Getting a Grip on Cash Flow

Publish date:

Ever since our

series on fundamental analysis and follow-up Q&As,


readers have been clamoring for information on reading cash flows -- the final statement in the fundamentalist's basic triad of financial reports.

Here you go, and once again, let me know what you think. Please keep those questions and comments

coming (with your full name!).

If the balance sheet represents the skeleton of a corporation, cash flow is the lifeblood. No matter how strong the muscle and bone of a firm, a company with a severely compromised circulatory system is bound to wither and die in short order. So what exactly is this concept of cash flow, how do we measure it, and what does it mean to investors?

First, keep in mind that the net income we

discussed in previous pieces is


cash. Because of those accounting vagaries known as the "accrual rules," a firm records


at the time of a sale but only counts the


when the payment check clears -- no matter how much later.

To see how this shakes out on the financials, let's take an extreme case. Say a firm called

Snipe Hunt

sells a million dollar's worth of left-handed smoke-benders in 1998, billed for payment sometime next year. Since the product was officially sold but no actual money changed hands, the firm can record income of an even million on the '98 financials although it hasn't seen a red cent in hard currency yet.

Where did the money go? It landed (at least on paper) squarely in the accounts receivable section on the asset side of the balance sheet -- in other words, as something owed to the firm like an outstanding loan. Some claim that this is all just accounting hocus-pocus and use the situation to bolster the argument that cash flows are a better basis than income for financial analysis. And they may be right.

After all, at year-end Snipe Hunt looks profitable if you just look at net income. So there sits the CEO, chomping a cigar, counting his expected bonus with a sly grin. Then the utility bill lands on his desk. Suddenly he realizes that the corporate coffers are as bare as Old Mother Hubbard's cupboard, and he starts frantically taking up a collection at the water cooler just to keep the lights on.


Blanche Dubois

, businesses can't operate long on the kindness of strangers. In other words, accounting profits recorded in pencil on some ledger don't pay the bills. Cash does.

So how do you get a read on the health of a firm from a cash standpoint? Break out the fundamentalist's sphygmomanometer and download a copy of the cash flow statement from a service like or (it's filed under the 10-K heading just like the balance sheet and income statement). For my examples, I'll be falling back on my old standby,


(BUD) - Get Report


Cash-Flow Statement Layout

The first thing you'll notice is that the statement is broken down into three sections to detail which functions of the firm are generating cash (a positive number) and which are spending it (a negative figure). The three sections are as follows:


The main source of a company's cash stems from the core business of a firm. In BUD's case, it's selling beer.


Any cash transactions involving land, buildings, equipment, investment securities and business acquisitions. It also includes any necessary maintenance costs associated with keeping the firm's physical assets operating, as covered under the generic term "capital expenditures." For BUD, this includes maintaining and replacing those big stainless steel brewing vats to keep them pumping out those 96 million barrels of beer a year -- enough six-packs to go from here to the moon and back, I might note (God bless America).


Transactions between the firm and its creditors and shareholders. These items can include things like taking out a long-term loan, retiring debt or paying dividends to shareholders.

Finally, the bottom line of the report will give the total amount of cash on hand at the end of the year and should correspond exactly to the figure on the balance sheet. If you look at some of the detail in each section, you might get the idea that cash flow is just calculated off of net income by making some simple adjustments for noncash items, and you'd be exactly right.

Going back to our Snipe Hunt example, net income for the firm would indeed be $1 million, but none of that came in as cash during the year. Once we subtract the increase of $1 million accounts receivable, it becomes clear that cash flow was zero for the period (in BUD's case, these adjustments are included under the heading "Increase / (Decrease) in noncash working capital").

Life Cycle of the Firm

You can tell a lot about where a firm is in its life cycle by looking at the relative proportions of the cash flow from each of these main sections.

New firms in their infancy usually have negative cash flow from operations as they build inventory and invest heavily in new plants and equipment. Their main source of funds is through financing activities, and this section usually shows big cash inflows (large positive numbers).

Firms in the growth stage often have positive cash flow from operations, but not enough to fully finance their continued investments, which still show up as negative figures. As a result, the difference is made up with moderate inflows from financing activities.

Mature firms show large operating cash inflows along with moderate and stable outflows in the investment section, as the firm simply maintains its existing equipment. For the first time, financing cash flow turns negative as the firm pays off debt and distributes the remainder to shareholders as dividends.

In a decline phase, operating cash flows can still be positive as the firm reduces accounts receivables and inventories. One telltale sign, however, of a contracting business is that the investment cash will likely go positive as the firm sells off hard assets.

Although none of these are hard-and-fast rules, the general ideas can be helpful as summarized here:

Looking at BUD, the company seems to be squarely in the "mature" phase with big operational cash flows coupled with solid dividend payments.

Free Cash Flow

I've seen several different yet similar formulas to calculate the increasingly media-hyped concept of free cash flow. The simple way is to just take the total cash flow from operating activities and subtract capital expenditures from the investing section. For BUD, the equation looks like this:

FCF = Operating Cash Flow - Capital Expenditures =

1,816.6 - 1,199.3 = $617 million

Obviously, the more free cash flow the firm has, the better. But how much is enough? To go any further, we need to look at some relative measures to get some basis for comparison.


Often, after-tax operating cash flow is just subbed in for net income for calculating some basic ratios. The feeling is that cash is a more solid measure than the wispy notion of income.

Cash Flow Per Share

Similar to the EPS figure, this ratio gives you a view of how much money the firm is making for the shareholders. For BUD, it looks like this:

(Operating Income - Taxes) / Shares Outstanding =

(1,816.6 - 703.6) / 487 = $2.29

Cash Flow to Current Liabilities

Some argue that this ratio is a much better indicator of liquidity than the current ratio as described in

Dissecting a Balance Sheet. In BUD's case:

Cash Flow from Operations / Average Current Liabilities for Period


1,816.6 / (¿ * (1,500.7

97 Curr Liabilities + 1,430.9

96 Curr Liabilities)) = 124%

Pundits claim that anything more than 40% is a healthy number, so BUD passes with flying colors.


The statement of cash flows gives you a read on the circulation of the vital lifeblood of a company. Overall, the statement can give you an idea of which stage of the corporate life cycle a firm is operating in. Other ratios use operating cash flow as a substitute for income to generate (arguably) more accurate indicators of a company's performance and liquidity levels.

I encourage you to try out the tools provided in the entire series on fundamental analysis on your own picks. If you get stuck, we're

here to help. Keep those questions rolling in and we'll answer them in future columns.

Andrew Greta, an occasional contributor to

, is a business student and onetime stockbroker who lives in West Lafayette, Ind.