The cash flow statement (CFS) provides insights into a company's cash inflows and outflows over a specific period. It is categorized into three primary activities: Operating Activities (cash generated or used from core business operations), Investing Activities (cash related to the purchase and sale of long-term assets), and Financing Activities (cash related to debt, equity, and dividends). Understanding each activity's contribution to the overall cash position is critical.

Direct vs. Indirect Methods:

• Direct Method: Lists all cash inflows and outflows directly from operating activities (e.g., cash received from customers, cash paid to suppliers). Rarely used by companies for public reporting due to the work involved in tracking all cash transactions.
• Indirect Method: Starts with net income and adjusts for non-cash items (e.g., depreciation, amortization) and changes in working capital accounts (e.g., accounts receivable, inventory, accounts payable). This method is widely used. We will focus on this method in this lesson.

Example:

Let's say a company has net income of $100,000. It also has depreciation expense of $20,000, an increase in accounts receivable of $10,000, and an increase in accounts payable of $5,000. Under the indirect method, the cash flow from operations is calculated as follows:

• Net Income: $100,000
• Add back Depreciation: + $20,000
• Subtract Increase in Accounts Receivable: - $10,000
• Add Increase in Accounts Payable: + $5,000
• Cash Flow from Operations: $115,000

Analyzing a company's CFS involves examining the trends in each activity. Key metrics include:

• Free Cash Flow (FCF): Cash available to the company after all expenses and investments are covered. (Cash Flow from Operations - Capital Expenditures) Indicates the cash available to pay dividends, repurchase stock, or repay debt.
• Cash Flow from Operations (CFO): Consistent positive CFO generally indicates a healthy and sustainable business. Negative CFO can be a concern if it persists over time. However, it can also be indicative of rapid growth which consumes cash.
• Quality of Earnings: Evaluate if reported earnings are supported by cash flow. If net income is significantly higher than CFO, it suggests potential issues with accounting practices or the sustainability of earnings. Pay attention to working capital management.
• Capital Expenditures: High capital expenditures in the investing section may suggest future growth. However, they reduce free cash flow in the short term.

Example:

Consider a company with consistent positive CFO but declining net income. This suggests that the company is struggling with profitability, but is still converting profits into cash flow which is a positive sign. Digging deeper is needed. The analyst should investigate revenue, cost of goods sold, and operating expenses to find the root cause of the decline in profitability. This is where it’s essential to analyze the Income statement in relation to the cash flow statements to get a better overall picture of the company. A company that consistently generates cash from operations while maintaining or growing profit margins is usually considered financially healthy.

Cash flow forecasting is essential for predicting future cash needs, assessing the company’s ability to meet its obligations, and making investment decisions. Forecasting involves:

1. Gathering Historical Data: Obtain at least three to five years of financial statements (balance sheets, income statements, and cash flow statements).
2. Developing Assumptions: Project key drivers, such as revenue growth, cost of goods sold (COGS) as a percentage of revenue, operating expenses, and working capital requirements. Revenue growth is often the most critical assumption.
3. Building the Model: Construct a spreadsheet model (e.g., in Excel) that links the income statement, balance sheet, and cash flow statement. Use formulas to calculate projected cash flows based on your assumptions. Start with Revenue, and calculate the rest of the statements based off of Revenue.
4. Forecasting the Key Drivers of Cash Flow: This could include:
   • Revenue Growth: Based on market analysis, industry trends, and company-specific information.
   • Cost of Goods Sold (COGS): As a percentage of revenue, factoring in potential efficiencies or changes in input costs.
   • Operating Expenses: Fixed vs. variable expense analysis, and incorporating known changes.
   • Working Capital: Project changes in accounts receivable, inventory, and accounts payable as a percentage of relevant balance sheet or income statement items. For example, Accounts Receivable might be expressed as a percentage of revenue based off of historical data.
   • Capital Expenditures: Based on planned investments in property, plant, and equipment (PP&E).
5. Performing Scenario Analysis: Develop best-case, worst-case, and most-likely scenarios. This helps assess the sensitivity of the forecast to changes in key assumptions.
6. Validating the Model: Compare the model's outputs to historical data to assess its accuracy. Review the forecasts monthly for significant deviations. Regularly update the model.