Looking at Company Financial Statements and Ratios: Operating Cash Flow and Free Cash Flow

When you are looking to invest in individual stocks, it makes sense to look at the company’s financial statements (or at least the company profiles on Yahoo! Finance and Morningstar). This series “Looking at Company Financial Statements and Ratios” tries to break down some of the things you should look at to help understand how the company is doing and whether it is priced fairly. Last week, we covered the Gross Profit Margin, Profit Margin, and Operating Margin, looking at how well companies controlled expenses relative to their income. This week, we’ll look at the cash the company is generating through operations.

Operating cash flow is the amount of cash generated by regular operations, and you can always find it on the Statement of Cash Flows, which is usually shown right after the Income Statement on a formal financial statement. To get to operating cash flow, you start with net income and begin backing out the balance sheet and income statement items that don’t directly consume or add cash. First, you adjust out the effect of all of your non-operating activities (interest, investment income, taxes, discontinued operations, etc). You add in noncash expenses, like depreciation, amortization, stock-based compensation, and deferred taxes. Then you adjust for changes in balance sheet items. What’s left over is operating cash flow.

Detail From Amazon's Statement of Cash Flows

Detail From Amazon’s Statement of Cash Flows

Let’s take a quick look at Amazon’s 2014 Financials. The first thing to note is that Amazon showed a loss of $241 million in 2014, although the income statement indicates that income from operations was $178 million. But let’s adjust for depreciation and amortization, which was $4.7 billion, and stock-based compensation, which was just under $1.5 billion. These are both listed as expenses on Amazon’s income statement totaling over $6 billion, but they aren’t reducing the company’s cash. Once you adjust for the rest of noncash and non-operating activity, Amazon added $5,868 million dollars to its cash position through operations on the income statement, even though the income from operations was only $178 million.

Now, let’s adjust for balance sheet items. If inventory increases on the balance sheet, then a company is tying up more of their cash in inventory. If it decreases, then they are tying up less of their cash in inventory. If accounts receivable increases, it means that a company is owed more cash from their customers, so cash flow would have to be adjusted down. On the other hand, if accounts payable or accruals increase, the company is holding on to more of the cash they owe for items they’ve already expensed. And if unearned income increases, the company is holding more of its customers cash for revenue they have yet to report but will report in a future period. So, balance sheet adjustment accounted for another $974 million in increased cash. The total cash flow from operations was $6842 million, an increase of over $7 billion from the net loss of $241 million.

While cash flow from operations is important, most analysts looking at cash flow want to know Free Cash Flow, which is simply the Cash Flow from Operations minus the amount of capital expenses, or the purchases of property and equipment. This can be found under Investing Activities rather than Operating Activities portion of the Statement of Cash Flows, and represents the amount of cash the company is plugging back into the business. For Amazon in 2014, capital expenses were $4893 million, making the 2014 Free Cash Flow $1949 million. This represents a big drop down from the cash flow of operations, but it still is a significant amount of cash generated compared to the $241 million net loss.

By looking at Amazon’s Cash from Operations and Free Cash Flow over the last 5 years, we can see that its financial position is much stronger than its net loss might indicate. Its continuing cash from its core business activities has been strong. It has a solid cash position, and it is consistently generating cash even in the face of mediocre earnings. We also know from the Free Cash Flow that Amazon regularly reinvests in future growth with its own cash.

Why should you care?

All businesses need cash to pay expenses, acquire assets like inventory and equipment, to pay down debt and other liabilities. Cash can also be used to acquire new businesses, repurchase stock and pay dividends, all of which increase the attractiveness of owning the company’s stock. By looking at the amount of cash a company is generating and how they are doing it, investors have a much better idea of the company’s health and continued viability than if they are only paying attention to earnings.

It is much more difficult (though not impossible) to manipulate cash flows than it is to manipulate earnings, particularly over time. A company with good cash flow but poor to middling earnings may be a good investment, but one with poor cash flow and good earnings may be using accounting tricks to look someone focused on earnings.  If a company is increasing its profitability, but not its cash, make sure that you try to check where the money is going on the cash flow statement. For instance, ballooning accounts receivable may indicate that the company is having trouble getting paid or not appropriately writing off bad debt, and rapidly rising inventory can also indicate management problems. Cash flow for capital expenses, however, means that the company is paying for improvements with its own money rather than taking on debt, which can have long term benefits for future earnings.

This article is for information purposes only. Amazon was picked to illustrate cash from operations and free cash flow, but there is no recommendation of the company’s stock was intended.   Past performance does not determine future performance. There are other factors to consider, particularly price, and an investor interested in any company’s stock should proceed with caution and do lots of research before putting their money in any investment.

References and Further Reading:

Cash Flow Statement (Explanation)-from AccountingCoach.com

Free Cash Flow: Free, But Not Always Easy,  Free Cash Flow Yield: The Best Fundamental Indicator, Fundamental Analysis: The Cash Flow Statement & What Is A Cash Flow Statement? from Investopedia

How to Master Analyzing the Cash Flow Statement-from Old School Value

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