Cash Flow Statement

The cash flow statement is one of the three primary components of a company's financial report, alongside the balance sheet and the income statement. It provides detailed insights into a company's cash movements and tracks how liquid assets change over a specific period. Unlike the income statement, which records revenues and expenses as they are accounted, the cash flow statement only includes actual cash transactions. This clarity allows businesses to understand how much cash they are truly earning and spending, offering vital information about liquidity and financial stability.

The Three Main Categories of Cash Flow

Cash flows are classified into three main categories: operating cash flow, investing cash flow, and financing cash flow. Each category provides insights into different financial aspects of a business and collectively paints a picture of its liquidity.

1. Operating Cash Flow (CFO): Operating cash flow represents cash generated from a company’s core activities—producing and selling goods or services. It reveals whether the day-to-day operations generate enough funds to sustain the business.
2. Investing Cash Flow (CFI): Investing cash flow reflects long-term investments, such as purchasing property, equipment, or other assets. This metric shows how much money the company is allocating to drive future growth or improve productivity.
3. Financing Cash Flow (CFF): Financing cash flow includes activities related to funding the business, such as issuing or buying back bonds and stocks or paying dividends. It illustrates how the company raises capital or returns value to its shareholders.

How are Cash Flow, Income Statement, and Balance Sheet Interrelated?

Cash flow, the income statement, and the balance sheet are closely interconnected and influence each other.

Deriving Operating Cash Flow from the Income Statement

Operating cash flow is derived from the income statement, using the EBIT (Earnings Before Interest and Taxes) as the starting point. Specific adjustments are made to determine the actual cash flow generated from operating activities.

First, non-cash expenses, such as depreciations, are considered. Depreciations reduce accounting profit but do not result in a real cash outflow, so they are added back to the EBIT.

Additionally, cash-related items outside the EBIT are included. A typical example is taxes paid: although taxes are not part of the EBIT, they represent a real cash outflow and are therefore subtracted.

Changes in working capital (net working capital) can also impact the operating cash flow. These include increases or decreases in inventory, receivables, or payables, which affect actual cash flows.

These adjustments ensure that the operating cash flow reflects the liquid funds genuinely generated or used by the company's operating activities.

The Balance Sheet as a Basis for Investment and Financing Cash Flows

To calculate investment and financing cash flows, the balance sheets of the past two years are used.

• Investment Cash Flow: This can be observed on the asset side of the balance sheet. An increase in assets due to investments indicates cash outflows, while a decrease, such as reducing inventory, reflects cash inflows.
• Financing Cash Flow: This is derived from the liabilities side of the balance sheet. An increase in equity or liabilities suggests that the company received additional funds, such as through loans or issuing new shares.

Ultimately, all three types of cash flows—operating, investment, and financing cash flows—culminate in a net change in the company’s cash position. This change is reflected in the balance sheet as the difference in cash balances between two fiscal years.

In the next section, you’ll see an example of how the three types of cash flows can be calculated indirectly.

Example: Indirect Calculation of the Three Cash Flow Types

This table illustrates how the three types of cash flows contribute to changes in cash. Although the company generated $120,000 from operations, significant investments (-$220,000) outweighed the inflows. Additional financing (+$80,000) reduced the cash decline to -$20,000.

Cash Flows and Their Role in Valuing a Company

Cash flows play a crucial role in determining a company’s value, especially when it comes to "free cash flow". Free cash flow shows how much money a company has available to distribute to shareholders as dividends or interest payments without using funds needed for day-to-day operations. For investors, this is an essential metric as it reveals how profitable and financially stable a company truly is.

A company’s value is often calculated based on its free cash flow using a method called "Discounted Cash Flow" (DCF). This involves estimating future cash flows and discounting them to their present value to determine how much the company is worth today.

To calculate free cash flow, non-cash expenses like depreciations, which don’t represent actual cash outflows, are added back to the income statement figures. After that, all necessary investments required to keep the business running, such as working capital, short-term receivables and payables, and capital expenditures for things like equipment or real estate, are subtracted.

The final figure provides a clear picture of the company’s potential to generate value and make payments to shareholders. Below is an example calculation to illustrate this.

Practical Applications of Cash Flow Analysis in Case Interviews

A cash flow analysis is a common tool in case interviews to evaluate a company's financial health and guide strategic decisions. Candidates are expected to interpret different cash flow categories and derive practical recommendations. Below are four typical scenarios where the cash flow analysis can play a key role in case interviews:

1. Assessing a Company's Financial Stability
   A company must ensure it has enough funds to meet its short-term obligations. By analyzing the operating cash flow, you can determine if the business can sustain itself financially. A positive operating cash flow is a strong indicator of stability and short-term liquidity.
   
2. Deciding on Investments in New Projects
   When evaluating a significant investment, such as building a new production facility, the free cash flow becomes a critical metric. It helps determine whether the company can finance the project without jeopardizing its liquidity. A sufficient free cash flow indicates that the business has the resources to support growth initiatives.
   
3. Valuing an Acquisition or Merger
   If a client is considering acquiring a company, a cash flow analysis can help estimate the target company's future value. The Discounted Cash Flow (DCF) method is a common valuation approach used to assess whether the acquisition price is justified and how the transaction might impact the cash flow.
   
4. Analyzing Cash Conversion Efficiency for a Manufacturing Business
   For a manufacturing company struggling to generate cash quickly, the Cash Conversion Cycle (CCC) is a key metric. A short CCC reflects operational efficiency and the ability to convert resources into cash quickly. A long CCC, however, highlights inefficiencies and areas for improvement.

Key Takeaways

• Cash flows are crucial for assessing liquidity. A positive cash flow indicates at least short-term solvency.
• Cash flow comes from three main sources: operations, investments, and financing activities.
• Operating cash flow helps evaluate a company’s ability to sustain its daily operations.
• Investment cash flow provides insights into opportunities for future growth through investments.
• Financing cash flow shows how a company raises capital or returns it to shareholders, serving as a marker of financial strategy and capital structure.
• Practical use in case interviews: A cash flow analysis helps assess financial stability, investment potential, acquisition decisions, and the efficiency of working capital management.