In this article, I will show you how to effectively read and analyze a cash flow statement. The cash flow statement tells investors and analysts how much cash is generated and used over a certain period, and is presented in quarterly (10-Q) and annual (10-K) reports. Every cash flow statement will list the value of a company's operating, investing, and financing cash flows over a period.
To comprehensively understand the cash flow statement, I will summarize the majority of the line items included on the cash flow statement, discuss what investors should look for when reading a cash flow statement as an investor, and will use the cash flow statement of a real publicly traded company in the U.S. to serve as an example.
For this article, I'll be using the cash flow statement from NVIDIA Corporation (NVDA) as an example. Its stock price performance can be seen in the chart below:
Introduction to the Cash Flow Statement
The cash flow statement explains why the cash balance of a business (i.e., cash and cash equivalents on the balance sheet) changes over a certain period. Therefore, this statement measures how well a company manages its cash position, including how well the company can fund its operating expenses and pay its debt obligations. The cash flow statement also shows how much cash was produced by the business for the owners (called "free cash flow" (FCF)), which is another reason why this statement is important to analyze.
The cash flow statement is also known as the "statement of cash flows" (SCF) or "funds flow statement" (FFS). If you're looking at the official financial statements of a company (e.g., in a 10-Q or 10-K), it may be called the consolidated statement of cash flows (or something very similar).
You can locate the most accurate cash flow statement of any publicly traded company in the U.S. by searching for it on SEC.gov, and looking under the "Financial Statements and Supplementary Data" category in the most recent 10-K annual report. You can also Google "company name + investor relations" and locate the most recent 10-K annual report from the company's website. Regardless, it's fairly simple to identify a cash flow statement as it'll always have operating, investing, and financing activities listed. Net income (earnings) will also be typically listed as the first line item.
Unlike the income statement, where revenues and expenses are only reported if the benefits are provided, the cash flow statement always reports how much cash was spent or produced over a particular period. Therefore, if a company paid its employees upfront for the year, for whatever reason, this cash payment would be included in the first quarter cash flow statement, but would be spread throughout the year on the income statement.
The three main components of a cash flow statement are summarized below:
- Operating Activities: How much cash a company generates during the period for its normal business operations.
- Investing Activities: How much and where a company reinvests cash during the period to sustain and grow its business.
- Financing Activities: How much cash a company raised from or returned to its debt and equity investors.
The cash flow statement equation is shown below:
Net change in cash balance = Cash flows from operations + Cash flows from investing + Cash flows from financing
When a company has positive cash flow, this indicates the company has more money flowing into the business than out of it over a particular period. This excess cash gives companies the ability to pay down debt, invest in growth opportunities for the business, and give back to shareholders (in the form of dividends and share buybacks). It's also important to keep in mind that positive cash flow does not always mean a company is profitable. Similarly, a company can be profitable without being cash flow positive.
When a company has negative cash flow, this indicates the company has more money flowing out of the business than into the business over a particular period. This may be due to the company trying to expand the business and invest in future growth at a rapid scale, so it's important to analyze cash flow changes over multiple periods to better understand a company's financial performance. Note that negative cash flow may be caused by an expenditure and income mismatch, which does not always mean that profit is negative as well.
We can locate cash flows from operating, financing, and investing activities on any publicly traded company's cash flow statement. For our example, we'll examine NVIDIA's cash flow statement from its most recent 10-K annual report:
As you can see, the financial data on the income statement in a 10-K annual report will often show two or three year period values (2019-2021 in this case), and not just the most recent year's financial data. Regardless, the focus should be on the most recent fiscal year end, which in NVIDIA's case is January 31, 2021.
In the most recent year, NVIDIA had cash outflows of -$10.049 billion, and $10.896 billion worth of cash on its balance sheet from the previous period, which resulted in cash and cash equivalents of $847 billion at the end of the period. This cash figure ($847B) will appear on the balance sheet, which can be used to determine whether a company can manage its debt obligations.
The three cash flow activities in a cash flow statement (operating, investing, and financing) are described, broken down, and analyzed in more detail further below.
Methods of Preparing the Cash Flow Statement
The direct method and indirect method are two different ways of presenting the cash flow statement, in regards to the cash flows from operating activities section. Companies in the U.S. have the option to choose from either the direct or indirect method, but 98% of U.S. companies use the indirect method, as does NVIDIA. Regardless, it's still important to briefly understand the differences and implications of using one method over the other.
The indirect method begins with net income (earnings) for the company, then makes adjustments to get to the cash flows from operating activities number. These adjustments include adding depreciation expense, decreases in accounts receivable, increases in accrued expense payable, and deducting increases in inventory and decreases in accounts payable.
The direct method uses the cash amounts received and paid by the company to get to the cash flows from operating activities number. This provides more visibility into the company's cash inflows and outflows. Under the direct method, you may see line items such as cash from customers, cash paid to employees, cash paid to suppliers, and cash paid for interest.
Because the indirect cash flow statement is more commonly used, and because NVIDIA uses it as well, I will only refer to the indirect cash flow statement in this article.
Cash flows from operating activities is typically the first section in the cash flow statement and explains the cash flows within the business for its normal operations over a particular period. This section will show whether a company is capable of generating positive cash flow to maintain and grow its operations.
NVIDIA's cash flows from operating activities section is shown below:
Note that under an indirect cash flow statement, all cash outflows and inflows (as shown above) only represent adjustments to the net income number to get to the final cash flows from operating activities number.
- Net Income: Derived from the company's income statement for the corresponding period and is calculated by deducting all expenses from the company's total revenues. Measures the profitability of a company.
The operating activities section is also often broken into "Items not requiring cash," which NVIDIA calls "Adjustments to reconcile net income to net cash provided by operating activities," and "Change in assets and liabilities," which NVIDIA calls "Changes in operating assets and liabilities, net of acquisitions." Common line items within these two categories will be listed and summarized below, some of which are also shown on NVIDIA's cash flows from operating activities section.
Items not requiring cash:
- Depreciation and Amortization: Depreciation is a non-cash expense and occurs when tangible assets lose value over the course of time (over its "useful life"). Eventually, these assets will have a value of zero, because they will no longer be useful to the business. Amortization refers to the practice of spreading an intangible asset's cost over the asset's useful life.
- Deferred Income Taxes: Refers to taxes a company will eventually pay on its taxable income.
- Loss on Disposal of Assets: When a company sells fixed assets (e.g., property, plant and equipment (PP&E)), and generates less than the asset's book value, this is reported as a loss on disposal of assets.
- Stock-Based Compensation Expense: How much a company paid to its employees for share-based compensation. This is typically done through issuing employees stock options or restricted shares.
- Tax Benefit From Exercise of Non-Qualified Stock Options: Non-qualified stock options (NSO) give employees, directors, contractors, and others the right to buy shares of their company at a preset price within a particular period. When NSO's are exercised, companies can take a compensation tax deduction equal to the ordinary income recognized by the employee.
- Provision for Store Closings and Impairment: Funds set aside by a company for store closing and impairment (the diminishing value of an asset).
- Minority Interest: Also known as non-controlling interest (NCI), is when the parent company owns less than 50% of a subsidiary.
- Equity Loss in Joint Ventures: Joint ventures are business agreements between two or more parties, and each party in the venture has a certain amount of control and responsibility for the losses in the joint venture.
Change in assets and liabilities:
- Accounts Receivable: Refers to the amount customers owe for products/services delivered to them, but not yet paid for (to the company). Increases (decreases) in accounts receivable will therefore be deducted (added) to net income.
- Inventories: Products available for sale and any raw materials used to produce these products. Cash outlays will occur when the company purchases inventory.
- Prepaid Expenses: Reported as an asset on the balance sheet and refers to payments made in advance for company expenses. Decreases in prepaid expenses therefore show as cash inflows, and indicate that less of the asset was acquired during the year than was consumed.
- Accounts Payable: Debts owed by a company for anything purchased (e.g., from suppliers) that has not yet been paid back. Considered a cash inflow (or outflow) if accounts payable increases (or decreases) because the company can retain more cash within its business.
- Income Taxes: Typically shown as operating outflows in the cash flow statement for any income taxes owed by the company.
- Accrued Expenses: Also known as accrued liabilities, and refers to operating expenses that have built up over time and are due to be paid. Increases (decreases) in accrued expenses will lead to increases (decreases) in cash flow.
- Other Long Term Liabilities: Any other long-term debts the company must pay back. Read the full financial report (e.g., 10-K or 10-Q) to understand what these are.
Positive Cash Flows From Operating Activities
Although understanding the line items (listed above) under the operating activities section in a cash flow statement is important, the first thing you should assess when looking at a company's operating activities number is to see whether it's positive or not. If this number is positive, then the company is generating more money than it's spending for the normal operations of its business. If this number is negative, there may be something wrong with the company, which may lead the company to borrow more debt just to keep their normal business operations running. Obviously, if a company is taking on more debt to pay for its operations and maintain its cash positions, this is not sustainable over the long-term.
In addition to being cash flow positive, cash flows from operating activities should exceed the company's net income. Put simply, this enables a company to remain solvent and grow its operations.
We can see that NVIDIA has done well to maintain positive cash inflow from its operating activities, which also exceeds the company's net income for the most recent fiscal year. Currently, its operating activities total is $5.822 billion.
Cash flows from investing activities explains the cash flows generated or spent for any non-current (long-term) assets over a particular period. Any long-term physical and/or intangible asset that the company expects to deliver value in the future will be included in this section.
NVIDIA's cash flows from investing activities section is shown below:
As you can see, NVIDIA's cash flows from investing activities is -$19.675 billion. Although this may appear concerning, if the cash flows from investing activities number is negative, this simply means the company is investing to grow the business. In NVIDIA's case, its largest cash outflow is from purchasing marketable securities, which are short-term securities such as common stock, Treasury bills, and money market instruments (among others) that generate interest payments and can be liquidated to cash quickly. Therefore, it appears that NVIDIA is reinvesting its cash appropriately.
Common line items included in the cash flows from investing activities section are listed and described below:
- Purchase of Property, Plant and Equipment (PP&E): This is another term for capital expenditures (CapEx) and refers to the buildings, land, machinery, equipment, and other tangible (physical) assets that are purchased to grow and run the company's business. This line item is especially important when calculating free cash flow or owners earnings.
- Proceeds from Disposal of Property and Equipment: Disposals occur by abandonment, sale, or exchange. Therefore, when property and equipment assets are disposed, any amounts received will be a cash inflow for the company.
- Proceeds from Disposal of Assets Held for Sale: Assets held for sale are long-term assets that a company plans to sell. These assets can be disposed, as the process for selling these assets can take time and be complex, which will be a cash inflow for the company.
- Proceeds from Maturities of Marketable Securities: Cash inflows relating to the sale or maturity of marketable securities, which are assets that can be liquidated to cash quickly.
- Acquisitions, Net of Cash Acquired: Refers to the cash the company used to acquire (purchase) another company, which is clearly a cash outflow. "Net of cash acquired" means that the cash held by the acquired company has been subtracted from the purchase price of the acquisition. Therefore, the cash held by the acquired company (subsidiary) now belongs to the buyer because it now owns the acquired company.
- Investments in Unconsolidated Joint Ventures: Unconsolidated joint ventures are subsidiaries in which the parent company may exercise significant influence, but the parent company may not have a controlling stake in the subsidiary. The financial statements of these subsidiaries are also not included in the consolidated financial statements of the parent company, but instead appear as investments on the consolidated financial statements.
- Proceeds from investments: Shows how much money the company generated or lost from investments made from the excess cash the company generated. These investments (i.e., bonds) are made to get better returns than what's possible in a savings account or money market fund, for example.
Cash flows from financing activities explains the cash flows used to fund the company's operations and payback its shareholders. In short, companies are funded through both debt and equity financing, and companies pay back shareholders through issuing dividends and by performing share buybacks.
NVIDIA's cash flows from financing activities section is shown below:
Common line items included in the cash flows from financing activities section are listed and described below:
- Borrowings of Long-Term Debt: Financial obligations that must be paid off after 12 months. Includes long-term leases, business loans, and company bond issues.
- Repayment of Long-Term Debt: Cash outflow that refers to the repayment of long-term loans, whether it be monthly, semi-annually, or annually payments.
- Net (Repayments) Borrowings From Revolving Line of Credit: A revolving line of credit gives companies the ability to access funds whenever needed, up to a preset amount called the credit limit.
- Repayment of Short-Term Debt -- Related Party: Cash outflows from the repayments made on short-term borrowings from a related party, where one party has significant influence over another party.
- Debt Issue Costs: Deferred costs that are incurred when debt is issued to investors. These costs are amortized over the term of the debt instruments.
- Proceeds From Exercise of Stock Options: Cash inflow for the amount received from the exercise of stock options.
- Proceeds from Stock Offering: Sales of any shares of common stock to the public. Issuing stock brings in cash proceeds to the company.
- Repurchases of Common Stock: When a company buybacks stock from the public stock market, thereby causing the number of outstanding shares in the company to decrease.
- Collection of Notes Receivable: Also referred to as a written promissory note, which gives the holder (the company) the right to receive the amount outlined in the legal agreement on or before a specified future date.
- Dividends Paid: Total amount of dividends paid to shareholders over the period. Only relevant if the company issues dividends.
Positive/Negative Cash Flows From Financing Activities
Cash flows from financing activities can either be negative or positive.
Positive cash flows from financing activities will increase the company's assets and make it more valuable, perhaps due to the company taking out more debt to leverage growth, which may be a good thing if this debt is manageable.
On the other hand, negative cash flows from financing activities can show that a company is paying off its past debt(s) more rapidly and not incurring much (if any) new debt, which is typically a good thing.
For reference, NVIDIA currently has a positive $3.804 billion in net cash provided by financing activities, largely due to the debt it issued over the most recent period. Most likely, this is a good sign for NVIDIA given its strong cash balance and ability to grow its free cash flow, as discussed below.
Free Cash Flow
One of the most important numbers you can calculate from the cash flow statement is free cash flow (FCF). FCF tells investors and analysts how much cash a business generates after growing and maintaining its business. This cash can therefore be paid to shareholders as a dividend, be used to pay down debt, buyback shares, or to just keep as cash on the balance sheet for any future possible investment opportunity.
The simple FCF formula is below:
Free cash flow (FCF) = Cash flows from operating activities - Total capital expenditures
As previously mentioned, total capital expenditures is often listed as "purchase of property, plant and equipment" (PP&E), and can be found in the investing activities section of the cash flow statement.
For our example, we can view a chart of NVIDIA's FCF over the last 10 years below:
In general, you should be aiming to invest in companies that have FCF growing at 10% or more over the 10-year period, and improving over time. This is because FCF is a strong indicator of how well a company's stock price will grow over time. In short, this is because if a company is generating more FCF, then they're essentially increasing the value of their business as well.
Therefore, if NVIDIA kept all of its most recent FCF and just stuck it on their balance sheet as cash, NVIDIA is now technically worth $4.694 billion more. In other words, if you owned NVIDIA stock, you now get an additional $4.694 billion in cash, which increases NVIDIA's value as a company. Over the long-term, this will likely cause NVIDIA's stock price to grow as well, which is obviously something you want as an investor.
We can calculate annual compound growth rates for NVIDIA below to determine its FCF strength:
As the chart and table shows, NVIDIA has done very well to achieve a 10% compound annual growth rate, which may make it a worthwhile investment. After calculating 10-year data for free cash flow (e.g., with QuickFS), you can calculate this by using the RATE function on Excel or Google Sheets. For example, the 1-year annual growth for FCF from 2020-2021 would look like: =RATE(1 ,, -2020 revenue, 2021 revenue).
Free Cash Flow and Debt
To briefly touch on company debt, often times companies that are not FCF positive will borrow large amounts of debt in order to fund their company's operations. If you see a company taking on large amounts of debt, while at the same time paying down a lot of debt, this can indicate that a company is paying off long-term debt with more debt.
Typically, this can be managed when interest rates are low, credit is readily available, and rates aren't changing. However, in uncertain economic environments, periods of higher inflation, or whenever the Federal Reserve chooses to increase interest rates, credit will be less available which can severely limit the growth of these over-levered companies with incompetent management teams.
Therefore, ideally you want to invest in companies that have FCF and are not taking on large amounts of debt. Even if the company you're analyzing does not have consistent 10% compound annual growth rates for its FCF, do your best to ensure the company is capable of paying off its debt obligations responsibly. After all, if a company cannot find additional debt to cover its initial investment, they'll go bankrupt.
The Bottom Line
In summary, there are three main sections in the cash flow statement (cash flows from operations, investing, and financing). Nearly all cash flow statements follow the indirect method, where net income (from the income statement) is adjusted to get to the cash flows from operating activities number.
The cash flows from operating activities section is also where the company's cash flows relating to its normal business operations are located. Cash flows from investing activities explain where the company reinvests its cash to sustain and grow its business. Cash flows from financing activities explain the cash inflows and outflows raised from or returned to its debt and equity shareholders.
When analyzing the cash flow statement, value investors should seek to invest in companies with positive cash flows from operating activities, with free cash flows (FCF) growing at a rate of 10% compounded annually (with manageable amounts of debt). In short, this will allow investors to focus on companies that are consistently growing with strong cash positions.
In closing, the cash flow statement shows how much cash different activities generate (or cost) a particular business over a period of time, and how much cash the company produces for its owners. The cash flow statement can then be interpreted together with the other financial statements, primarily the balance sheet and income statement, to get a complete picture of a company's financial health..