Understanding financial statements – cash flow statements

Revenue is sanity, profits are vanity, but cash is king – or so the saying goes. That’s because cash is what customers pay in, and what shareholders might get as a dividend.

Why is profit different to cash?

Profits can be sliced and diced in lots of different ways, but you can’t mess about with cash. It’s either there or it’s not.

For example, two key costs that affect profits, depreciation and amortisation, are not cash charges. They’re simply adjustments designed to smooth the cost of assets out over their usable lives.

Think about a company that invests £1m in a new processing machine. Rather than take a one-off cost of £1m against the income statement, it will depreciate the value of the asset over its useful life. If that’s ten years, the company might choose to evenly depreciate the cost at a rate of £100,000 a year.

That smooths the cost base. But of course, the only cash outflow is the initial £1m. See the example below.

There are other ‘non-cash’ movements associated with an income statement too, like when a company is forced to write off the value of an asset through an impairment, that reduces profit.

For example, banks often set aside provisions for bad debts. Despite their best efforts, not all bank loans end up being repaid and so banks must make estimates for loans they expect customers to struggle paying back. As major economies around the world look set to head into recession in 2023, banks have had to increase their bad debt provisions.

These pass through the income statement as an impairment charge, reducing reported profit. But, until bad debts materialise, there’s no cash impact of these charges. Should conditions be better than expected, those charges can be unwound, giving profits a non-cash boost in periods when this happens.

What goes on a cash flow statement?

Cash flow statements are divided up into three sections. Operating cash flows, financing cash flows and investing cash flows.

They do pretty much what they say on the tin. For example, operating cash flows reflect the day-to-day operations of the business. Think the money coming in from product sales minus the costs of doing business.

So how do we get to cash?

If you remember, profit figures can have non-cash items included. So, to get cash, we begin with net income and adjust for differences between accounting items and actual cash flows. For example:

Starting with net income, the first step is to adjust for non-cash items like the depreciation and amortisation expenses we discussed earlier.

We can then look at non-operating items. For example, gains or losses made on the sale of assets would pass through the income statement, but typically these proceeds aren’t part of a business’ standard operations. That means they’re likely to fall under cash flow from investing, not operations. We therefore need to deduct any gains and add back in any losses.

Then we can move to balance sheet items. Companies can book revenue before the cash has actually turned up, and record costs before a payment has actually been paid. Think about when you buy something on a credit card. The transaction happens, but the bank won’t take any cash on the day.

Two key items to keep an eye on are receivables and payables, both of which are recorded on the balance sheet. Receivables appear as assets because they reflect money owed from customers. Payables are liabilities, for example money owed to suppliers.

We’re interested in the change in the numbers from year to year. If the company’s payables rise and receivables fall, that means it’s deferred payments to suppliers, or improved collections from customers. Alternatively, falling payables and rising receivables are bad news for cash flow.

What you end up with is called operating cash flow, sometimes referred to as cash from operations (CFO). This reflects the cash that’s come into the company’s coffers from operating activities.

What do financing and investing cash flows tell us?

But of course, we need to think about financing and investing activities too.

By looking at the financing and investing cash flow sections, we can find out about a company’s longer-term investments in property and equipment. We can also find out about its financial comings and goings – think loan repayments, investments in other companies, proceeds from rights issues and share repurchases.

In investing cash flows, you’ll find ‘purchase of property, plant and equipment’. Again, the meaning is straightforward, it’s the cash the company has spent on new sites and equipment. If this is deducted from operating cash flow, we get a useful metric called free cash flow.

It shows what’s left over from operating cash after expansion and upkeep costs. A positive balance suggests the business has cash left over to give back to shareholders, pay off debts, invest in research & development (R&D) or use to acquire other companies.

It can be useful to determine if a company’s free cash flow is, and has consistently been, greater than the dividend paid. That’s another figure you’ll be able to find on the cash flow statement, under financing cash flows.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for advice. Investments and any income from them can rise as well as fall in value, so you could get back less than you invest. Figures shouldn’t be looked at in isolation, it’s important to consider the whole picture.

Share insight: our weekly email