying debts would lower the liability on the balance sheet. The income statement or balance sheet in 1987 would have money flowing in off and that money would be whether the assets were becoming a higher value or the liabilities were decreasing. You'd have to surmise how that money is being employed based off of how the balance sheet changed for months. The cash flow statement shows where the money is generated, spent, and employed.


    Here’s another example. Let's say $100 flows into the Dan’s candy store through the sales of his product. Once it reaches his corporate bank account, he can do whatever he wants with that money. Not only can he have money flowing in the product that he has reproduced, but Dan has the publicly traded company. Dan can actually pay revenue for his company through the issuance of stocks.


    Let's say there are 100 shares outstanding on Dan’s store. If he wanted to issue another 100 shares, there'd be 200 shares outstanding now. It'll bring additional revenues and cash funds into his business when he sells those. Also, he might make another $100 just through the sale of his stock.


    Another way Dan can raise money is by issuing bonds. Bonds are not captured in the income statement. Understand this: Dan issued $100 worth of bonds. He collects $100 from some investors. In addition, he's already making from his product, so there’s additional $200. If Dan has been using money in his account to purchase publicly traded companies just like you do inside of his corporate account, this would make his candy store a holding company. The companies he owns the inside of his Dan’s Candy Store corporate account are making dividend payments to him. That’s additional income not listed in the income statement.


    Those are just a few of the different income streams that could be coming into a dance candy store that aren’t going to be listed on that income statement that need to be captured somehow. The cash flow statement become useful all the more at this point.


    There are funds flowing out of Dan’s candy store that haven’t been properly accounted for. The first one is if Dan’s paying dividend to the owners of his company (himself) that’s not captured in the income statement, that dividend payment has to be captured somewhere. The cash flow statement does that. Dan is using the $100 that flowed into his company. He's taking a portion of that – $25. He's either reinvesting that back into inventory or upgrading his facilities. That’s all going to be captured on the investing portion of the cash flow statement.


    The cash flow statement is that the money used to pay off his debt. When you are just working with an income statement and a balance sheet, you'd see maybe the liabilities would decrease, but you wouldn’t know how much of his cash was being allocated towards paying off those debts. With the cash flow statement, you can now see how much money he’s using to pay off his debt and how much money he might be using to retire stock. Let's say he has raised money before selling stock and he’s buying 100 shares back. Let's say there are 300 shares outstanding and he’s using $100 back to his business. That increases the value of the shares he's holding. That would be the incentive for him to do something like that.


    All of these things are all captured in this very important document called the cash flow statement. If we look at it, it is broken down into three categories. First is operating activities. In here are all those funds that are flowing into the business. If he was receiving dividend payments from companies that he owns inside of his corporation, that would be listed on the operating activities. If the net income is the first thing listed on the operating activities which comes straight off the income statement, all that money being generated for the business that he's producing is listed there on the operating activities. The investing activities are the money used inside of his corporate account to buy more supplies to upgrade his facilities or further expand his business. All those investing types of activities are the second item. The third item is financing activities. Commit to issue more shares and bonds.


    The important number to watch out of those three on the cash flow statement is the operating activity. This is where you should see the green on the sheet. When you see a negative number below that, that’s the true numbers that is providing the life of the company. If you see a positive number order investing activity, he means he sold some of his investments and that's the positive cash flow. Sam for the financial activities. Positive numbers mean he has sold bonds and he has a debt. A cash flow statement should have positive operating activities, while the investing and the financing are negative.


    Here are examples of 2 companies. Company A’s cash flow statement is a steady growth with positive numbers in the operating activities. This is what the business does – producing income. If it’s a candy store you, the candies are the primary thing that generates that operational activities income. The investing activities numbers are all negative. This means the owner takes $500 in 2010 to invest in something else. If you see a positive number, he sold something that he owns, and now he doesn’t have the capability to generate the cash flow of the next period. He’s investing and increasing on a larger sum as he kept making more money under that operating activity. The financing activity is also negative. This means company A is paying off its debt. In 2010, it paid $400. It has $100 remaining after that year. In 2011, they paid off another $500. If this number was positive, the company would be taking on debt. This a good example of the cash flow statement. If the company needed a lot of cash to consult an acquisition of another business, you'd see that any starts stocks calendar cash and see that net changing cash be a positive number quarter after wuarte as they prepare for that occasion. In Company A is a good cash flow statement.


    Company A Cash Flow Statement


    Operating Activities
    $1200
    $1100
    $1000
    Investing Activities
    ($600)
    ($550)
    ($500)
    Financing Activities
    ($600)
    ($500)
    ($400)
    Net Change in Cash
    $0
    $50
    $100

    Company B is not as good as company A if you would just compare.


    Company B Cash Flow Statement


    Operating Activities
    $400
    $450
    $500
    Investing Activities
    ($350)
    ($300)
    ($600)
    Financing Activities
    $600
    $300
    $500
    Net Change in Cash
    $650
    $450
    $400

    In this lesson we learn that the cash flow statement is the third of the three financial statements. The other two are the Income Statement and the Balance Sheet, which has been discussed in earlier lessons. The reason why companies today are required to disclose the cash flow statement is to give a deeper insight to outsiders of the details of the business.


    The income statement is disclosed for the investor the amount of revenue that the company is producing, but as we learn in this lesson it does not disclose funds poured into the business from the issue from stocks and bonds. The cash flow statement shows us that. The same is the case if the company starts to buy listed stocks or paying out dividends. This would immediately have no influence on the income statement, but the cash flow statement shows that the company now possesses less cash.


    The cash flow statement can be broken down into three components:


  • Operating Activities (Look for a high positive number)

  • This is the most important number to look for. This is the cash that is produced by the company’s operations, and without that, the cash flow from investing and financing activities cannot be healthy. While the net income is a key number and is also included in the calculation of operating activities, many other factors influence how much cash the company is actually making. If you see a high positive cash flow from your operating cash it is typically a positive of a healthy business.


  • Investing Activities (Look for a negative number)

  • All companies need cash to reinvest in the business. It might be for new machines, cars or property. Often companies also invest in common stock or bonds, and all of that is too finance by the investing activities. If you see that the cash flow from investing activities is positive, this would imply that the company has sold income producing assets. While that may nice in the short run to obtain more cash, this would most often be followed by a decline in in later earnings. Therefore, you want to invest activities to show a negative cash flow.


  • Financing Activities (Look for a negative number)

  • Financing activities include handling of debt and relationship to the investors, and is a neat number to investigate for management’s financial discipline. If you see that this number is positive it would typically imply that the company has obtained more debt, or in some cases that it has issued more shares. While this extra cash can be very useful in some cases, it can also be a sign of trouble. An increase in debt means higher interest payment in the long run, and common stock issue dilutes the investor’s ownership of the company. A negative number on the other hand indicate that debt has been repaid, common stock has been bought back (increasing investor’s ownership of the company), or a dividend has been paid out to the shareholders.


    In this lesson we also became familiar with the net change of cash. It is simply a summation of operating, investing, and financing activities for a given period. While a company should have sufficient amount of cash, it is not always positive if there is more cash at the end of the period. It all depends on how the cash has been used.


    Imagine a company who has taken on a ton of debt for no apparent reason. In that situation the net change in cash would be positive, but the implication is not good for the company. A company might also invest in great equipment that can be expected to yield high earnings in the years to come. By only looking at the net change in cash one might think is skeptical, although the implications are good for the company.