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Cash flow statements reveal how a company spends its money and where that money comes from.

They have three distinct sections – operations, investing and financing.

Cash produced internally, as opposed to money coming in from investing and financing, comprise operations. This section adjusts net income for non-cash charges and records changes to working capital items, like operating assets and liabilities.

Transactions from investing generate cash outflows, such as capital expenditures for equipment, business acquisitions and purchasing investment securities. Inflows come from selling assets. Capital expenditures are important, because cash is necessary to ensure the proper support of, and additions to, a company’s assets and operation.

Debt and equity dominate the cash flow from the financing section. Companies borrow and repay debt. But for investors, cash dividends paid is the most important item because cash, not profits, is used to pay dividends.

Investors should use two indicators to measure the investment quality of a company’s cash flow.

The operating cash flow/net sales ratio shows how much cash a company gets for every dollar of sales. The higher the percentage, the better. Investors should track this indicator’s historical performance to find significant variations, and remember that cash flow and sales should increase at a similar rate.

A steady stream of free cash flow, which is the cash a company has after spending money necessary to run or expand its business, is a favorable investment quality. Part of that necessary spending includes paying dividends for companies with a history of doing so, because shareholders expect them.

Stable or growing levels of free cash flow show the company should be able to continue to fund its operations and pay dividends.

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