The cash flow statement breaks down a company's change in cash over a period of time and consists of three sections: Operating, Investments, and Financing. In this post, we review why a cash flow statement is necessary and how to comprehend its components.
Why do we need a cash flow statement?
Before we dive into the sections and line items of the cash flow statement, we should discuss why it is necessary in the first place. Why do we need a cash flow statement if we already have an income statement? Doesn't the income statement already show us the change in cash over a period of time?
There are several reasons net income does not equate to the net change in cash flow over that same period. Many of these reasons relate back to the concept of accrual accounting, which was discussed in our Intro to Financial Accounting guide.
Here are several reasons the income statement does not reflect cash profit due to accrual accounting principles:
- Revenues on the income statement do not necessarily reflect cash collections. Cash can be collected after the service/product is delivered (where accounts receivable would be recorded), or before (where deferred or unearned revenue would be recorded)
- Similarly, operating expenses on the income statement do not reflect cash payments. Costs to purchase products from suppliers are typically paid after delivery (accounts payable), some expenses are accrued (including payroll expenses), and other expenses are paid before the expense is incurred (including prepaid expenses such as rent).
- Provision for income taxes on the income statement does not necessarily reflect cash payments to the state, local, and federal tax authorities. Taxes can be accrued (owed but not yet paid), or prepaid.
- Additionally, deferred tax assets and deferred tax liabilities can cause significant variations between GAAP and cash taxes. For example, if a company has a net operating loss (or NOL, which would be a deferred tax asset), the provision for income taxes on the income statement would still show tax paid even if the NOL wiped out all cash taxes. Why would GAAP require such accounting? Even though cash taxes weren't paid, it's as if the company paid taxes by reducing its NOL balance. The reduction of the asset is akin to an expense.
- Some expenses on the income statement are non-cash, including depreciation and amortization (D&A) and stock-based compensation. Even though part of employees compensation may be non-cash, it still has economic value and costs the company (in this case the cost is an increase, or potential increase, in share count which would reduce EPS).
The adjustments above (typically made by starting with net income and adjusting the cash discrepancies) will form the Cash Flow from Operations section, which we will discuss below.
In addition to the accrual accounting discrepancies mentioned above, the income statement does account for investing or financing activities.
- Investing activities include capital expenditures, purchases or divestitures of businesses, and buying or selling securities (for example, purchasing short-term investments with cash).
- Financing activities include share issuances or repurchases, debt issuances or repurchases, and payments of dividends.
What are the sections in the Statement of Cash Flows?
The statement of cash flows is broken into three sections:
- Operating: This section is essentially a "cash version" of the income statement. It provides (or adjusts for) the cash revenues and expenses.
- Investing: Capital expenditures, purchases or divestitures of businesses, and buying or selling securities (for example, purchasing short-term investments with cash).
- Financing: Share issuances or repurchases, debt issuances or repurchases, and payments of dividends.
Each section can have a positive (cash inflow) or negative (cash outflow) amount. The sum of the three sections provides us with the net change in cash over a period of time. To calculate the ending cash balance, take the beginning cash balance, and add/subtract the change in cash.
Cash Flow from Operations
This section of the cash flow statement provides a cash-based income statement. There are two methods of doing so:
- The Direct Method: Each line item in the income statement is provided as the actual cash inflow or outflow. For example, the revenue number reflects the cash collections. Expenses reflects those paid in cash, not those accrued and not non-cash expenses such as D&A and stock-based compensation.
- The Indirect Method: Starting with net income, the indirect methods adjust for each component that causes cash to diverge from the income statement:
- Strat with Net Income as reported on the income statement
- Addback: D&A
- Addback: Stock-based compensation
- Addback: Loss from the disposition of assets (since the loss is non-cash at the time of the sale)
- Adjust for current assets: accounts receivable, inventories, and prepaid expenses. When current assets increase from the previous period, cash flow is reduced. Take accounts receivable as an example: the more your customers owe you that you didn't collect, the less cash you collected. Same logic for inventory: the more inventory you purchase that you didn't sell, the less cash you have. And for prepaid expenses: the more cash you laid out before receiving the benefit, the less cash you have.
- Adjust for current liabilities: accrued expenses, accounts payable, and unearned revenue. The reverse is true for current liabilities - when current liabilities increase compared to the previous period, cash flow is increased. For example, the more money you owe to suppliers or employees, the more cash you're keeping. The more revenue you collect before the service/goods are delivered, the more cash you have.
- Adjust for deferred tax assets and liabilities: As mentioned above, deferred tax assets such as net operating losses can cause the income statement tax to substantially differ from actual cash taxes. Deferred tax assets and liabilities are primarily due to the difference between GAAP and tax (IRS) depreciation rules. Often, the IRS allows for accelerated depreciation (taking more depreciation early on to reduce tax burden and incentivize investment) while GAAP adheres to straight-line depreciation. So early on the asset's life, there is more depreciation for IRS and hence lower taxes. Later on in the lifecycle, that reverses and cash taxes will be higher.
Cash Flow from Investments
The cash flow from investments section deals with investments relating to capital expenditures (CapEx), M&A, asset sales, and purchases or sales of securities.
- CapEx includes any additions to Plant, Property & Equipment. While CapEx does not show up directly on the income statement, it is depreciated over the useful life of the asset per GAAP guidelines. That depreciation will show up on the income statement, either as a separate line item or buried in another expense item, like Cost of Goods Sold.
- Mergers & Acquisitions: the acquisition or dispositions of businesses or business units
- Securities: purchasing or selling short and long-term securities
Cash Flow from Financing
The cash flow from financing breaks out activities relating the debt & equity issuances and repayments, as well as dividends paid to common stockholders.
- Debt: this includes issuances or repayments of bonds, loans, or other borrowings. Note that interest expense is not included in this section.
- Equity: the issuance of shares either through an IPO or follow-on offering, as well as the repurchase of shares. Proceeds from the exercise of employee stock options would be included as well.
- Dividends: Any payments to common stockholders would be included in this section.
Why the Cash Flow Statement is Important for Financial Modeling?
For the various types of financial models, the goal is to calculate and project free cash flow. The statement of cash flows provides important cash flow data that wouldn't be available (or would be very difficult to back into) that we need for the financial model:
- CapEx: One of the most integral cash flow items, this can be found explicitly on the cash flow statement (depending on the reporting, it may be possible to calculate capital expenditures based on the beginning and ending balances of PP&E, dispositions, and depreciation).
- Depreciation & Amortization: Sometimes companies do not break out D&A on its income statement but include it in other line items. In those cases, it is necessary to pull the D&A number from the cash flow statement.
- Changes in working capital: While these can be derived from the balance sheet, it is helpful to see the cash impact to double check that you have your inflows and outflows done correctly.
- Stock-based compensation: For corporate valuation and DCF valuation models, stock-based compensation should be treated as cash compensation. The theory is that the compensation is worth the same amount regardless of the form of payment. However, in other models, like a credit model, you may want to add this back in your free cash flow calculation. When evaluating a credit investment, since debt is senior to equity, the debtholders benefit from stock-based comp over cash.
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