'Cash Is A Fact, Profit Is An Opinion' Understanding The Cash Flow Statement

  • The cash flow statement reflects the changes in the cash positions of a company.
  • As an investor it is important to check cash flow from operations, financing and investing activities.
  • The cash flow statement is important as even profitable companies can fail to adequately manage their cash flow.

cashflow analysis
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It is often said profit is an opinion while cash flow is a fact. A profit of $X on a company's income statement does not mean that $X has been added to its bank balance, however a cash inflow of $X on the cash flow statement means that the company has added exactly $X to its bank account.

If you have wondered what that meant and how that is possible, then we shall help you understand just that. Continuing our series on how to better understand financial statements, we focus on the cash flow statement of a company and its implications for an investor.

The cash flow statement is essentially divided into three parts:

  • Cash flow from (or used by) operations, which tracks cash inflow and outflow related to the basic business of a firm.
  • Cash flow from (or used by) financing activities, which track the external cash inflow and outflow related to finance the business.
  • Cash flow from (or used by) investing activities, which tracks cash inflow and outflow resulting from the sale or purchase of assets and investments.

To better understand the cash flow statement an investor need to look at all of these three parts. Financing activities deal with the question of how to finance a business and involves raising of loans and equity capital which funds the business, and the payments of dividends and other cash distributions to the providers of the capital. Investment activities deal with the question of where to invest the collected funds. The funds can be put in as investments in subsidiaries, purchase of assets or to run a business. Operating activities deal with the fundamental operations of a business and help to generate returns on the funds raised and invested into a business.

Now that we have a fair idea of the three main parts of a cash flow statement and its various uses, let’s try and understand the working difference between the income statement and cash flow statement. The income statement reports ‘profits’ which have been accrued or generated based on the revenues and expenses in a particular financial period. However, a profit of $X does not mean that a company has added $X to its bank balance. Then what exactly is the profit number and what does it indicate? The profit number simply indicates that if a company realizes its entire revenue for a period and subtracts its expenses from this revenue, $X is the money it will make. However, in reality not all sales happen on a cash basis and therefore while the books might report a significant profit the actual cash generated from operations is significantly different from the reported profits.

Cash flow change, on the other hand, reflects the actual cash inflow and outflow which has happened over a financial period (typically a quarter or a year). It indicates the amount of cash increase or decrease which has happened over the financial period. Therefore a cash inflow of $100 essentially means that the company has added $100 to its bank balance. We now know the major difference between income statement and cash flow statement and will now look at the significance of a cash flow statement to an investor.

As an investor, the cash flow from operations (OCF) deserves significant attention. The difference between profit and OCF is often the difference between success and bankruptcy for a company. As investors none of us would like to invest in a firm which is heading to bankruptcy and therefore cash flow from operations assumes tremendous importance. The cash flow from operations is the real ‘cash’ generated by a business over a financial period and at Amigobulls we believe this number indicates the financial health of a business. The cash flow from operations indicates a company’s ability to finance its current operations as well as generate funds for future growth.

We shall now focus on the OCF and profits as an indicator of bankruptcy. It is possible for a firm to carry on without generating profits in the short term as long as it is able to generate stable cash flows. However a firm unable to generate cash flows to even finance its day-to-day cash flows will face bankruptcy inspite of huge profits in the Net Income statement. A case in point is Amazon cash flow from operations and Amazon Net Profit numbers over the last 10 years. The below chart shows Amazon’s net income and operating cash flow over the last 10 years.

Amazon-cash-flow-from-operations-and-Net-IncomeA widely known fact is Amazon’s importance to market share. In the process of chasing market share and topline growth the company has sacrificed profitability and even today has a Net Income margin close to 0. However the company has done a great job generating tons of cash flow from operations. While the company will eventually have to generate profits for investors to realize returns, Amazon’s current valuations are based on its topline growth and its ability as a cash engine.

Amazon has been able to generate cash flows to finance its growth, which has kept it far away from bankruptcy. On the other hand if it wouldn’t have generated huge cash flows to finance its growth and operations, Amazon would have been a part of history and not trading at the huge valuations it commands today. Therefore it is rightly said cash is king and cash flow from operations should be an important metric in deciding an investment decision. We believe that as long as the operating cash flow is higher than the Net Income for a particular financial period, it is an important indicator of the financial health of a company.

You can read our earlier articles on How to better understand the financial statements of a company at the below links:

To see Amazon’s latest stock price movement, click here Amazon (NASDAQ:AMZN)

Virendra Singh Chauhan Virendra Singh Chauhan   on Amigobulls :

Neither Amigobulls, nor any members of its staff hold positions in any of the stocks discussed in this post. The author may not be a certified/registered investment advisor, and the opinions expressed should not be treated as investment advice.

Buying and selling of securities carries the risk of monetary losses.Readers/Viewers are advised to carry out their own due diligence and consult their investment advisors before making any investment decisions.

Neither Amigobulls, nor the author have any business relationship with any of the companies covered in this post.

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