Tutorial: read a cash flow statement
Profit is an opinion. Cash is a fact. When they disagree for long, the cash is telling the truth.
Spot the gap between what a company earns and what it actually collects.
How read a cash flow statement works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
The divergence that precedes most disasters
Reported profit climbing while the cash it supposedly generated goes nowhere. Either customers are not paying, or the sales were never really made.
- 1
Operating: the money the business made
Starts at net income and reverses everything that was an accounting entry rather than money moving: adds back depreciation, adjusts for unsold stock and unpaid invoices.
Compare it against net income across five years. Persistent divergence, profit rising while operating cash does not, has preceded a very large share of accounting scandals. It means the company is selling to people who are not paying, or building inventory nobody wants.
- 2
Investing: the money it had to spend to stay alive
Mostly capital expenditure. Some of it is growth, some of it is simply replacing worn-out machines. The accounts rarely separate the two, which is a shame, because the difference is the difference between a business that produces cash for its owners and one that merely produces revenue.
- 3
Financing: where the gap was filled
Borrowing, issuing shares, paying dividends, buying stock back. If a company is paying a dividend out of new borrowing, this section is where it confesses, and the income statement will never mention it.
- 4
Do the subtraction that matters
Operating cash flow minus capital expenditure is free cash flow: the money genuinely available to pay you, repay debt, or buy something, without borrowing. It is the number a DCF is built on, and the single most honest figure in a set of accounts.
A company can have wonderful EBITDA and no free cash at all, if every pound goes back into replacing equipment.
You can compute free cash flow yourself and say whether the dividend is being paid out of it.
Read next
Profit is an opinion. Cash is a fact. When they disagree for long, the cash is telling the truth.
Every one shows its exact method, and the circumstances in which it is wrong. Free, and no account to look.