How to Determine a Firm's Cash Flow From Its Financial Statements

by Alan Rambaldini ; Updated July 27, 2017
While the financial statements are on an accrual basis, actual cash flows can still be determined

Analysing a firm's cash flows is one of the most important steps in determining whether or not to invest in the company, either through a share purchase or loan. Stock investors want to see growing cash flows, while creditors want to see that the cash flows are regular and secure enough to repay the loan. The financial statements include a statement of cash flows broken down into operations, investing and financing components, which each depict a different source for and use of cash, but cash flows can also be determined from the income statement and balance sheet.

Income Statement

Step 1

Subtract the firm's tax rate from one. The tax rate can often be found in the footnotes to the financial statements, or else analysts use the U.S. corporate tax rate of 35% to avoid one-time changes in the firm's taxes. In this case, one minus 35% equals 65%.

Step 2

Multiply the earnings before interest and taxes (EBIT) by one minus the firm's tax rate. This estimates the actual taxes the company would owe on earnings if it were financed entirely by equity and had no debt.

Step 3

Add back the depreciation and amortization charges. These are non-cash charges that are accounted for in the income statement but do not affect the firm's cash flows.

Balance Sheet

Step 1

Subtract the firm's changes in working capital from the prior year's balance sheet to the current year. The working capital accounts include all the current asset and liability accounts on the balance sheet such as cash and short-term debt.

Step 2

Subtract the capital expenditure during the year. Calculate this expenditure by subtracting the prior year's property, plant and equipment (PP&E) account from the current year's PP&E.

Step 3

Compare the resulting free cash flow (FCF) with prior year's FCF to determine whether or not the company's cash flows are steady and/or growing.

Tips

  • Calculate the FCF from the Statement of Cash Flows by subtracting the Capital Expenditure amount from the Investing section from the Cash Flows from Operations amount from the Operations section.

Warnings

    1. When sales are decreasing, capital expenditures will likely decrease and receivables will likely increase, so the FCF can be unsustainably high.
    2. Small fast-growing companies may require more cash for expansion than they can currently generate on their own, so the FCF will provide little insight to analysts.

About the Author

Alan Rambaldini has been writing about investing and the financial markets since 2007. He has written about the insurance industry and the Exchange Traded Fund market for Morningstar.com and Morningstar.co.uk. Rambaldini holds a Masters of Business Administration from the University of Notre Dame.

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