Foolish Fundamentals: The Cash Flow Statement

"Cash is king."

"Follow the money."

If either of those sayings strikes a chord with you, then allow me to introduce you to the cash flow statement, which shows you how cash makes its way from the income statement to the balance sheet.

See, just because the income statement shows net income of $10, that does not mean that cash on the balance sheet will increase by $10. In the typical "accrual" accounting system, as opposed to a cash-in/cash-out system, a $10 "profit" isn't necessarily a profit at all. Let's walk through a simple example that will show the difference between the two forms of accounting, and then we'll use that knowledge to make sense of a company's cash flow statement.

This past Friday, Lil' Jimmy's Lemonade Stand opened for business. (Jimmy's mom told him that if he really wanted that new Motley Fool jester cap, he'd have to save up the money on his own.) Here's what his balance sheet looked like on Friday:

Assets

Cash

$5

Inventory (Powdered Lemonade)

$30

Total

$35



Liabilities and Equity

Interest-Free Loan From Mom

$30

Equity

$5

Total

$35



By staking out a busy street corner where runners pass frequently, and by serving up the finest ice-cold pink lemonade, and -- most importantly -- by wearing a sad puppy-dog look, our shrewd 8-year-old proprietor made out like a bandit. A hot and sunny Saturday and Sunday worked to his advantage; he sold 100 cups at the ridiculously high price of $1 apiece, which was four times his cost. Wowzers! That's a 75% gross margin. Being quite the little businessman, Jimmy knew that not all joggers carry cash, but instead of missing those potential sales, he allowed his suckers ... er, customers to pay him at any time in the next week. In fact, half of the passers-by took him up on the option to pay later. Last night, Jimmy "closed the books." Here's what the income statement looks like on an accrual basis:

Accrual Income Statement
for the Weekend

Sales

$100

- Cost of Sales

-$25

= Net Income

$75



As you can see, accrual accounting allows you to count items as "sold" even if you haven't yet collected the cash from that sell. In Jimmy's case, that means he booked a "profit" of $75 even though he collected only $50 in cash (half of his sales). Now, let's consider what things would look like if Jimmy were to account for his entrepreneurial venture on a cash basis.

Cash Income Statement
for the Weekend

Cash sales

$50

- Cost of sales

-$25

= Net income

$25



On a cash basis, Jimmy would not record the other $50 in sales until his customers paid up. Nevertheless, as you can see, he would go ahead and record right now the full amount of his $25 of lemonade powder costs because they had been used. This type of accounting shows the true cash profit of $25. Under the accrual system, the balance sheet would appear as follows for Sunday:

Assets

Cash

$55

Accounts Receivable

$50

Inventory

$5

Total

$110



Liabilities and Equity

Interest-Free Loan From Mom

$30

Equity

$80

Total

$110



Since Jimmy's $100 in sales was half cash and half to be paid later, cash increased by $50 and Jimmy registered the other $50 as "accounts receivable." (Smart kid, eh?) All public companies use an accrual accounting system. Therefore, the important lesson to take away from the heroic tale of Jimmy, a Budding American Capitalist, is that the income statement does not tell you what's really happening inside a company. For the real story, we use the balance sheet, and for the rest of the story, we look to the Cash Flow Statement. The cash flow statement is divided into three sections -- operating activities, investment activities, and financing activities. Let's walk through the Motley Fool Income Investor recommendation California Water Service Group (NYSE: CWT  ) cash flow statement as an example. The operating section is most important, since it allows us to follow the cash involved in a company's core business operations. Before talking about the other sections, let's look just at the company's operating cash flow:

Operations

2004
(in thousands)

2003
(in thousands)

Net Income

$26,000

$19,400

Depreciation and Amortization

$26,100

$23,300

Gain on Sale

$0

($4,600)

Change in Accounts Receivable

($3,500)

$700

Change in Accounts Payable

($4,000)

($300)

Change in Income Taxes

($7,200)

($2,900)

Change in Deferred Taxes

$17,600

$2,800

Change in Working Capital -- Others

$2,500

$7,300

Other Operating Activities

($2,200)

($1,400)

Net Cash From Operations

$55,300

$44,300



Starting with net income on the top line, the cash flow statement makes adjustments to net income that "un-accrue" the effects of the income statement. A positive number means that cash is being "added back" to net income where the income statement had deducted it, and vice versa for a negative number. (Notice the substantial amounts of cash that come from deferred expenses.) The bottom-line result is "net cash from operations." Think of this number as the company's true cash profit.

The next section is financing activities:

Financing

2004
(in thousands)

2003
(in thousands)

Total Debt Issued

$3,500

$80,100

Total Debt Repaid

($7,200)

($91,000)

Issuance of Common Stock

$37,500

$43,800

Total Dividends Paid

($20,100)

($17,700)

Other Financing Activities

$16,200

$17,700

Net Cash From Financing

$29,900

$32,900



Cash flow from financing activities tells us the goings-on of cash associated with dividends and stock repurchases.

Finally, we have the investing activities:

Investing

2004
(in thousands)

2003
(in thousands)

Capital Expenditures

($68,600)

($74,300)

Sale of Plant, Property, and Equipment

$0

$4,800

Cash Acquisitions

($900)

($6,100)

Divestitures

$0

$0

Total Other Investing Activities

$0

$0

Net Cash From Investing Activities

($69,500)

($75,600)



Here, we see how much the company spends on capital expenditures, or "capex," as it's sometimes called. These are investments that the company is making for the purpose of building its business. The other items are simply "movements" of cash.

Below is the final portion of the cash flow statement:

Cash and Short-Term Investments

2004
(in thousands)

2003
(in thousands)

Net Change in Cash and Cash Equivalents

$16,000

$1,800

Cash and Equivalents, Beginning of Period

$2,900

$1,100

Cash and Equivalents, End of Period

$18,900

$2,900

Short-Term Investments, End of Period

$0

$0

Cash and Short-Term Investments, End of Period

$18,900

$2,900



This final section combines the cash flows from the three subsections and thereby reconciles the cash balance from one period to the next. The $18.9 million you see at the bottom is the amount of cash that exists at the end of the most recent year and therefore is the amount you would see on the company's balance sheet.

Matt Richey, Shruti Basavaraj, and Adrian Rush contributed to this article.


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