I like to think of the statement of cash flows as the real income statement. Neither financial statement can really stand completely on its own, but the statement of cash flows gives you that critical look at the actual cash that is flowing into and out of a company. If and how fast that cash flow is growing is a critical piece of information as you conduct your analysis.

The cash flow statement has three sections, and each of these sections reconcile the information on the income statement with the information on the balance sheet. To begin that reconciliation, the statement of cash flows begins with the net income number from the income statement. Net income is then increased or reduced as it flows through the three sections of the statement of cash flows. The three sections of a cash flow statement are as follows:

1.  The statement of cash flows begins with cash flow from operating activities. At this point, non-cash expenses like depreciation and amortization are added back to net income. Uncollected cash like accounts receivable is deducted because although those sales were included in revenue or net income, no cash has been collected yet.

2.  The second section of the statement of cash flows tracks investing activities. The largest components of this category include money spent on acquisition of capital assets like property, plants, and equipment. If applicable, loans or investments made to customers and suppliers are also included here as outlays of cash.

3.  The final section includes financing activities. For example, if a company issues stock, the proceeds of that offering will be added to cash in this category. Dividends paid are also included here, as are payments on the principle of debt owed by the company.

The statement of cash flows will contain several individual line items, but they will each fall within one of these three categories. Once these three categories of cash flows have been accounted for, the end result is a net increase or decrease in cash for the period. This is an important number to understand.

Because of the rules regarding how and when you can recognize revenue or sales, it is not uncommon to see a company that appears to not be making much net income or earnings to be accumulating a lot of cash. This speaks to one of the issues with the income statement. When and how a company recognizes revenue can be a little misleading unless you are also watching the increase or decrease in cash from period to period.

In the image below, you can see these sections in the statement of cash flows for Microsoft (MSFT).

chart

While the statement of cash flows can be extremely revealing and is easier to understand than the income statement, there are two things to keep in mind while reading the report.

1. As a shareholder, you should be concerned not only with how much cash is growing but the dividends paid by the company as well. It is usually a good idea to include dividends paid when evaluating the net increase in cash because that is a clear benefit to shareholders.

2. You will often hear analysts refer to "free cash flow" or "free cash flow per share" as a measure of financial performance, but that it not equal to the net increase or decrease to cash at the bottom of the cash flow statement. Free cash flow excludes financing activities and it may not be a complete picture of the cash-generating abilities of the company being analyzed.

The cash flow statement is just one of the three primary reports issued to shareholders and should not be analyzed all by itself. However, when used with the income statement and balance sheet, a solid picture of the overall financial performance of a company will begin to emerge.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.