Reading a cash flow statement: operating, investing and financing cash flow, free cash flow

What you will learn

• The three sections of the cash flow statement and what belongs in each
• How the indirect method turns net income into operating cash flow
• How to calculate free cash flow (FCF) and FCF per share
• How to use cash conversion to judge earnings quality

Explanation

The cash flow statement shows the actual cash coming in and going out during a period. It links the income statement and the balance sheet: the net change in cash equals the change in the cash line on the balance sheet (ignoring exchange-rate effects).

Three sections

• Cash flow from operating activities (CFO, operating cash flow): cash generated by the normal business.
• Cash flow from investing activities (CFI): purchases and sales of long-term assets. The largest item is usually capital expenditure (capex), money spent on PP&E and intangible assets. Acquisitions also appear here.
• Cash flow from financing activities (CFF): borrowing and repaying debt, issuing shares, share buybacks and dividends paid.

Under IFRS, companies may show interest and dividends paid in different sections, so check where your company puts them.

The indirect method

Most companies start with net income and adjust it:

1. Add back non-cash expenses, mainly D&A: they reduced profit but no cash left the company in this period.
2. Adjust for changes in working capital: an increase in receivables or inventory uses cash (subtract); a decrease releases cash (add). An increase in payables preserves cash because you pay suppliers later (add); a decrease uses cash (subtract).
3. Adjust for other items such as provisions, non-cash gains and the difference between tax expense and tax paid.

Free cash flow

A simple, common definition: free cash flow = operating cash flow − capital expenditure. It is the cash available for dividends, buybacks, debt repayment or acquisitions after keeping the business running and growing. Definitions vary; some analysts also subtract lease payments, which under IFRS 16 appear in financing cash flow. State your definition and use it consistently.

Cash conversion = FCF ÷ net income. If it stays well below 100% for many years, reported profits are not turning into cash. Reasons can be heavy growth investment (often fine) or rising receivables and inventory (a warning sign). One year is not enough: look at five or more years, because capex and working capital are lumpy.

Reading the pattern

A mature, healthy company often has positive CFO, negative CFI (it invests) and negative CFF (it pays dividends or repays debt). A young growth company often has negative CFO and positive CFF: it depends on new money from investors or lenders. That is not wrong, but it means the company must keep raising capital, which can dilute shareholders (see lesson 1).

Worked example

Hypothetical example: Nordlicht AG, € million, figures from lessons 3 and 4 plus these assumptions: receivables rose by €10m, inventory rose by €8m, payables rose by €5m; capex €25m, an acquisition €10m, sale of an old building €3m; dividends paid €12m, debt repaid €8m, new loan €15m. Opening cash €40m. Taxes are already in net income; no other adjustments.

1. CFO: €35m (net income) + €20m (D&A) − €10m (receivables) − €8m (inventory) + €5m (payables) = €42m.
2. CFI: −€25m − €10m + €3m = −€32m.
3. CFF: −€12m − €8m + €15m = −€5m.
4. Net change in cash: €42m − €32m − €5m = +€5m. Closing cash: €40m + €5m = €45m.
5. FCF: €42m − €25m = €17m; per share: €17m ÷ 50m = €0.34.
6. Cash conversion: €17m ÷ €35m = 48.6% (rounded).

Interpretation: the €12m dividend is covered by FCF of €17m, but the €10m acquisition was partly financed with new debt. Only about half of net income became free cash. The rise in receivables and inventory explains €18m of the gap, so these deserve attention next year.

Common mistake

Practice activity

Hypothetical: net income €10m, D&A €6m, receivables increased by €4m, inventory decreased by €2m, payables decreased by €1m, capex €9m. Calculate CFO, FCF and cash conversion. What do you notice?

Key takeaways

• CFO shows cash from the business, CFI shows investment, CFF shows financing and payouts.
• Indirect method: net income + non-cash costs ± working capital changes.
• FCF = CFO − capex; always state your definition.
• Low cash conversion over many years is a warning sign about earnings quality.

Next step

Next, you will combine the three statements into profitability and efficiency ratios.