Why do investors need to review the cash flow statement and how to interpret it correctly

Most investors tend to focus on the income statement to see how much profit a company makes. However, what they often overlook is the actual cash in the company’s accounts because cash is the lifeblood that allows the company to continue operating. This is why the cash flow statement(Cash Flow Statement)has become one of the essential tools that investors need to understand deeply.

All three financial statements tell different stories

When analyzing a company’s financial health, you need to look at three parts:

Balance Sheet(Balance Sheet) is like a snapshot of what the company owns(Assets), what the company owes(Liabilities), and the shareholders’ equity, helping us understand how strong the company’s financial position is at a given time.

Income Statement(Income Statement) shows the company’s performance, indicating how much profit it can generate over a period(such as annually or quarterly), and reveals the flow of revenue and expenses.

Cash Flow Statement(Cash Flow Statement) verifies how much actual cash the company is circulating because sometimes paper profits do not match the real cash received.

All three statements are fundamental parts of(Fundamental Analysis)that investors must understand if they want to select companies with potential at reasonable prices.

There are three channels of cash flow within a company

When talking about the cash flow statement, we need to understand where the cash inflows and outflows come from and go to. These are divided into three main sections:

Cash flows from operating activities(Operating Activities) are the core, showing the cash inflows and outflows from the company’s normal business operations, such as cash received from sales, services, and cash paid for expenses, insurance premiums, wages, taxes, etc. If this cash flow is positive, it indicates the company can generate real cash from its operations.

Cash flows from investing activities(Investing Activities) relate to buying or selling long-term assets, such as proceeds from selling land or securities, and cash paid for purchasing machinery, buildings, or investing in other companies. This section is often negative for growing companies because they are investing for the future.

Cash flows from financing activities(Financing Activities) reflect changes in borrowing and equity, such as proceeds from issuing debt or raising capital, and payments for debt repayment, share buybacks, or dividends. This indicates how the company raises funds.

Having a lot of cash does not always mean it’s good

Having a large amount of cash does not guarantee that the company is financially healthy, nor does a negative cash flow necessarily mean the company is in a crisis. Negative cash flow might be due to the company making large investments to build long-term growth capacity.

The key point in analysis is to look at where the cash outflows are coming from and how they are used.

How to analyze the cash flow statement correctly

First, check the cash flows from operating activities as the main focus of analysis. If the primary cash flow comes from operations, it shows sustainability and quality of cash. A company with profits but negative operating cash flow should be scrutinized because it might mean that profits are only on paper, not actual cash.

Second, analyze cash flows from investing activities. Growing companies need to continually invest in machinery and technology. Negative cash flow from investing activities may indicate that the company is strengthening itself. Conversely, positive cash flow might result from selling assets like land or reducing investments, which could be a sign of trouble.

Third, look at cash flows from financing activities to see if the company needs additional funding. Continuous negative cash flow from this section suggests the company is paying down debt and not borrowing more, which is positive. However, if it’s positive over a long period, it might mean the company relies on borrowing to maintain cash flow.

Microsoft as an example of a good cash flow statement

Looking at Microsoft’s cash flow from 2020 to 2023, we see the company has a strong operating cash flow, increasing from $60 billion to $87 billion, indicating its ability to generate real cash from business operations.

The details show that most of the incoming cash comes from operating income(Operating Income), reflecting a solid financial base.

Another interesting point is that Microsoft has increased investments, with about one-quarter of its operating cash flow reinvested, indicating ongoing strength while still retaining additional cash.

Most notably, Microsoft consistently has $40-50 billion in cash from financing activities(Share Buyback), mainly through share repurchases, returning value to shareholders. This signals that the company has ample cash and is actively using it to create value for shareholders.

Finally, the company maintains a Free Cash Flow(Free Cash Flow) of $50-60 billion, which is the remaining cash after investments, demonstrating a strong financial position—this is what a truly good cash flow statement looks like.

Summary: Look at the details, not just the final numbers

Cash Flow Statement(Cash Flow Statement) is not just a tool to see how much cash a company has left at the end; it tells the story hidden in each section. Investors should examine whether the cash from operating activities is sustainable, how cash from investing activities reflects the company’s future, and whether cash from financing activities indicates independence or reliance on borrowing.

Deep understanding of the cash flow statement(Cash Flow Statement)will help investors make more reasonable investment decisions and avoid falling for impressive but unsustainable figures.