Cash is, quite simply, king when it comes to stocks. While the income statement captures the earnings of a company for a given period, some of those earnings haven’t been realized yet. That is, the company may have sold 100 mainframes in the first quarter of the year, which will show up as revenue booked on the income statement. However, if the company which purchased those items doesn’t pay for them until the end of the year, that money won’t be reflected as “cash flow” until Q4. Thus, net income is more representative of transactions, while cash flow reflects when money actually changes hands. As you would expect, investors prefer cash since it is “money in hand” vs. an IOU.
There are typically 3 main components of the cash flow statement. In general, these are comprised of a number of detailed line items. We’ll cover the high level concepts below.
Cash Flow from Operations
Cash from operations is the bread and butter of a company. The core operations of the firm should generate a healthy stream of cash flow, since this reflects the tangible performance of its business. As a result, analysts and investors closely follow operating cash flow and use it to cross check company earnings. In fact, the “top line” of the cash flow statement is the bottom line of the income statement: net income.
In a nutshell, adjustments are made to net income in order to reconcile to the cash received in a given quarter or year (that is, you work backward from net income to get to operating cash flow). For example, depreciation (which is an accounting vehicle used to spread the cost of an asset over its usable lifespan) does not represent actual cash received in the period. Therefore, the depreciation entry from the income statement is added back to net income since it is not true cash flow.
Cash Flow from Investing Activities
Capital expenditures for items such as property, plant, and equipment are cash outflows which fund future growth in the business. For example, “capex” (for short) can include costs associated with remodeling existing stores, replacing equipment used for manufacturing, or even upgrading computer systems. In addition, one of the key metrics used by analysts in assessing the profitability of a company is “free cash flow”. FCF is simply operating cash flow minus capex, and represents the cash available to investors after funding business operations.
Cash Flow from Financing Activities
Finally, cash flow related to financing activities details items such as issuance of debt or stock, as well as dividend payments to investors. In addition, any share buybacks are reflected here as well (note that repurchases of stock by the company usually boost price per share, since fewer investors have a claim on earnings).