Reading a cash flow statement: sources, uses and common-size

How do you read a cash flow statement?

Work through four steps in order: the big picture of sources of cash and uses of cash , then what drives each of operating, investing and financing cash flow. A source is any inflow that brings cash in (customers, asset sales, borrowing, share issues). A use is any outflow that sends it out (suppliers, capital spending, repayments, dividends).

Reading a cash flow statementwhere cash came from and where it went

• 1. Major sources and uses Memorize is CFO positive and enough to cover capital spending?
• 2. Drivers of CFO Memorize
  • Receivables, inventory, payables is the business using or releasing cash?
  • CFO versus net income mature company: CFO above net income
  • Variability of CFO risk, and harder to forecast
• 3. Drivers of CFI Memorize
  • Capital spending versus depreciation growth or replacement
  • Acquisitions and asset sales why, and with what effect
  • Securities bought and sold
• 4. Drivers of CFF Memorize
  • Borrowing versus repaying when is repayment due
  • Issuing versus buying back shares
  • Dividends paid

1. Major sources and uses. Is CFO positive, and enough to cover capital spending? Borrowing and share issues can fill a gap for a few years, but every one of those providers expects a return that only the business itself can produce.
2. Drivers of CFO. Changes in receivables, inventory and payables show whether operations are using or releasing cash. Then compare CFO with net income, and ask how steady CFO has been.
3. Drivers of CFI. Is capital spending replacing worn assets or adding capacity? Are acquisitions or asset sales involved, and why? Was the spending paid for by operations or by new money from step 4?
4. Drivers of CFF. Is the company borrowing or repaying, issuing or buying back shares, paying dividends? Is it financing a gap or returning a surplus?

Exam tip On the exam, a one-line answer to “what does this statement show?” is almost always about which section funds which.

Why should operating cash flow exceed net income?

Because net income is struck after non-cash charges such as depreciation and amortization, and the indirect method adds them back. For a mature company the operating cash flow vs net income comparison should therefore show CFO at or above net income.

When the reverse persists, with healthy profit and weak cash, ask why. The usual culprits are receivables growing faster than sales (revenue booked but not collected) and inventory building up. That pattern is an earnings-quality warning, taken further in the reporting quality module.

Look at how steady CFO is, too. A business whose operating cash swings from year to year is riskier, and any forecast of its cash flows is less reliable.

What do the signs of CFO, CFI and CFF say about a company?

They reveal its stage of life. The table below is the pattern the exam expects you to recognize, and it is worth knowing the story behind each row.

Stage	CFO	CFI	CFF	Story
Start-up or fast growth	negative or small	large negative	large positive	building receivables, inventory and capacity with outside money
Mature	strongly positive	moderately negative	negative	funds capex itself, returns cash to lenders and owners
Decline or distress	weak	positive (selling assets)	mixed	shrinking, selling assets to pay debts

These life-cycle cash flow patterns are tendencies, not laws. A growth company with negative CFO is normal for a while, but not forever. A mature company with negative CFF is not in trouble: it is repaying lenders and paying owners.

How do you tell growth capex from replacement capex?

Compare capital spending with depreciation. Depreciation is a rough measure of how fast the existing assets are wearing out, so spending close to it mostly replaces them, and spending far above it adds capacity.

In the Orchard Pumps statement below, capex of 1,500 against depreciation of 500 is three times as large, which signals expansion. The same sign pattern also shows that CFO (1,520) just covers capex, with the equipment sale, borrowing and a share issue funding the dividend and the debt repayment.

How do you build a common-size cash flow statement?

Divide each line by a base and show the result as a percentage. There are two bases, and both make it easier to see trends than raw amounts do.

Common-size cash flow statementevery line expressed as a percentage

• Total inflows and total outflows Memorize two columns, each adds to 100%
  • Each inflow ÷ total inflows
  • Each outflow ÷ total outflows
  • Indirect method shows only net CFO, as an inflow or an outflow
• Net revenue Memorize one base for every line
  • Each line ÷ net revenue
  • CFO ÷ revenue compare with net margin

The first base is the percentage of total inflows for inflows and of total outflows for outflows. The second is the percentage of revenue (net revenue), which puts every line on the same yardstick as the income statement. Together they make up the common-size cash flow statement .

$$\text{Share} = \frac{\text{cash flow line}}{\text{total inflows (or outflows, or net revenue)}}$$

Because the statement uses the indirect method, there is a single net operating line. Under the direct method each operating receipt and payment would appear separately, and each would get its own percentage.

Go deeper Reading a trend in common-size data

One year of percentages describes the mix. Several years describe a story. If CFO’s share of inflows falls from 70% to 45% over three years while borrowing climbs from 10% to 35%, the company is leaning more and more on lenders to fund the same activity. If capex stays near 70% of outflows but dividends rise, the payout is eating into what is left for debt repayment. The exam usually gives one year, so treat this as the analyst’s habit behind the rule.

Go deeper Why CFO volatility matters for valuation and risk

Valuation models discount forecast cash flows. The more erratic a company’s operating cash flow has been, the wider the range of sensible forecasts and the higher the risk premium investors ask for. Two companies with the same average CFO are not equally valuable if one swings between strongly positive and negative. That is why the curriculum asks how consistent CFO is, not just how large.