The cash flow statement shows how much cash comes in and goes out of the company over a given period usually quarterly or yearly. It is distinguished from the income statement because of accrual accounting, which is found on the income statement. Accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. The income statement often includes non-cash revenues or expenses, which the statement of cash flows does not include.
The cash flow statement is crucial in understanding a company’s fundamentals as it shows how much actual cash a company has generated. It shows how the company can pay for its operations and finance future growth. A profit on the income statement does not mean that a company cannot get into trouble later because of insufficient cash flows. A close examination of the cash flow statement can give investors a better sense of how the company will fare.
Companies produce and consume cash in different ways, so the cash flow statement is divided into three sections: cash flows from operations, financing and investing. The sections on operations and financing show how the company gets its cash, while the investing section shows how the company spends its cash.
Investors are attracted to companies that produce plenty of free cash flow (FCF). Free cash flow signals a company’s ability to pay debt, pay dividends, buy back stock, and facilitate the growth of business. Free cash flow, which is essentially the excess cash produced by the company, can be returned to shareholders, or invested in new growth opportunities without hurting the existing operations.
Ideally, investors would like to see that the company can pay for the investing figure out of operations without having to rely on outside financing to do so. A company’s ability to pay for its own operations and growth signals to investors that it has very strong fundamentals.