The Third Financial Statement - The Statement of Cash Flows

Imagine reading a news article about a company that earned $10 million in profit over the past year. Since the company made so much money, does that mean it also has plenty of cash in its bank account? Not necessarily. A company can report a profit while still running short of cash. To understand why, we need to look at the statement of cash flows. The statement of cash flows is one of the three main financial statements, along with the balance sheet and the income statement. The balance sheet shows what a company owns and owes at a particular point in time. The income statement shows its revenues and expenses over a period of time. The statement of cash flows shows where cash came from and where it went during that period. It is similar to checking the transaction history of your bank account. If you get paid for a part-time job, your account balance increases. If you spend money on food or transportation, your balance decreases. Companies work in much the same way. Cash may come in when they sell products or borrow money, and cash goes out when they pay employees or buy equipment. But this raises an interesting question. How can a company report a profit on its income statement and still have a shortage of cash? Imagine a company sells $10,000 worth of products to another business. The customer receives the products immediately but agrees to pay the following month. Under normal accounting rules, the seller can record $10,000 in revenue this month. However, since the customer has not paid yet, the company has not received any cash from the sale. Now consider the opposite situation. What happens if the company borrows $10,000 from a bank? Its bank account increases by $10,000, but that money is not revenue or profit. It is a loan that must eventually be repaid. As these examples show, accounting profit and actual cash movements are not always the same. That is why investors examine the statement of cash flows as well as the income statement. The statement of cash flows divides cash movements into three main categories: operating activities, investing activities, and financing activities. First, operating activities involve cash generated and spent through a company's everyday business. Consider a coffee shop. Money received from customers buying coffee is cash from operating activities. Money spent on coffee beans, employee wages, and other everyday expenses is cash used in operating activities. If more cash comes in from operating activities than goes out, operating cash flow is positive. Generally, this is a good sign because it suggests that the company is generating cash from its main business. The second category is investing activities. These involve cash movements related to buying and selling assets, often to support the company's future operations. For example, if the coffee shop purchases a new espresso machine, cash goes out through investing activities. If it sells an old machine it no longer needs, cash comes in. Negative cash flow from investing activities is not necessarily bad. A company might spend money building a new factory or purchasing equipment to prepare for future growth. However, investors still need to consider whether those investments are likely to pay off. The third category is financing activities. These involve cash movements related to raising money for the business or returning money to investors and lenders. When a company borrows from a bank or issues new shares of stock to raise money, cash comes in. When it repays the principal on a loan or pays dividends to shareholders, cash goes out. Positive cash flow from financing activities is not automatically a good sign. A company's cash balance might be increasing because it is borrowing more money, not because its business is performing well. Now let's put all three categories together. Imagine a coffee shop begins the month with $10,000 in cash. During the month, it collects $30,000 from customers and spends $24,000 on coffee beans, wages, rent, and other operating expenses. Its operating cash flow is therefore positive $6,000. During the same month, the shop spends $8,000 on a new espresso machine. Its investing cash flow is negative $8,000. The shop also borrows $5,000 from a bank and repays $1,000 of an existing loan's principal. Its financing cash flow is positive $4,000. When we combine these three categories, the coffee shop's cash has increased by $2,000. Since it began the month with $10,000, it ends the month with $12,000. This example shows why the statement of cash flows is useful. It tells us not only how much a company's cash increased or decreased, but also why that change happened. So what should investors look for when reading a statement of cash flows? One important question is whether a company consistently generates cash from its main business. If operating cash flow remains positive over several years, that can be an encouraging sign. On the other hand, if a company continually reports profits while struggling to generate operating cash flow, investors should investigate the reasons. Of course, not every company can be judged by exactly the same standards. A young, rapidly growing business may use large amounts of cash while expanding its operations. Cash flow should therefore be evaluated in the context of a company's stage of growth and the nature of its business. Ultimately, the statement of cash flows is a record of how a company actually receives, spends, and raises cash. While the income statement tells us how much profit a company reports, the statement of cash flows reveals how its cash is actually moving. Understanding both statements before investing in stocks can help us develop a more balanced picture of a company's financial health.