by Joe Lan, CFA

Earnings, dividends and growth rates are useful figures in investment analysis. However, like water to humans, there is an underlying element essential to the survival and success of any firmcash flow.

In this installment of the financial statement analysis series, I discuss the corporate cash flow statement, providing an in-depth look at its sections and explaining what the line items mean.

The Linking Statement

Under accrual accounting (the methodology followed by publicly traded corporations), earnings and cash flow are two very different figures. The earnings figure, the income statements bottom line, is based on the principles of accrual accounting. Accrual accounting attempts to match expenses with revenues regardless of when the cash transactions that deal with the creation of the goods being sold and the receipt from the sale occurred. In essence, accrual accounting is not entirely concerned with when cash trades hands. This method of accounting introduces many interpretations and estimates from management that can vary from firm to firm.

For example, higher sales may not translate into higher cash flow if accounts receivable are allowed to rise. (Customers may not pay when goods are delivered, but rather may be invoiced.) Furthermore, cash may be used to build up inventories, which may depreciate in value or even become obsolete if products are not sold in a timely manner. The expenses to build up these inventories are not recorded until products are actually sold. Even inventory recognition may vary from firm to firm if one company uses first-in-first-out (FIFO) accounting and another uses last-in-first-out (LIFO) accounting.

The cash flow statement helps alleviate many of these issues by providing a link between the income statement and the balance sheet. Think of the cash flow statement like your checking account. Once a transaction occurs and the cash is used, the cash is gone. There is no waiting to expense the spending throughout the life of your purchased product. The cash flow statement works in the same way: It allows you to see whether a company was able to generate more cash than it used during the stated period. If the company spent more cash than it was able to bring in, its cash balance is reduced. If the cash balance is depleted significantly (or if there is a threat of a significant depletion), the company must either take on additional debt or sell more stockboth of which may have negative financial implications.

Cash flow statements are separated into three segments: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. Table 1 shows an example of a sample cash flow statement.

Cash Flow From Operating Activities

Cash flow from operating activities has a very simple objectiveto show whether a firms day-to-day operations generated or depleted cash. If net cash flow from operations is negative, it means that the company is spending more cash than it is generating in producing and selling its goods and services. If it is positive, the company is generating more cash than it is spending on its day-to-day operations.

Needless to say, cash flow from operations is vital. Negative cash flow from operating activities will eventually lead companies to seek funding from outside sources, either through increased debt loadwhich increases interest payments, hinders growth and makes the company more vulnerable to business downturnsor by issuing stock, which dilutes ownership. Although a rapidly growing company may have negative operating cash flows as it expands its inventory and pays its increasing bills, the cash flow from operating activities must eventually turn positive for the firm to survive. Conversely, a contracting company may exhibit positive cash flows for a period of time, as spending falls at a faster rate than sales and earnings. If the sales and profits fall far enough, however, the firm will have to liquidate portions of its business or declare bankruptcy.