A cash flow statement is a financial document that clarifies the variations in a company’s cash balance (referring to cash and cash equivalents found on the balance sheet) over a specified timeframe. Reading a cash flow statement is one of the routine evaluative processes all investors use when considering an investment. Now, you can do it too!
It indicates how effectively a company handles its cash resources, particularly in covering operating costs and meeting debt commitments.
Additionally, the cash flow statement reveals the amount of cash generated by the business that is available to its owners, known as “free cash flow” (FCF). This aspect further underscores the significance of analyzing the cash flow statement to gauge a company’s financial performance.
In contrast to the income statement, where revenues and expenses are recorded based on when the associated benefits are realized, the cash flow statement consistently tracks the actual cash disbursed or generated within a specific period.
For instance, if a company pays its employees in advance for the entire year, this expenditure would appear in the cash flow statement for the first quarter. However, this cost would be distributed across the entire year on the income statement.
The key elements of the cash flow statement are as follows:
- Operating Activities: This section shows the cash generated or used by the company’s core business operations during the period.
- Investing Activities: This reflects the cash invested or received from the sale of assets, such as property or equipment, indicating how the company allocates resources to maintain and expand its operations.
- Financing Activities: This area details the cash flows between the company and its debt and equity investors, showing how much capital was raised or paid back to these stakeholders.
This article will use Microsoft’s cash flow statement as an example.
Operating Activities
Operating activities on an income statement represent the core functions of a business that generate revenue and incur expenses. These activities are central to the company’s primary mission and directly affect its profitability.
Microsoft offers a comprehensive example of operating activities.
- Revenue Streams: Microsoft’s operating activities generate multiple streams of revenue. These include:
- Software Sales: Profits from selling operating systems like Windows and software suites like Microsoft Office.
- Cloud Services: Revenues from Azure, its cloud computing service, a major growth area for the company.
- Hardware Sales: Income from selling devices like the Surface tablets and Xbox gaming consoles.
- Subscription Services: Earnings from subscription-based services like Office 365 and Xbox Game Pass.
- Licensing Fees: Income from licensing its technologies to other companies.
- Cost of Goods Sold (COGS): This comprises the direct costs of creating Microsoft’s products and services. It includes:
- Manufacturing Costs: For hardware products, it involves material, labor, and overhead costs.
- Operational Costs: For software and cloud services, expenses related to server maintenance, electricity, and other data center operations are included.
- Research and Development (R&D): A crucial part of Microsoft’s operating activities, R&D expenditure goes into:
- Innovating New Products: Developing new software, cloud solutions, and technologies.
- Improving Existing Offerings: Enhancing the features and security of existing products.
- Sales, General, and Administrative Expenses (SG&A): These expenses are critical in supporting Microsoft’s operations and include:
- Marketing and Advertising: Costs of promoting products and services.
- Employee Salaries: Administrative and sales personnel wages.
- Office Maintenance: Costs related to maintaining Microsoft’s offices and facilities worldwide.
- Depreciation and Amortization: Reflecting the gradual reduction in value of Microsoft’s assets, these non-cash expenses are essential for:
- Accounting for Asset Usage: Recognizing the cost of using assets like machinery, equipment, and software over their useful life.
While it’s important to understand the various items under the operating activities section of a cash flow statement, the initial step in assessing a company’s operating activities is to check if the figure is positive. A positive number indicates that the company generates more cash than spending in its regular business operations. Conversely, a negative figure could signal potential issues within the company, leading it to accrue more debt to sustain its day-to-day activities. Relying excessively on debt to finance ongoing operations is not a viable long-term strategy.
Furthermore, for a company to maintain solvency and support growth, its cash flows from operating activities should surpass its net income. This ensures the company has sufficient cash flow, not just accounting profits, to fund its operations and expansion.
Financing Activities
Financing activities are a crucial part of an income statement, providing insights into how a company manages its capital structure, including interactions with debt and equity. These activities are pivotal in understanding a company’s financial strategy and approach to funding operations and growth. Using Microsoft as a case study, we can explore the various facets of financing activities more deeply.
- Issuing and Repaying Debt: Microsoft may issue debt, such as bonds or taking loans, to raise capital. This can be for strategic reasons like financing acquisitions, investing in new technology, or capitalizing on market opportunities. The cash inflow from such activities is recorded as a positive figure. Conversely, when Microsoft repays its debt, either the principal amount or interest payments, these are recorded as cash outflows. The company’s strategy around managing debt, including the timing and terms of repayment, provides insights into its financial health and creditworthiness.
- Equity Transactions: This includes issuing new shares to investors. For a company like Microsoft, equity issuance can be a way to raise funds without increasing debt. This activity results in a cash inflow. On the other hand, if Microsoft buys back its shares, it is a way to return value to shareholders and improve earnings per share. Share buybacks, representing a cash outflow, may indicate the company’s confidence in its financial stability and prospects.
- Dividend Payments: Regular dividend payments to shareholders are a significant part of Microsoft’s financing activities. These payments, representing a distribution of profits, are recorded as cash outflows. The size and frequency of dividend payments can signal the company’s profitability and commitment to returning value to shareholders.
- Stock Buybacks: Another common financing activity for Microsoft is repurchasing its shares. Stock buybacks can be a method to return value to shareholders, often reflecting the company’s confidence in its financial health. These buybacks are also noted as cash outflows in the financing activities section.
- Issuing Equity: At times, Microsoft may issue new shares to raise capital. This could be to fund expansion plans or diversify its investment portfolio. The cash received from issuing shares positively contributes to the company’s cash flow from financing activities.
- Financing Costs: This includes costs associated with raising funds, like underwriting fees, legal expenses, and other related costs. For a global corporation like Microsoft, these costs, though smaller than other financing activities, are a regular feature and represent cash outflows.
- Lease Obligations: With extensive property and equipment leases, Microsoft’s lease payments are another aspect of financing activities. These reflect long-term commitments and are important for understanding the company’s fixed financial obligations.
Cash flows stemming from financing activities in a company can be either positive or negative.
When there’s a positive cash flow from financing activities, the company’s assets increase, potentially enhancing its overall value. This increase could be due to the company acquiring more debt to drive growth. If managed properly, this additional debt can be beneficial for the company.
Alternatively, a negative cash flow from financing activities indicates that the company focuses on paying off existing debts more aggressively and is cautious about acquiring new debt. Generally, this approach is viewed positively, suggesting prudent debt management and focusing on financial stability.
Investing Activities
Investing activities, a critical component of an income statement, provide insight into how a company allocates its resources to sustain and grow its business. These activities mainly focus on purchasing and selling long-term assets and investments. Analyzing Microsoft’s investing activities can offer a clear view of this crucial financial aspect.
- Capital Expenditures: For Microsoft, capital expenditures (CapEx) form a significant part of its investing activities. This includes investments in physical assets like buildings, data centers, and equipment for developing and expanding its technology infrastructure. Capital expenditures signify Microsoft’s commitment to long-term growth and capacity enhancement.
- Acquisitions and Mergers: Microsoft has a history of strategic acquisitions and mergers to diversify and strengthen its product portfolio. These investments, often amounting to billions, are aimed at acquiring new technologies, entering new markets, or eliminating competition. For example, the acquisition of LinkedIn or GitHub expanded Microsoft’s presence in professional networking and open-source platforms.
- Investments in Marketable Securities: Microsoft invests in marketable securities, including stocks, bonds, or other financial instruments, to manage its substantial cash reserves effectively. These investments can vary in risk and liquidity and aim to optimize returns on surplus cash.
- Sale of Assets: Another key aspect of Microsoft’s investing activities is the sale of assets. This may include the divestment of underperforming business units, the sale of real estate, or the disposal of outdated equipment. Such sales result in cash inflows and are often strategic decisions to focus on core business areas.
Research and Development Investments: While R&D expenses are usually reported as operating expenses, significant investments in long-term research projects are sometimes categorized under investing activities. Such investments are critical for innovation and maintaining competitive advantage for a tech giant like Microsoft.
Wrapping Up…
A cash flow statement typically comprises three primary sections: cash flows from operating activities, investing activities, and financing activities. Most cash flow statements utilize the indirect method, where the net income figure from the income statement is adjusted to arrive at the cash flows from operating activities.
The operating activities section details the company’s cash flow related to its regular business operations. The investing activities segment elucidates how the company is reinvesting its cash for maintenance and expansion. Meanwhile, the financing activities section outlines the cash movements involving raising funds from or returning capital to the company’s debt and equity investors.