In the previous module, we learned that a company can show millions in profit while actually being broke. This happens because the Income Statement works on Accrual Accounting—it records revenue when a sale is made, not when the cash actually hits the bank account.
The Cash Flow Statement (CFS) strips away all the accounting estimates, non-cash entries, and creative reporting to show one thing: Cold, Hard Cash. It tracks every penny entering and leaving the company. If a company's profits are growing but its cash is disappearing, you are looking at a potential disaster.
1. The Three Pillars of Cash Flow
The CFS is divided into three distinct sections. To understand the health of a business, you must analyze these separately.
A. Cash Flow from Operating Activities (CFO)
This is the most important section. It shows the cash generated by the company's core business (e.g., selling shoes for Nike, or selling iPhones for Apple).
To calculate CFO, we start with Net Profit and adjust for:
- Non-Cash Expenses: We add back Depreciation and Amortization (because no real cash left the company).
- Working Capital Changes: If "Receivables" increased, it means cash is stuck with customers, so we subtract it. If "Payables" increased, we kept cash for longer, so we add it.
Golden Rule: Over the long term, CFO should be equal to or higher than Net Profit. If Net Profit is much higher than CFO for many years, the company is likely "cooking the books."
B. Cash Flow from Investing Activities (CFI)
This section shows how the company is spending its cash for the future. It includes:
- CAPEX (Capital Expenditure): Buying new machinery, factories, or land. (Usually a Negative number).
- Investments: Buying stocks or bonds of other companies.
- Acquisitions: Buying other businesses.
A negative CFI is usually good for a growing company because it means they are reinvesting in themselves. If CFI is positive, it means the company is selling its assets (shrinking).
C. Cash Flow from Financing Activities (CFF)
This shows how the company is funding its operations and rewarding owners. It includes:
- Raising Debt/Equity: Taking loans or issuing new shares. (Positive cash).
- Repaying Debt: Paying back bank loans. (Negative cash).
- Dividends/Buybacks: Returning cash to shareholders. (Negative cash).
2. Free Cash Flow (FCF): The Holy Grail
While the CFS provides great detail, professional investors look for one specific number: Free Cash Flow.
FCF = Cash Flow from Operations - Capital Expenditure
FCF is the money left over after the company has paid for all its operating expenses and updated its equipment. This is "free" money that can be used to pay dividends, acquire competitors, or survive a recession. Companies with consistent positive FCF are the safest and most rewarding investments.
3. Cash Flow Patterns: Decoding the DNA
By looking at the signs (+ or -) of the three sections, you can identify what stage the company is in:
| CFO | CFI | CFF | Interpretation |
|---|---|---|---|
| + | - | - | The Cash Cow: Generating cash from core business, reinvesting in growth, and paying back debt/dividends. (Ideal!) |
| - | - | + | The Startup: Losing cash on operations and investing heavily. Surving on loans/investors. (High Risk). |
| + | + | - | The Declining Firm: Selling assets to pay off debt because the business isn't growing. |
| + | - | + | The Aggressive Grower: Using both internal cash and new debt to expand as fast as possible. |
4. Red Flags in the Cash Flow Statement
When analyzing a company, watch out for these "smoke signals":
- The Divergence: Net Profit is growing 20% YoY, but CFO is flat or negative. This means the profits are only "on paper."
- Interest Coverage from CFO: Check if the CFO is large enough to cover the interest payments on the company's debt. If not, the company is in a "Debt Trap."
- Consistent Negative FCF: If a company has been around for 10 years and still has negative FCF, it is a "Cash Burner" and will eventually need to dilute its shareholders to survive.
The Cash Flow statement helps you calculate how many days it takes for a company to turn a raw material into cash in the bank. A shorter cycle means a more efficient business.
Summary of Module 7
- CFO tells you if the engine is running; CFI tells you if the driver is maintaining the car.
- Always prioritize CFO over Net Profit. Cash doesn't lie.
- Free Cash Flow (FCF) is the actual value created for shareholders.
- Use the Cash Flow Pattern to identify the maturity of a company.
Now that we have mastered the three financial statements—the Balance Sheet, Income Statement, and Cash Flow Statement—we have the raw data. In the next three modules, we will learn how to connect these numbers using Ratios to find truly great stocks. First up: Profitability Ratios.