Understanding the Cash Flow Statement: An Analytical Tool Every Investor Must Know

Most investors tend to focus on the income statement, but in reality, the cash flow statement tells a more truthful story about a company because cash is the lifeblood that circulates within the business. It drives all activities from purchasing raw materials to paying employee salaries.

This statement not only reveals how cash flows have changed but also indicates whether the company has enough cash to continue operations. In this article, we will analyze the cash flow statement in depth so investors can use this tool to select promising companies.

How is the cash flow statement different from other financial statements?

Financial statements consist of three main parts that work together, but each tells a different story.

Balance Sheet (Balance Sheet) provides a snapshot of the company’s status at a specific date. It shows how much assets the company owns, how much debt it has, and the owner’s equity. It’s like a photograph of the current assets and liabilities, showing how much cash and assets you have right now.

Income Statement (Income Statement) shows how much profit or loss the company generated over a period, such as a year or six months. It summarizes revenue minus expenses and operating costs. However, figures in this statement may include non-cash items like depreciation.

Cash Flow Statement (Cash Flow Statement) tells a completely different story. It shows how actual cash moves in and out of the business—cash from sales, cash paid for operating expenses, cash from borrowing, and ultimately, how much cash remains. If the income statement reports profit but the cash flow statement shows negative cash flow, that’s a major warning sign for investors.

What are the components of the cash flow statement?

Analyzing the cash flow statement requires looking at three main sections, each with its own meaning and interpretation.

1. Operating Cash Flow (Operating Cash Flow)

This is the most important section. It shows the actual cash generated from core business activities, such as cash received from sales minus cash paid to employees, suppliers, and taxes.

An increasing Operating Cash Flow over time is a good sign, indicating healthy business operations. Conversely, if Operating Cash Flow is negative, caution is advised as the company may not be generating enough cash from its core activities.

2. Investing Cash Flow (Investing Cash Flow)

This section reflects cash paid for purchasing assets like machinery, land, or investments in securities, and cash received from selling those assets.

Negative Investing Cash Flow isn’t necessarily bad—it often indicates the company is investing in growth, such as buying new equipment or building factories. On the other hand, a large positive Investing Cash Flow suggests asset sales, which may be a one-time event and potentially unsustainable.

3. Financing Cash Flow (Financing Cash Flow)

This part relates to borrowing and repaying debt, issuing new shares, and paying dividends.

Consistently negative Financing Cash Flow indicates the company is paying down debt and not increasing borrowings, which is a positive sign. Continuous positive Financing Cash Flow might mean the company is borrowing more to sustain operations, which could be risky.

How to properly read and analyze the cash flow statement

Step 1: Examine Operating Cash Flow first

Assess whether the Operating Cash Flow is growing over consecutive periods, such as six months or a year. Steady or increasing Operating Cash Flow suggests the business is generating cash from its core operations.

Step 2: Check the quality of profits

Compare Operating Cash Flow with Net Income (Net Income). If Operating Cash Flow exceeds Net Income, that’s a good sign, indicating reported profits are backed by actual cash.

Step 3: Look at long-term investments

Review Investing Cash Flow to see how much the company is investing. Investing around 15-25% of Operating Cash Flow is reasonable. Larger investments might mean heavy capital expenditure, while very high inflows could indicate asset sales.

Step 4: Assess financial sustainability

Subtract necessary Investing Cash Flow from Operating Cash Flow to determine Free Cash Flow. This figure shows how much cash is left for dividends or debt repayment after investments.

Case Study: Analyzing Microsoft’s cash flow statement

Let’s look at Microsoft’s cash flow from 2020 to 2023 as a real example.

Microsoft’s Operating Cash Flow has steadily increased from about $60 billion in 2020 to $87 billion in 2023. This indicates the company is consistently generating strong cash from its core business, not relying on borrowing or asset sales.

Investing Cash Flow has been around $15-20 billion annually, roughly a quarter of Operating Cash Flow, reflecting appropriate investments in technology and infrastructure.

Interestingly, Microsoft’s Financing Cash Flow is about $40-50 billion annually, mainly from share buybacks. This shows the company is returning wealth to shareholders, signaling confidence in its business.

Finally, Microsoft’s Free Cash Flow remains high at $50-60 billion per year, demonstrating that despite investments and share repurchases, the company still has substantial cash remaining for other uses.

How to identify a healthy cash flow statement

Characteristics of a strong cash flow statement:

• Operating Cash Flow is growing or at least stable and consistently positive
• Operating Cash Flow exceeds Net Income, confirming profits are backed by cash
• Investing Cash Flow is negative but not more than a quarter of Operating Cash Flow
• Financing Cash Flow is negative or minimal, indicating limited new debt
• Free Cash Flow is positive and increasing

Things to watch out for:

• Negative or declining Operating Cash Flow = trouble ahead
• Positive Operating Cash Flow but negative Free Cash Flow = the company is investing heavily or spending cash elsewhere
• Continuous positive Financing Cash Flow = the company is borrowing more
• Large cash reserves but low Operating Cash Flow could mean asset sales rather than genuine earnings

Summary

The cash flow statement is a powerful tool for investors seeking the true picture of a company’s health, beyond accounting figures.

Looking only at the final cash balance isn’t enough; you need to understand where the cash comes from and how it’s used over different periods, such as six months.

By understanding the three components of the cash flow statement, investors can distinguish between genuinely strong companies and those hiding problems behind profit figures. Fundamental analysis thus becomes a deeper and more valuable tool.