Are you ready for another story?
In the previous tutorials in this series, we saw that complex-looking financial statements are actually just a company’s way of telling its story. Learn a few simple steps to decode the story, and you can read it as easily as you’re reading this tutorial.
So that leaves one more story to decipher: the cash flow statement.
You’ll start by learning the purpose of the cash flow statement and how it’s structured, and then you’ll dive into the details and go through line by line to understand what each part means.
Then you’ll take what you’ve learned and apply it to a real-world example: the accounts of technology giant Apple Inc.
Finally, you’ll learn about any variations you might come across in how the information is presented, either in the U.S. or in other countries.
By the end of the tutorial, you’ll have a clear idea of what the cash flow statement can tell you about a company’s health, understand how it fits in with the other two main financial statements, and feel confident reading the cash flow statement of any company.
1. The Difference Between Cash and Profit
Here’s a situation most of us have been in at one time in our lives. It’s the day before payday, and your bank account is almost empty. You make a good salary, and you cover your expenses each month, so in corporate terms you’re “profitable.” But until that next paycheck hits your bank account, ATMs will keep telling you “transaction declined.”
That, in a nutshell, is the difference between cash and profit. There’s often a disconnect between when you earn money and when you actually receive the funds in your account. That applies just as much in the corporate world as it does for you and me. Profitable companies can run out of cash, and companies with plenty of cash can be unprofitable.
So we have two statements: The income statement shows what the company earned in the past year, and the cash flow statement tracks how much money it received and what it paid out.
Now that we know what the cash flow statement shows, let’s look at the details. As in the previous tutorials, we’ll use the example of a fictional technology company, CoolGadget Corp. You can download its cash flow statement as a spreadsheet, or follow along using the screenshots.
CoolGadget’s cash flow statement starts by showing how much cash it had at the start of the year, then tracks how much cash flowed in and out in three main areas — operations, investment and financing — and finishes by adding it all up to show how much was left at the end of the year. Here’s a simplified version:
We’ll go through those three sections of the cash flow statement in turn, starting with cash flow from operating activities.
2. Cash Flow from Operating Activities
Here’s the first section of the cash flow statement, with all the details showing:
CoolGadget started the year with $50,000 in cash. It’s the same number that we saw on the balance sheet on Dec 31, 2012. Let’s see what happened to that cash over the course of the year.
Well, first of all, CoolGadget earned some money. $8,000 in net income to be precise. That number comes from the bottom line of the income statement.
But as we’ve seen, income and cash are not the same thing, so now we need to make some adjustments:
- We saw on the balance sheet that CoolGadget’s inventory increased by $25,000 between 2012 and 2013. That’s $25,000 it has paid out, so it’s a negative cash flow.
- Net receivables also increased by $10,000, so we’ll subtract that too. As you’ll remember, this line on the balance sheet refers to gadgets the company has sold but not been paid for yet. It’s fine to include that as income, but we need to take it out of cash.
- Accounts payable is the opposite: things CoolGadget has bought but not paid for yet. This item on the “liabilities” side of the balance sheet increased by $50,000. In terms of cash flow, that increase is a good thing: CoolGadget has an extra $50,000 sitting in its account. So we add that on.
- CoolGadget has incurred a $2,000 tax bill, but hasn’t paid the money out yet. That’s more money in the company’s pocket, so it needs to be added to the cash flow.
At the end of all that, we have operating cash flow of $30,000. So CoolGadget is generating more operating cash than profit. That’s largely because it’s delaying paying its bills (in accounting-speak, a large increase in accounts payable). You might employ a similar tactic if you’re short of money before payday: put off paying the utility bill for a week or two, and suddenly your immediate cash flow position improves.
3. Cash Flow From Investing
After CoolGadget has finished doing its regular business of selling gadgets, it needs to invest for the future. Unfortunately its ability to do that is constrained by the limited cash flow. You can’t do a lot of investing in the business world with just $30,000. But let’s see what it managed:
- We saw from the balance sheet that CoolGadget is plowing money into its swanky office space in downtown San Francisco. In 2013, that meant a $100,000 outflow of cash under capital expenditures.
- CoolGadget also bought $50,000 in stocks and bonds, which fall under the category of marketable securities.
- The business acquisitions line would be used if CoolGadget acquired another company. It didn’t do that this year, so the figure is zero.
As you can see, CoolGadget had a total cash flow from investing activities of $160,000. That doesn’t seem like a smart strategy when you’ve only generated $30,000 from your regular business of selling gadgets. Having a nice office space might impress the clients, but it seems as if the company’s investing more than it can afford right now.
4. Cash Flow From Financing
So what can CoolGadget do to make up the shortfall? That’s right, borrow. That’s what the financing section shows: any money received from borrowing, as well as money paid to or received from shareholders.
Of course, CoolGadget isn’t really in a position to pay a dividend right now. Generally that’s what profitable, cash-rich companies do to reward shareholders, but CoolGadget needs to generate cash, not give it out.
The owners would probably love to sell stock to raise more cash, but any savvy investor would run a mile after looking at these financial statements. So it’s a zero on that line.
The one option open to them (and it may not be open for much longer if the bank manager’s paying attention) is to borrow. CoolGadget borrowed $85,000 in 2013, adding to the already considerable debt pile we saw on the balance sheet.
That influx of cash means that the total cash flow for the year is -$45,000 (adding the $30,000 cash flow from operations, the -$160,000 from investing, and the $85,000 from financing).
The bottom line is that of the $50,000 CoolGadget had in its bank account at the start of the year, just $5,000 is left. The company is surviving, but only just. The prospects for the coming year look bleak.
5. The Real World: Apple’s Accounts
Has Apple sold enough iPads to keep the lights on? Let’s find out. Here’s Apple’s 2013 cash flow statement, taken from page 49 of its latest annual report:
In terms of structure, it’s pretty similar to what we’ve seen with CoolGadget. Apple’s business is larger and more complex, so it gives some more details. Depreciation and amortization, for example, means the company reduced its net income by writing down the value of assets, but needs to add the money back here because it wasn’t an actual cash outflow. And because it’s a public company, it shows more details about issuance of stock. But the overall layout is the same.
As you’d expect, Apple’s cash flow is a lot healthier than CoolGadget’s. We saw in the income statement tutorial that Apple’s net income fell in 2013 for the first time in a decade, but it still generated more than enough cash to pay for $33.7 billion of investments. And instead of tapping shareholders for more money, it gave money back to them, paying a whopping $10.6 billion dividend and repurchasing $22.9 billion of stock.
At the end of the year, Apple was left with a healthy $14.3 billion in cash. And because it generates more than $50 billion in cash every year from its main operations, it’s hard to see the business running short of cash any time soon. Even if it doesn’t sell as many iPads next year, it should still have a positive cash flow. And it could easily dip into its existing cash, or sell some of the $132 billion in marketable securities it has on its balance sheet, or borrow more, or cut back on the amount it gives to shareholders.
Whereas CoolGadget’s cash flow statement showed us that it’s in danger of suffering its own version of the credit crunch, Apple’s makes it look like a gigantic cash-generating machine.
The general layout of cash flow statements from different companies is usually the same: start with the cash position at the beginning of the year, then track the inflows and outflows in those three areas of operations, investment and financing, and add it all up to find the cash position at the end of the year.
You’ll see quite a few variations in the details, though, both in the U.S. and in other countries. Companies show what’s relevant to their own business, and may also swap the order of lines around to present the information in a way that makes sense to them. The overall structure should always look familiar, though.
Here’s the 2012 cash flow statement for British pharmaceutical company GlaxoSmithKline plc, for example:
You can see a few differences in how the information is presented. Instead of putting the start-of-year cash balance at the top, for example, GSK shows it in a separate section at the bottom. It also has some additional lines for things specific to its business, like “Shares acquired by ESOP Trusts” (that’s to do with its employee stock ownership plan).
But the basic structure of showing cash flows from the three main areas of operating, investing and financing activities is very familiar from our U.S. examples.
You’ll see the same with this 2012 cash flow statement for German auto maker Volkswagen AG:
Again, the details are different, but the structure is the same. Don’t worry too much about the details for now, because you can always read the company’s notes to find out what a particular item means. If you understand the concept and overall structure of the cash flow statement, you’re good to go.
So that’s the final story in our three-part series. If you’ve been following along from the start, you should now have a good understanding of how to read financial statements, and how to use them to find out details about a company’s health and future prospects.
This last tutorial has shown that the cash flow statement is an important one to understand. Companies can sometimes deploy slick accounting maneuvers to pretty up the income statement, but the cash flow statement tracks the actual flow of money in and out of the firm, so usually reveals the unvarnished truth.
You’ve also seen how the three statements work together. Each one shows a different side of the business, and when you put them together you get a comprehensive story about how well a company is doing, and what strategies its managers are pursuing.
As with the income statement and balance sheet, you can find cash flow statements for any public company on a financial website like Morningstar or Yahoo Finance, or from the “Investor Relations” section of the company’s website.
So practice following the cash. Examine the cash flow statements of different companies, and see what you can learn about them. Soon it will be easy for you to understand the company’s underlying story, and to tell whether a firm is rolling in cash, or whether it will soon be seeing the corporate equivalent of “Transaction declined.”