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A Guide to Cash Flow Statements

Just about everyone has heard the phrase " cash is king" in investing. That's true for business finances, too.

A simple definition of a cash flow statement is how money, that is cash and cash equivalents, enters and exits a company.

Julie Neitzel, partner at WE Family Offices, says cash flow is how businesses pay their employees, buy materials and cover basic expenses. Companies need cash to pay down debt, invest in the business and pay shareholder dividends.

Cash flow statements are part of the mandatory financial quarterly reports that companies release. While many investors simply focus on a company's balance sheet, Colin McWey, vice president and portfolio manager at Heartland Advisors, says income and cash flow statements are released concurrently and are just as important.

According to McWey, investors can use cash flow statements to analyze a business's finances because it is harder for companies to manipulate those versus income statements, which focus on revenues and expenses. "The income statement and the cash flow statement should be telling you the same story over a long enough period of time. If the two are consistently not lining up and telling you the same story over time, it's a real potential red flag," he says.

With this in mind, here are three key concepts investors should understand about cash flow statements:

-- The structure of a cash flow statement. -- Cash flow versus net profits.
-- Using cash flow metrics.

The Structure of a Cash Flow Statement

Cash flow statements start with net income from the income statement and add in depreciation and amortization, which are recognized as noncash expenses, McWey says. The company then works through all the adjustments made throughout the quarter to come to the actual cash flow. It's important to distinguish income from cash. "Income is earnings, but income does not equal the actual cash that goes in and out the door of a company in any time period," he says.

[7 Ways to Prepare Your Portfolio for a Recession.]

Dwain Phelps, founder and CEO of Phelps Financial Group, says the three main components are operating activities, financing activities and investment activities. "Operating activities are all the funds that flow into the business. You want that number to be consistently positive through a five-to-10-year period," Phelps says.

Operating cash flow is where the detailed adjustments occur to reflect swings in a company's working capital, which can positively or negatively impact actual cash flow, according to McWey.

Financing activities include issuing stock, bonds and loans, Phelps says. Those activities bring money into a company, and a large positive number here can mean a company is accumulating a lot of debt or is using debt to grow, he says. Transactions that are negative for cash flow include paying down debt, issuing dividends or buying back stock. Phelps prefers if this line item is negative.

Investing activities can include buying or selling equipment or other assets, Phelps says. These figures can sometimes be negative if a company is investing in long-term assets, which can be a good sign. Over the long run, investors should look at positive line items for operating activities and negative line items for financing and investing activities, he adds.

To get from operating cash flow to free cash flow, McWey says to subtract the company's capital expenditures. The leftover money is the free cash flow. High free cash flow is usually a positive sign, but he points out that it can be a red flag if the firm's capital expenditures are consistently below asset depreciation and amortization. "That could be telling you that for the long term, the company is potentially underinvesting in its business. So the cash flow you're seeing them report is overstated and not sustainable," he says.

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Cash Flow Versus Net Profits

Neitzel says sometimes investors may confuse cash flow and net profits, but it's more important see strong cash flow.

"Cash flow is really more indicative of the health of a business. Why do I say that? You can book accounting profits and not have any cash," she says.

Investors may look at a company's balance sheet and its profit and loss statement, which lists the accounting entries that show the net income of the operating business. But that doesn't show how much cash the firm has to pay down debt or to buy raw materials, and it doesn't show how efficiently a company collects its accounts receivable. Those details are on the cash flow statement, not the profit and loss statement, she says.

According to McWey, it has become Wall Street practice over time for companies to "smooth out" earnings to meet or exceed previously given guidance. "Cash flow analysis can help confirm or refute whether or not financial reality jibes with what's being reported as 'earnings,'" he says.

[See: How Investing Can Boost Your Emergency Savings.]

Using Cash Flow Metrics

McWey says cash flow metrics help value a company's financial health, especially as accounting practices for recognizing earnings and assets have morphed over the years. One metric he uses is free cash flow yield, which is free cash flow divided by a company's enterprise value. Enterprise value is the stock's market cap minus net debt. Free cash flow yield can often be more helpful than a price/earnings ratio because of the practice of smoothing out earnings.

"A free cash flow-based valuation metric is useful if it represents a sustainable level of free cash flow generated by a company without underinvesting in its business by underspending on things like capital expenditures or employing an unsustainably low level of working capital to support the business," he says.

A company with strong free cash flow is like a person with an emergency fund -- it is money firms can rely on during economic downtimes.

Phelps gave an example of how Walmart (ticker: WMT) is likely using its significant free cash flow to respond to the current market turmoil and demand for its products. The retailer is seeing a sudden surge in demand for its products both in stores and online as people stock up on essentials in an effort to stay home amid the coronavirus outbreak. Walmart recently reported that it is hiring more workers to accommodate the rise in business and will pay out $5.5 million in cash bonuses.

Neitzel says well-known investors are also looking at buying stakes in companies, but they are focusing on those with high cash flow. "Cash flow is the lifeblood of a business, and that really provides the framing. That's really important for investors to study when they're looking at a business or stock," she says.

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