Foolish Fundamentals: The Cash Flow Statement

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"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, right now he would record 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 (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

2006 (in thousands)

2005 (in thousands)

Net Income

$25,600

$27,200

Depreciation and Amortization Total

$30,700

$28,700

Gain on Sale

 ($300)

($2,300)

Change in Accounts Receivable

($5,300)

$3,400

Change in Accounts Payable

 ($900)

$12,600

Change in Income Taxes

 ($400)

$6,500

Change in Deferred Taxes

$3,200

$3,900

Change in Working Capital -- Others

$7,800

$1,700

Net Cash From Operations

$61,000

$82,500

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 investing activities:

Investing

2006 (in thousands)

2005 (in thousands)

Capital Expenditures

($114,400)

($90,700)

Sale of Plant, Property, and Equipment

$400

$2,300

Cash Acquisitions

($500)

($500)

Divestitures

$0

$0

Total Other Investing Activities

$0

$0

Net Cash From Investing Activities

($114,600)

($88,900)

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.

Finally, we have financing activities:

Financing

2006 (in thousands)

2005 (in thousands)

Total Debt Issued

$19,900

$200

Total Debt Repaid

($1,800)

($1,200)

Issuance of Common Stock

$79,500

$700

Total Dividends Paid

($22,000)

($21,100)

Other Financing Activities

$28,800

$18,500

Net Cash From Financing

$104,400

($2,900)

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

Below is the final portion of the cash flow statement.

Cash and Short-Term Investments

2006 (in thousands)

2005 (in thousands)

Net Change in Cash and Cash Equivalents

$50,800

($9,300)

Cash and Equivalents, Beginning of Period

$9,500

$18,800

Cash and Equivalents, End of Period

$60,300

$9,500

Short-Term Investments, End of Period

$0

$0

Cash and Short-Term Investments, End of Period

$60,300

$9,500

This final section combines the cash flows from the three subsections and thereby reconciles the cash balance from one period to the next. The $60.3 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.


Read/Post Comments (4) | Recommend This Article (20)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 31, 2010, at 4:12 PM, biggwyther wrote:

    I am a newcomer to the investing world. I have a beginner's question: in the Operations Table on this page it states that the Depreciation & Amortization Total in 2006 is $30.7 million to the plus side. What I don't understand is how can Depreciation & Amortization be a positive number?

    I think I must be missing something very basic.

    Any info would be greatly appreciated!

  • Report this Comment On October 24, 2010, at 10:22 PM, CapitalIC wrote:

    Net income is reduced by depreciation and amortization, so they are indeed negative numbers on the income statement.

    However, since net income is the starting line for the cash flow statement, and the depreciation and amortization aren't actually paid to anyone in real cash, they get added back into the cash statement.

  • Report this Comment On August 08, 2011, at 1:08 AM, phissith wrote:

    People in Washington, the politicians have they all been blind to where we are as America? We are going through the same thing that businesses like GM, United Airline, Amtrak among many other company had gone through....they were too big for their own goods. Bondage into paying pension, insurance, union, labor cost and benefits. Rapid large expansion of branches in good times but when unthinkable struck they find themselves too big to compete against smaller but more efficient company. So they went bankrupt!! And who bail them out....the government, and yet the same entity did not recognize that they themselves is getting bog down by being too big and very very inefficient. We all need to call for an efficient government structure and system and let the capitalist do they things. Its good to protect the little guys but without hurting ourselves. It will not be easy but the politician need to find away to decrease spending including overpaid salaries a cross the whole country but yet keep people working. We are a victim to living a luxury we as a country can't afford because we all are living beyond our means, so as a country we are in debt!! Sacrifice must be make, line must be drawn, if we can do it together things we get better!! Stop export all the jobs to China and other countries. Made in America use to mean something!!

  • Report this Comment On August 15, 2011, at 10:59 AM, rodnog wrote:

    phissith, that's really interesting, but i'm not sure what it has to do with the cash flow statement.

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