A company’s earnings can be misleading, which is why cash flow is so important. Accounting decisions can hide blemishes and adjust the numbers to suit whatever story a company wants to tell. Accounting rules give companies some leeway in how they report certain items.

On the other hand, cash flow provides a more straight-forward picture of a company’s financial situation. It’s either generating cash flow or it’s not. That’s why it’s a good idea for investors to study a company’s cash flow disclosures.

With that in mind, let’s take a look at how companies report their cash flow. Hopefully it will give you a basic understanding that will help you in your investing endeavors.

Different Standards

First, note that there are two major accounting standards in the world, GAAP (General Accepted Accounting Principles) and IFRS (International Financial Reporting Standards). U.S. GAAP is used in the U.S. while IFRS is used in the rest of the world. Some foreign companies that list in the U.S., such as Alibaba (NYSE: BABA), also use GAAP.

There are important differences in how certain items are recorded and reported between the two standards. But for the purpose of this discussion, we will limit our discussion to U.S. GAAP because if you are reading this, chances are you invest in the U.S. market.

As is the case with other important statements like the Income Statement and the Balance Sheet, the Cash Flow Statement is broken into sections. You will typically see a company report operating, investing, and financing cash flows.

Most Important Section

The operating cash flow statement is the most important part to study. It shows how much cash the company’s normal day-to-day operations are generating. Ideally, you want to see positive and growing operating cash flow. After all, even if a company books a tremendous amount of profit, if it doesn’t have the cash to pay for expenses, the profits on paper don’t do any good.

True, a company with insufficient cash flow from operations can keep the lights on by borrowing, but that’s not a sustainable way to do business. Sooner or later, it needs to make enough money through every day operations to stand on its feet.

Still, even the operating cash flow numbers are limited in what it can tell you because most companies use the indirect method. They do not break down the sources of cash flow. Instead, they start with the net income (profit/loss) and make adjustments for items that impacted earnings but did not involve cash receipt or expense. (By contrast, companies that use the direct method show the sources of the cash inflow and outflow.)

One common and large adjustment to net income is depreciation. The depreciation expense is added back to net income to derive operating cash flow. Depreciation is a non-cash expense that lowers the carrying value of assets. It lowers net income, but the company didn’t actually have to pay out any cash for it, so that amount is added back to net income. (As an aside, all else equal, depreciation is a cash-positive item because it lowers earnings without actually requiring a cash outlay, and it reduces taxes that the company would have to pay.)

Read through the reported numbers in the operating cash flow section and compare the figures to prior periods. If you see abnormally large or small numbers, try to find out why. If the company’s operating cash flow trends consistently don’t match with its sales and earnings trends, that’s another sign to dig deeper. In general, consistently positive and growing operating cash flow is a sign of financial strength.

Investing and Financing

Investing cash flow covers the cash received and spent on, yup, investing activities. These would include the net cash flow from purchase/sale of plants and equipment and marketable securities. One example of a red flag would be if the company generated a lot of cash from sale of plants and equipment. This raises cash for the company, but selling these assets may negatively impact the company’s ability to grow in the future.

Watch This Video: Red Flags That Signal a Sinking Company

It’s worth further investigation to find out what the sales were and whether they were core assets. Similarly, if a company has negative cash flow for purchase of plant and equipment, that’s not necessarily a bad thing. It means the company is investing for future growth.

The third part is financing cash flow. This is where dividends paid and cash spent on share repurchases will be reported. This also is where the company reports the proceeds from the issuance of debt and equity. Note that if a company has high positive cash flow overall, but a big chunk of it is coming from financing, then clearly that is not as good as the cash coming from operations.

Lastly, if there are footnotes to the statement, be sure to take a look as well.

I cannot emphasize enough the importance of not neglecting a company’s cash flow. It can reveal things about the company that earnings alone cannot tell you.

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