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303-The Statement of Cash Flows
  Course 303:
  The Statement of Cash Flows
  Now that we've run through the income statement and balance sheet, it's time
  to take a look at arguably the most important as well as the most complex of
  the three major types of financial statements, the statement of cash flows.
  The statement of cash flows tells you how much cash went into and out of a
  company during a specific time frame like a quarter or a year. In other words,
  it shows how much cash a company is generating from one period to the
  next--and cash is what matters most.
  
  
  What It Tells You
  The statement of cash flows seems similar to the income statement, which shows
  how much revenue came in and how many expenses went out. The difference lies
  in a concept called accrual accounting. As discussed in Lesson 301, accrual
  accounting requires companies to record revenues and expenses when
  transactions occur, not when cash is exchanged. The principle is known as
  matching--expenses must match the revenues those expenses created whenever
  possible. While that explanation seems simple enough, it gets messy in
  practice, and the statement of cash flows helps investors sort it out.
  
  The statement of cash flows strips out all the abstract, noncash revenues and
  expenses that are included in the income statement. Many companies have shown
  profits on the income statement but have stumbled later because of
  insufficient cash flows. A good look at the statement of cash flows for those
  companies may have warned investors that rocky times were ahead.
  
  
  Cash Flows from Operating Activities
  Because companies can generate cash in several different ways, the statement
  of cash flows is separated into three sections: cash flows from operating
  activities, from investing activities, and from financing activities.
  
  The cash flows from operating activities section comes first and tells you how
  much cash the company generated from its core business, as opposed to
  peripheral activities such as investing or borrowing. This is the area you
  should focus most of your attention on because it paints the best picture of
  how well a firm's business operations are producing cash that will ultimately
  benefit shareholders. Some of the main line items found in this section are
  described below:
  
  Net Income. This figure is taken directly from a company's income statement.
  Net income is the starting point of how much cash a company provides from its
  operations. However, there are plenty of items on the income statement that
  affect income but don't affect cash flow, so all the remaining items are
  adjustments to net income that help you reconstruct how much actual cash was
  generated by the business.
  
  Depreciation and Amortization. As we mentioned in Lesson 301, depreciation is
  accounting's way to record wear and tear on a company's property, plant, and
  equipment (PP&E). Even though it's an expense on the income statement,
  depreciation is not a cash charge, so it's added back to net income.
  
  Changes in Working Capital. Working capital is calculated as current assets
  minus current liabilities on the balance sheet (see Lesson 302). Just as the
  name suggests, working capital is the money that the business needs to "work."
  Therefore, any cash used in or provided by working capital is included in the
  "cash flows from operating activities" section.
  
  Any change in the balances of each line item of working capital from one
  period to another will affect a firm's cash flows. For example,
  Harley-Davidson's accounts receivable increased at the end of 2004. This means
  that the firm collected less money from its customers than it recorded in
  sales during 2004 on its income statement. This is a negative event for cash
  flow and is one of the reasons Harley's "Net changes in current assets and
  current liabilities" on its 2004 cash flow statement is negative. However, if
  accounts payable were also to increase, it means a firm is able to pay its
  suppliers more slowly, which is a positive for cash flow.
  
  We're all about shortcuts to make financial statement analysis easier, so
  here's a little secret that's all you really need to remember regarding
  changes in working capital:
  
    If balance of an asset increases, cash flow from operations will decrease.
    If balance of an asset decreases, cash flow from operations will increase.
     
    If balance of a liability increases, cash flow from operations will
    increase.
    If balance of a liability decreases, cash flow from operations will
    decrease.
  Current assets may include things like inventories and accounts receivable,
  while current liabilities would include short-term debt and accounts payable.
  
  Net Cash Provided by Operating Activities. After all adjustments to net income
  are accounted for, what's left over is the net cash provided by operating
  activities, also known as operating cash flow. This number is not a
  replacement for net income, but it does provide a great summary of how much
  cash a company's core business has generated.
  
  
  Cash Flows from Investing Activities
  This section of the cash flow statement shows the amount of cash firms spend
  on investments. Investments are usually classified as either capital
  expenditures--money spent on items such as new equipment or anything else
  needed to keep the business running--or monetary investments such as the
  purchase or sale of government bonds. The most important parts of this section
  for investors are typically the capital expenditures line item and the line
  item for acquisitions of other businesses.
  
  Capital Expenditures. This figure represents the amount of cash a company
  spent on items that last a long time, such as property, plant, and equipment
  (PP&E). Basically, capital expenditures--often referred to as "capex"--are
  brick-and-mortar types of investments that are necessary to keep the company
  running and growing in its current form. For example, in order for a
  supermarket to keep operating and growing, it will typically need to remodel
  its existing stores, replace its equipment, and build new stores. These
  expenditures will show up in the capex line item in the "cash flows from
  investing activities" section.
  
  One of the most important terms and figures you should become familiar with is
  free cash flow. Free cash flow is calculated as net cash from operating
  activities minus capital expenditures. This figure represents the amount of
  excess cash a company generated, which can be used to enrich shareholders or
  invest in new opportunities for the business without hurting the existing
  operations. We can't emphasize enough that this figure--free cash flow--is one
  of the most important foundations in determining a company's ability to enrich
  its shareholders.
  
  Cash Used for Acquisitions. The acquisitions line item refers to how much cash
  a company paid to acquire another. Because companies tend to overpay for
  acquisitions, it's a good idea to keep an eye on this line item to see how
  much cash a company is spending on acquisitions. This line item will also give
  you a good sense of how much of a company's growth is coming from internal
  sources versus acquisitions.
  
  
  Cash Flows from Financing Activities
  The final section of the statement of cash flows is "cash flows from financing
  activities." This section includes any activities that involve the company's
  owners or creditors. For example, the issuance or purchase of common stock,
  the issuance or repayment of debt, and dividends paid to investors would be
  found in this section. Although these line items are pretty
  self-explanatory--dividends paid is exactly what it says--we think investors
  should look carefully at how much stock a company is issuing or repurchasing.
  
  Issuance/Purchase of Common Stock. This is an important number to look at
  because it shows how a company is financing its business. Newer companies and
  rapidly growing companies often need to issue lots of new stock to fund their
  growth. New stock issuance typically dilutes existing shareholders'
  ownership--they own a smaller piece of the whole pie--but it also gives the
  company cash to expand.
  
  Meanwhile, mature companies that have ample free cash flow often will buy back
  their own stock, which has the effect of increasing the value of existing
  shares--existing shareholders own a bigger piece of the pie. Share repurchases
  and dividend payments are typically the only two ways a company can enrich its
  shareholders with its cash flows.
  
  
  The Bottom Line
  Congratulations! You've made it through three lessons of pretty in-depth
  coverage of the three most important financial statements. While this
  knowledge may not make you the life of your next party, understanding how to
  read financial statements is a fundamental skill required to be a
  knowledgeable investor.