Skip to content 
TIP Academy
LESSON SUMMARY
In this video, we learn that cash flow statement is an additional statement that provides you with information that the income statement and the balance sheet don’t. Whenever a business is conducting a transaction, whether it is selling a good or acquiring a new piece of equipment, it’s logical to assume that all transactions are settled in cash. However, in reality it’s not the case. The cash flow statement tells the investor how the cash flows in and out of the business, thereby giving you a very accurate picture of the health of the business, and makes the business more transparent for the investor. This lesson also answers the following questions:
1) What are the components of the cash flow statement: The cash flow statement consists of 3 major parts: “Operating, investing and financing activities”. As an investor, you should always take a close look at cash from the operating activities. This is the cash the company generates from the core business. The operating activities capture the investments the company is making, while the financing activities measure how cash from debt, equity, and dividend payments flows in and out of the business.
2) What components of the cash flow statement should generate cash, and what components should rather spend cash: Intuitively, it would make sense that a business should generate as much cash as possible right? Unfortunately, it’s not that simple. The quality of cash is very dependent on where it’s from. As operating activities measure the cash the company makes from the core business, you want this number to be as high as possible. This is in contrast to the investing activities, which should be negative. If you spend cash on investments, it implies that the business is growing, while the opposite might imply that the company is selling off assets, which might be good for the cash holding in the short run, but bad for business in the long run. Finally you want financing activities to be negative. A positive number implies new debt and issuing new shares that dilute your ownership of the company.
LESSON TRANSCRIPT
In course 1 unit 1, we discussed income statements and balance sheets with Nancy’s ice cream stand. The cash flow statement was briefly mentioned there, so this lesson is about it.
CASH FLOW STATEMENTS
Before 1987, a cash flow Statement was not even required. However, in order to provide more fidelity as to what’s happening inside of a publicly-traded company, a cash flow statement is now required.
Dan has a basic candy store. The income statement demonstrates the amount of money being generated on the operating activities of his business. This report will show how much money is flowing in and out of the company based on that product. This would be the sale of Dan’s candy store. If Dan sold enough candy to generate enough net income of $100, it would be recorded off of that income statement.
At the top is the revenue and at the bottom is the net income or the profit. The profit of $100 flows in Dan’s candy store and the income statement would capture that. The money could be paid to the owner through a dividend, listed as an asset on his balance sheet, or used to pay off debts. Paying debts would lower the liability on the balance sheet. The income statement or balance sheet in 1987 would have money flowing in off and that money would be whether the assets were becoming a higher value or the liabilities were decreasing. You’d have to surmise how that money is being employed based on how the balance sheet changed for months. The cash flow statement shows where the money is generated, spent, and employed.
Here’s another example. Let’s say $100 flows into Dan’s candy store through the sales of his product. Once it reaches his corporate bank account, he can do whatever he wants with that money. Not only can he have money flowing in the product that he has reproduced, but Dan has the publicly traded company. Dan can actually pay revenue for his company through the issuance of stocks.
Let’s say there are 100 shares outstanding on Dan’s store. If he wanted to issue another 100 shares, there’d be 200 shares outstanding now. It’ll bring additional revenues and cash funds into his business when he sells those. Also, he might make another $100 just through the sale of his stock.
Another way Dan can raise money is by issuing bonds. Bonds are not captured in the income statement. Understand this: Dan issued $100 worth of bonds. He collects $100 from some investors. In addition, he’s already making from his product, so there’s an additional $200. If Dan has been using money in his account to purchase publicly traded companies just like you do inside of his corporate account, this would make his candy store a holding company. The companies he owns inside of his Dan’s Candy Store corporate account are making dividend payments to him. That’s additional income not listed in the income statement.
Those are just a few of the different income streams that could be coming into a dance candy store that isn’t going to be listed on that income statement that needs to be captured somehow. The cash flow statement becomes useful all the more at this point.
There are funds flowing out of Dan’s candy store that hasn’t been properly accounted for. The first one is if Dan’s paying dividends to the owners of his company (himself) that’s not captured in the income statement, that dividend payment has to be captured somewhere. The cash flow statement does that. Dan is using the $100 that flowed into his company. He’s taking a portion of that – $25. He’s either reinvesting that back into inventory or upgrading his facilities. That’s all going to be captured on the investing portion of the cash flow statement.
The cash flow statement is that the money is used to pay off his debt. When you are just working with an income statement and a balance sheet, you’d see maybe the liabilities would decrease, but you wouldn’t know how much of his cash was being allocated towards paying off those debts. With the cash flow statement, you can now see how much money he’s using to pay off his debt and how much money he might be using to retire stock. Let’s say he has raised money before selling stock and he’s buying 100 shares back. Let’s say there are 300 shares outstanding and he’s using $100 back to his business. That increases the value of the shares he’s holding. That would be the incentive for him to do something like that.
All of these things are captured in this very important document called the cash flow statement. If we look at it, it is broken down into three categories. First is operating activities. Here are all those funds that are flowing into the business. If he was receiving dividend payments from companies that he owns inside of his corporation, that would be listed on the operating activities. If the net income is the first thing listed on the operating activities which come straight off the income statement, all that money being generated for the business that he’s producing is listed there on the operating activities. The investing activities are the money used inside of his corporate account to buy more supplies to upgrade his facilities or further expand his business. All those investing types of activities are the second item. The third item is financing activities. Commit to issue more shares and bonds.
IDENTIFYING STRONG VS RISKY COMPANIES
The important number to watch out of those three on the cash flow statement is the operating activity. This is where you should see the green on the sheet. When you see a negative number below that, that’s the true number that is providing the life of the company. If you see a positive number order investing activity, he means he sold some of his investments and that’s the positive cash flow. Sam for the financial activities. Positive numbers mean he has sold bonds and he has a debt. A cash flow statement should have positive operating activities, while the investing and the financing are negative.
Here are examples of 2 companies. Company A’s cash flow statement is steady growth with positive numbers in the operating activities. This is what the business does – producing income. If it’s a candy store, the candies are the primary thing that generates that operational activity’s income. The investing activities numbers are all negative. This means the owner takes $500 in 2010 to invest in something else. If you see a positive number, he sold something that he owns, and now he doesn’t have the capability to generate the cash flow of the next period. He’s investing and increasing on a larger sum as he kept making more money under that operating activity. The financing activity is also negative. This means company A is paying off its debt. In 2010, it paid $400. It has $100 remaining after that year. In 2011, they paid off another $500. If this number was positive, the company would be taking on debt. This is a good example of the cash flow statement. If the company needed a lot of cash to consult an acquisition of another business, you’d see that any starts stocks calendar cash and see that net changing cash be a positive number quarter after quarter as they prepare for that occasion. Company A is a good cash flow statement.
Company A Cash Flow Statement
| Operating Activities | $1200 | $1100 | $1000 |
| Investing Activities | ($600) | ($550) | ($500) |
| Financing Activities | ($600) | ($500) | ($400) |
| Net Change in Cash | $0 | $50 | $100 |
Company B is not as good as company A if you would just compare.
Company B Cash Flow Statement
| Operating Activities | $400 | $450 | $500 |
| Investing Activities | ($350) | ($300) | ($600) |
| Financing Activities | $600 | $300 | $500 |
| Net Change in Cash | $650 | $450 | $400 |
LESSON VOCABULARY
Cash Flow Statement
A financial statement that is showing the flow of cash in the company. The cash flow statement can be broken down into three components showing the cash from operating, investing, and financing activities.
Operating Activities
This is the most important source of cash for the company, and that cash is basically paying for all activities that are reinvested or distributed back to the investors. You want the cash flow from operating activities to be high and positive.
Investing Activities
Companies that are growing or even just to sustain their earnings need to reinvest. You will therefore often see that investing activities represent a negative cash flow. As long as the investments made are profitable you should feel comfortable with a negative cash flow from this component in the cash flow statement.
Financing Activities
Cash flows from financing activities tell the investor if the management show financial discipline. In other words, the information about the handling of debt and financing of the company can be found under this component. You want this cash flow to be negative as it represents dividend paid out to the shareholders or repayment of debt.
Net Change in Cash
Summing up operating, investing, and financing activities for a given period shows the net change in cash.
Free Cash Flow
Often referred to as “owner’s earnings”.
