Evaluating A Statement Of Cash Flows

By Martha V. Shelton | October 15, 2012 AAA

When it comes to financial statement analysis, many people tend to focus their attention on a company's income statement when determining whether a firm is profitable or financially healthy. However, it is important to remember that a cash flow statement offers quite a bit of insight into a company's financial health. If you are familiar with the basic structure of a statement of cash flows, then try to use some of these cash flow metrics the next time you find yourself sizing up a company's financial statements.

Cash Flow Per Share
A close cousin to earnings per share, cash flow per share is calculated as follows:

Cash Flow Per Share = (Cash Flow from Operations - Dividends on Preferred Stock)/Common Shares Outstanding

A company's cash flow per share is useful, as it informs an analyst of how well positioned a company is when it comes to funding its future growth through existing operations. Companies that are able to internally fund their own growth do not need to turn to external debt or equity markets. This keeps borrowing costs low and generally tends to be viewed favorably by shareholders.

Cash flow per share also reveals how much cash could potentially be made available for future dividend payments. Of course, one has to consider the firm's growth prospects and financing needs when considering whether a dividend might be paid, but cash flow per share does inform cash flow statement users whether their cash is potentially available for dividend payments.

Like many cash flow metrics, cash flow per share tells a more complete story if it is analyzed over several time periods, so be sure to look at a few years' worth of data before drawing any conclusions.

Free Cash Flow
Among analysts' favorite metrics, free cash flow indicates how much cash is available from operating cash flows after accounting for capital expenditures required to maintain current production capacity. Said differently, free cash flow is calculated as follows:

Free Cash Flow = Cash Flow from Operations - Capital Expenditures Necessary to Maintain Current Growth

(Note: Many companies do not disclose the capital expenditures required to maintain current growth; therefore, some analysts use total capital expenditures in their free cash flow calculation. An alternative approach is to estimate maintenance capital expenditures as a percentage of total capital expenditures.)

Free cash flow represents a company's financial flexibility. The higher a company's free cash flow, the more flexible that company is when investment opportunities such as strategic acquisitions present themselves. While some of the information presented on an income statement, such as operating and net income, can be managed by a company's management team, it is very difficult to alter free cash flow. For this reason, many analysts evaluate free cash flows when sizing up a company's profit and growth potential.

Cash Flow to Debt
Yet another useful group of metrics derived from a statement of cash flows is the cash flow-to-debt family of metrics. Expressing operating cash flows as a multiple of debt offers information to analysts about whether or not sufficient cash flows are generated by the business to service debt payments. You can calculate cash flows to current maturities of debt, which represents whether enough cash is generated to pay off debt that matures within one year.

Cash Flow to Maturing Debt = Cash Flow from Operations\Current Debt Maturities

A similar metric is the cash flow to total debt ratio, which is among the ratios used by credit rating agencies when evaluating a company. This ratio is calculated as:

Cash Flow to Total Debt = Cash Flow from Operations\Total Debt

The Bottom Line
The statement of cash flows is an informative financial statement whose metrics are best viewed over time. Many users of financial statements prefer to use metrics derived from the statement of cash flows because cash flows are much more difficult to manipulate versus operating or net income. Cash flow per share, free cash flow and cash flow to debt are among the measures that can be calculated using information found on the statement of cash flows. Each of these metrics offers a unique insight into a company's financial health.

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