Change In Cash And Cash Equivalents

$1,995

Cash Flows From Operating Activities

Cash flow from operating activities is equal to the sum of the company’s net income and all of its non-cash items that either took away or added to its earnings. While depreciation and other non-cash items (like certain one-time charges) are very real expenses, they are not currently eating up cash, which can be used for other things, like reinvestment into the business, stock buybacks, or dividends.

If you look at the cash flow statement of XYZ Company above, you will see in this section of the statement the items of depreciation, adjustments to net income, changes in accounts receivables, and changes in inventories. Depreciation is how a business writes off the purchase of equipment. A certain amount of the purchase price is charged against the company’s earnings every year. This is a very real expense from an accounting standpoint, but it is a non-cash item in that it represents cash that has been spent in past time periods. So, for purposes of determining current cash flows, depreciation needs to be added back to the net income.

It can be seen in the above cash flow statement that there was a change in accounts receivable of $427 million, that represents a negative toward operating cash flow. Remember that receivables are sales or services that were booked as earnings, but have yet to be paid for. For this reason, receivables do not represent an inflow of cash into the company, so it needs to be subtracted from the earnings for purposes of determining operating cash flows.

Changes in inventories total up to a $77 million positive contribution to operating cash flows. This may have been from a write-down in the value of the company’s inventories, which would have been a negative toward earnings, but because it is a non-cash charge, it has no bearing on cash flows. For this reason, it is added back to the net income.

Cash Flows From Investing Activities

In this section of the cash flow statement, you will see how much cash the company puts toward making more money. The biggest expense in this section is capital expenditures, which represents the company’s cash outlays in the purchase of assets that are held for longer than a year. Some of these assets may include land, buildings, equipment, and intangible items like patents. These are all items that are expensed on the income statement by way of either depreciation or amortization over several years. Because this is an item that represents a depletion of cash, it is always listed as a negative toward cash flows. The amount of cash that is devoted toward capital expenditures is often a function of what the company does. For instance, a telecommunications company will probably have high amounts of capital expenditures every year due to constantly having to build and upgrade its networks, while a credit reporting agency might have very little in the way of capital expenditures. Also, companies that have sustainable competitive advantages usually don’t have to constantly change and upgrade their facilities in order to keep up with the competition, so they will generally allocate less cash toward capital expenditures. Due to the negative impact that capital expenditures have on a company’s cash flow, less is more. Generally speaking, you don’t want to see a company spend more than 50% of its net income on capital expenditures, as huge cash outflows in this area normally translate into less cash being used for things like buybacks and dividends that are good for shareholders. In the case of XYZ Company, less than 37% of its earnings are spent on capital expenditures.

In determining whether or not a company has enough cash to pay out dividends or buy back stock, investors will often look toward a metric known as free cash flow. Free cash flow is simply the cash from operating activities minus the amount of cash toward capital expenditures. In the case of XYZ Company, it is calculated like this:

Free Cash Flow = Operating Cash Flow — Capital Expenditures = $13,610 — $3,964 = $9,646 million. From this, it can be seen that XYZ has generated more than $9.6 billion in free cash flow during the reporting period. This is money that can be used toward buybacks and dividends.

There is another items in the investing activities section that is labeled as other cash flows from investing activities. This is simply the amount of cash flow that comes from investments in other income-producing assets. A negative value represents negative cash flow in this area, while a positive value represents a positive cash flow contribution. In the case of XYZ, this item contributed nearly $2.8 billion toward cash flows.

Cash Flows From Financing Activities

Cash flows from financing activities represent cash that either entered or left the business through other means, such as dividends, issuance or retirement of company stock, or net borrowings. Dividends will always be reported as a negative here, as the company has to expend cash to pay the dividends. If the company sells stock on the open market, then they raise money, causing a positive cash flow here. However, if the company buys the stock back, the transaction goes as a negative toward cash flows. When a company borrows money, that goes as a positive toward cash flow. However, if the company is paying down debt, then this figure will be a negative.

In the case of XYZ, the company paid out over $6.1 billion in dividends, and bought back almost $2.3 billion in stock. These two items total $8.4 billion, which means that they are covered by the company’s free cash flow of over $9.6 billion. It can also be seen that the company paid down their debts by almost $2 billion, which is good.

Generally speaking, you like to see a company buy back its stock year after year. This is because every share of the company represents a bigger stake of the company when other shares are retired, making remaining shares worth more money, at least in theory. Investors also don’t have to pay taxes on capital appreciation from buybacks unless they sell their shares, where they always have to pay taxes on any dividends that they get. The main things that you have to look out for here are whether or not the company has enough free cash flow to finance the repurchase, and at what share price the repurchase is being done. If the stock has gotten ahead of itself and is at a relatively high price when shares are repurchased, then the company may have been able to put that money to better use. On the other hand, if the stock has had a sizable pullback, then management may be wise to buy in at that point. Most companies that have durable competitive advantages will buy back stock every year, as they have to have something to do with their strong cash flows that come in every year.

Change In Cash And Cash Equivalents

The total change in cash and cash equivalents during the reporting period is the sum of the cash flows from all three sections. It is calculated like this:

Change In Cash = Operating Cash Flow + Investing Cash Flow + Financing Cash Flow

If either cash flow is negative, then it is subtracted instead of added. Let’s do this calculation for XYZ.

Change In Cash = $13,610 — $1,205 — $10,410 = $1,995 million

Over this reporting period, XYZ Company recorded an increase in cash of almost $2 billion.

Now, you should be able to read the cash flow statement of any company and determine whether it is a cash-generating machine, or a cash-burning disaster in progress.