Reading a cash flow statement without falling asleep

The income statement tells you what a company earned according to a set of accounting conventions. The cash flow statement tells you what actually moved. When the two disagree persistently, the cash flow statement is usually the one worth believing.

Three sections, three questions

1. 1Operating: did the core business generate cash this year?
2. 2Investing: what did the company spend on assets, acquisitions, and securities?
3. 3Financing: did it borrow, repay, issue shares, buy them back, or pay dividends?

A healthy mature business funds its investing from its operating cash and returns the remainder. A business funding operations from financing year after year is telling you something important.

Free cash flow, and why definitions differ

Free cash flow is operating cash flow less capital expenditure — the cash left after keeping the business running. It is what funds buybacks, dividends, and debt repayment without new borrowing.

Five lines worth checking every time

• Stock-based compensation. Added back as a non-cash expense, but it is real dilution. Check it against net income.
• Working capital movements. A large positive swing can flatter one year and reverse the next.
• Capital expenditure against depreciation. Spending persistently below depreciation may mean the asset base is being run down.
• Acquisitions. Growth bought rather than built has a different risk profile and shows up here, not in revenue.
• Share issuance and buybacks. Compare against the share count on the balance sheet — buybacks that merely offset issuance are not returning anything.

The pattern that matters most

Over five to ten years, does free cash flow track net income? If cash consistently lags profit, find out why. Sometimes there is a good explanation — rapid growth consuming working capital is a real one. Sometimes the explanation is that the profit was never quite as solid as reported.