Cash Flow Statement

Cash Flow Statement (aka ‘statement of cash flows’ or CFS) is used to calculate and report cash flows into and out of business. As financial value is determined by cash flows (free cash flows, to be more precise), CFS is by far the most important financial statement for a financial analysis. P&L and balance sheet are important, too, but only to the extent how changes in balance sheet and P&L accounts affect corporate cash flows.

Unlike P&L and balance sheet, CFS can be prepared using either direct or indirect method (i.e., in direct or indirect form). The direct method of preparing CFS results in a more easily understood report; however, the indirect method is substantially more convenient for building financial valuation models, because it focuses more on cash flows while the direct method is more concerned with changes in corporate cash position.

Direct Method

Direct method for preparing a CFS breaks corporate cash flows into operating, investing and financing activities. Each of these flows can be either positive (cash inflow) or negative (cash outflow).

Sum of these flows gives the net increase or decrease in the amount of cash in corporate bank accounts, which is then added to cash at the beginning of the financial year to yield cash at the end of financial year. Often ‘cash equivalents’ are added to ‘cash’ which is a bit misleading, because ‘cash equivalents’ are marketable securities and spending cash on these instruments is actually a financing activity.

Indirect Method

With indirect method, CFS calculates two cash flows: (1) free cash flow that is used in financial valuation model for a business entity prepared using the discounted cash flows (DCF) method; and (2) cash flow available to investors. ‘Investors’ in this particular context refer to holders both of corporate stock (investors proper) and holders of the long-term debt of the company (i.e., creditors).

Cash flow available to investors has a dual purpose in this CFS. It (1) indicates how the cash flow generated by the firm's assets are distributed to the debt holders and equity holders and (2) is used to balance the CFS, making sure that it is done correctly. Which is another major advantage of indirect method.

This ‘balancing of the model’ becomes possible because cash flow available to investors is calculated twice (two ways): from operating and financing activities

Oh, and FAS 95 (standard for cash flow reporting issued by FASB as part of GAAP) requires a supplementary report similar to the indirect method if a company chooses to use the direct method. Which makes the indirect method almost universally used.

For all these reasons, in this guide I will cover only the indirect form of CFS.