Understanding the Cash Flow Statement

This article looks at the cash flow statement, the final of the 3 primary financial statements that all public companies must report to the SEC. In the first article, we covered the income statement, and the second article looked at the balance sheet.

The purpose of the cash flow statement. The cash flow statement has 2 primary purposes. One, it indicates to the investor how much cash money flowed into or out of the business over a period of time, usually a year or a 3-month quarter. Second, it reconciles the other two financial statements - income statement and balance sheet. For the income statement, it reconciles the accounting assumptions with the actual cold, hard cash the business earned. For the balance sheet, the cash flow statement shows the differences in the level of assets or liabilities from the previous reporting period.

One major difference between the cash flow statement and it's siblings is that there are no accounting assumptions or estimations on the cash flow statement. The income statement contains many accounting assumptions for things like depreciation and taxes. Likewise, the balance sheet estimates the worth of acquired businesses (goodwill) and intangibles like patents or brand names. The cash flow statement values are very real - this is the *exact* amount of cash coming in and going out of the business. Since creating cash from assets is the basic function of any business, the cash flow statement has a well earned reputation amongst value investors for being the most important of the 3 reports.

Cash flow statements are organized into 3 sections. The first, cash from operations, is the most important. This is the section that reconciles reported net income from the income statement and adds back non-cash costs, as well as accounting for the change in working assets like inventory, and so forth. The second, cash from investing activities, is where the company lists out items like capital expenditures, acquired businesses, and purchase/sale of equity or bond holdings. The third, cash from financing activities, is where dividend payouts, stock repurchases, cash received from bond issues, and debt repayments are listed.

As before, we'll look at Intel's (INTC) fiscal year 2007 cash flow statement, and then briefly explain each item. All values are in millions of dollars, and parenthesis represent negative values (cash going out). In order to keep this somewhat brief, some line items have been grouped together.

Net Income: 6,976
Depreciation: 4,546
Share Based Compensation: 952
Asset Impairment: 564
Tax Benefit from Share Based Payments: (118)
Amortization of Intangible Assets: 252
Gains on Equity Investments: (157)
Gains on Divestitures: (21)
Deferred Taxes: (443)
Changes in Working Assets and Liabilities: 74
Net Cash from Operations: 12,625
Additions to Property, Plant, Equipment (Capital Expenditures): (5,000)
Acquisitions, Net of Cash Acquired: (76)
Purchases of Available-for-sale Investments: (11,728)
Maturities and Sales of Available-for-sale Investments: 8,011
Investments in Non-marketable Equity Instruments: (1,459)
Net Proceeds from Divestitures: 32
Other Investing Activities: 294
Net Cash from Investing Activities: (9,926)
Decrease in Short-term Debt: (39)
Proceeds from Government Grants: 160
Excess Tax Benefit from Share-based Payments: 118
Additions to Long-term Debt: 125
Proceeds from Sales of Shares to Employees: 3,052
Purchase and Retirement of Common Stock: (2,788)
Payment of Dividends: (2,618)
Net Cash from Financing Activities: (1,990)
Net Change in Cash Holdings: 709
Free Cash Flow: 8,079
Dividend Payout Ratio: 32.4%
Free Cash Flow Margin: 21.1%
Free Cash to Earnings Ratio: 181%

A brief explanation of each line item:

Net Income. The net income line from the income statement. Cash is reconciled against this starting point.

Depreciation. Depreciation expenses in the income statement do not affect cash. For a personal example, think of the depreciation in your vehicle's value each year. Although it diminishes your net worth by reducing the amount you could sell the car for, it does not affect your cash holdings.

Share Based Compensation. Tech companies like Intel often reward employees by granting them stock or stock options. The estimated final value of these must be expensed on the income statement, but issuing stock or options does not require cash, so the amount expensed is added back here.

Asset Impairment. The value of assets on the balance sheet are in most cases estimated. Intel's accountants decided that, due to weak demand, the value of some assets was lower than was being carried on the balance sheet. The resulting write-down affected the balance sheet value, but did not affect cash holdings, so it is added back here. This line item also contained employee severance charges that were expensed in the current period, but not yet paid out in cash.

Tax Benefit from Share Based Payments. When employees exercise their stock options, the amount of profit they receive can be written off Intel's tax bill, as employee compensation is tax deductible. On the cash flow statement, this value is subtracted from operating cash and added to cash from investments as a re-classification exercise.

Amortization of Intangible Assets. Similar to Depreciation or Asset Impairment, Intel has set up a schedule to degrade the balance sheet value of some of it's intangible assets over a period of time. While this affects the balance sheet and is counted as an expense on the income statement, it does not affect cash and is added back in here.

Gains on Equity Investments. As mentioned in the balance sheet article, Intel holds equity positions in a few companies it works with, notably VMware (VMW) and Micron (MU). Like your personal portfolio, unrealized gains and losses affect net worth, but not cash balances. Therefore the gain recorded in the income statement is subtracted back out here.

Deferred Taxes. As mentioned in the balance sheet review, deferred taxes represents over or under-estimated tax payment carry-forwards. Again, this is a carrying account, only for tracking tax balances; changes in it are strictly for accounting purposes and do not involve cash.

Changes in Working Assets and Liabilities. Intel's accounts receivable, inventory, accounts payable, and other working capital balances obviously fluctuate on a daily basis. Two things to look for here are accounts receivable rising (Intel not able to collect it's owed cash payments), and inventory rising as a percentage of revenues. These represent weakness in Intel's customer base, and rising inventory is a big concern as technology products degrade in value very quickly. Over time, this line item should work out to about break-even. Consistent negative values here indicate poor management of collection and demand forecasting.

Net Cash from Operations. The sum of all of the above line items. This is the amount of cash Intel earned over the reported period, one of the most important pieces of data available.

Additions to Property, Plant, and Equipment (Capital Expenditures). Any items the company purchases for business that have a useful life over one year are considered "capital expenditures". These are not expensed in the income statement, but are charged off gradually through depreciation. For Intel, these are things like new chip-making equipment, office furniture, computers, and so forth.

Acquisitions, Net of Cash Acquired. This is the cash Intel spent purchasing other businesses.

Purchases of Available-for-sale Investments. Cash Intel put into purchasing equity and/or bonds for the purpose of earning a higher return. "Available-for-sale" means these are usually done on the open market.

Maturities and Sales of Available-for-sale Investments. The inverse of the above. Proceeds from equity and/or bonds that matured or were sold in the period.

Investments in Non-marketable Equity Instruments. Cash spent for a considerable equity investment that was done off-the-market. In this particular case, Intel invested nearly $1.5 billion for a joint venture stake in IM Flash Technologies.

Net Proceeds from Divestitures. Cash received from the sale of various assets and businesses the company no longer deemed strategic. Looking over the 10-K, this includes optical networking components group, media and signaling businesses, and several others.

Other Investing Activities. The catch-all for investing-based items that don't fit anywhere else. These consist of a number of items spread all over the 10-K, which I won't list here.

Net Cash from Investing Activities. All of the investing based items (here, the previous 7) added together.

Decrease in Short-term Debt. Cash Intel used to pay off some of it's short-term debt balances.

Proceeds from Government Grants. There is not much detail on this in the 10-K. Presumably Intel received a nominal amount of cash from some government agency.

Excess Tax Benefit from Share-based Payments. See the similar entry under the operating cash section.

Additions to Long-term Debt. Cash received from selling corporate bonds.

Proceeds from Sales of Shares to Employees. Most tech companies, and many other companies as well, have employee share purchase programs where employees can purchase equity at reduced prices. The amount of cash Intel's employees paid the company for these shares is recorded here.

Purchase and Retirement of Common Stock. The amount Intel spent to buy back and retire it's own shares.

Payment of Dividends. Just what it seems - the cash paid out to shareholders in the form of dividends.

Net Cash from Financing Activities. All of the financing based items (here, the previous 7) added together.

Net Change in Cash Holdings. Calculated as (Net Cash from Operations + Net Cash from Investing + Net Cash from Financing). This is the amount of cash added to or subtracted from Intel's balance sheet during the period. In this case, Intel increased it's cash balance by $709 million dollars over the fiscal year.

Free Cash Flow. Free cash flow can be calculated two ways. Classically it's (Net Cash from Operations + Depreciation - Capital Expenditures). MagicDiligence, and Joel Greenblatt in The Little Book that Beats the Market, calculate it as (Net Cash From Operations - Depreciation). Free cash flow is the cash available for the company to invest in growth or pay back to shareholders through share buybacks or dividend payments. MagicDiligence uses depreciation as this is a more accurate view of "maintenance capital expenditures". The traditional calculation can include capital expenditures used for growth (for example, buying new property or buildings), which unfairly skews the free cash flow calculation for quickly growing companies.

Dividend Payout Ratio. Calculate as (Dividends Paid / Free Cash Flow). This percentage shows you how much of free cash flow is being paid out in dividends. Too high of a percentage (over 60-70%) could indicate an unsustainable dividend.

Free Cash Flow Margin. Calculate as (Free Cash Flow / Revenues). This is the amount of every dollar of sales that is converted into free cash flow. The higher the better here. Look for at least 5%. Intel's very high 21% figure is just another indication of the top quality nature of the company.

Free Cash to Earnings Ratio. Calculate as (Free Cash Flow / Net Income). A big red flag is when this is consistently less than 100%. We will discuss this more in the red/green flag articles.

Now, we have a working explanation of all three financial statements that all public corporations report to the SEC. Next, we'll look at 10 red flags to look for when examining these statements.

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