Part 3: Analyzing Financial Statements - Cash Flow Statement
A short overview of the three main financial statements for beginner knowledge.
This is a three-part series where I will go over each of the three main financial statements at a high-level. For those investing in individual stocks, you should be knowledgeable in all of these statements to understand the financial health and performance of a company.
The Cash Flow Statement: A Snapshot of Liquidity
This statement could not be described any clearer. Its purpose is to track the inflow and outflows of cash for an organization. This is a great way to analyze how an organization manages its cash position over a specific period. The statement consists of three main components:
Operating Activities – Cash generated from core business operations.
Investing Activities – Cash spent on and earned from investments.
Financing Activities – Cash flow from borrowing, repaying debt, and shareholder transactions.
Note: All the financial excerpts are of Coca Cola’s ($KO) 2023 earnings report. Keep in mind that not all statements have the same sub-categories under these sections.
Operating Activities: The Core Cash Flow
These type of cash flows are strictly related to the operations of the organization. It begins with the organization’s net income, and then proceeds to make several adjustments. You may ask why are these adjustments needed on such a statement? For that, you need to understand accrual vs. cash accounting.
Accrual Accounting: the task of recording transactions when they OCCUR, not when the money is received or expended - think of it like booking revenue before getting paid.
The first two financial statements, the balance sheet and the income statement, are based on the accrual method of accounting.
Cash Accounting: the task of recording transactions when cash related to those transactions is actually received or expended.
The cash flow statement, as per its name, is adjusted based on accrual totals to reflect the cash basis.
The main adjustments that occur include:
Non-cash items - Depreciation, amortization, and stock-based compensation.
Changes in working capital - that is, the difference between the changes in operating assets and liabilities.
Think of this one like this,
If you’re receivables increase, this means the organization has less cash available as it is tied-up in the hands of the consumer as a ‘promise to pay’ for a good or service. Therefore, the organization has a negative cash flow adjustment.
If you’re payables increase, this means the organization has more cash available as it has delayed payments to a future point in time. Therefore, the organization has a positive cash flow adjustment.
And vice-versa to those scenarios.
A positive cash flow from operations suggests a company can sustain and grow its business without needing additional financing.
Investing Activities: Capital Allocation
These type of cash flows are related to, you guessed it, investments. This builds on the previous section and adds/deducts any related long-term investment transactions that occurred during the fiscal year.
This section includes:
Purchases or sales of property, equipment, and securities.
The amount spent on capital expenditures (CapEx), indicating how much a company reinvests for future growth.
Financing Activities: Managing Capital Structure
These type of cash flows are related to the name itself, financing. This further builds on the two previous sections and adds/deducts any related financing transactions that occurred during the fiscal year.
Financing cash flows involve transactions affecting a company’s capital structure, such as:
Raising capital through equity issuance or loans.
Paying down debt or repurchasing stock.
Distributing dividends to shareholders.
This section provides insights into how a company funds growth and rewards investors.
The calculation of all three sections combined results in the organizations cash position at the end of the fiscal year. This can be cross referenced to the cash position on the balance sheet.
Free Cash Flow: A Key Performance Metric
One additional item should also be noted in the analysis of the cash flow statement. Free cash flow (FCF) is a term that many investors speak of. The simplest form of calculation of free cash flow comes directly from this statement using the following formula:
FCF = Cash provided by Operating Activities - Capital Expenditures
Therefore, the total from the first section of the cash flow statement minus the spend on capital taken from the second section of the cash flow statement will result in the free cash flow of the organization. Remember, higher FCF gives an organization more financial flexibility for sustaining operations, investments, debt repayment, dividends, and share buybacks.
Final Thoughts
Analyzing financial statements is essential for investors assessing company performance. By understanding the cash flow statement, you gain insight into liquidity, operations, investments, and financial strategies.
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