Securities For Beginners

Wednesday, January 04, 2006

Terms Explained - Cash Flow

The cash flow statement in a company's financial statement shows you the inflow and outflow of money. The difference between cash flow and income is that the net income is heavily influenced by depreciation, amortization and other non-cash items. Sometimes a company announces a loss although they earned a lot of money throughout the year. Investors now wonder wether buying the stock was a fault or the loss is the result of one-time effects that only affect the financial statement without affecting the company's economical health in general.

To answer this question you can take a look at the cash flow statement. The change of cash flow compared to the last year tells you wether the situation remained (nearly) unchanged, became better or worse. The higher the cash flow the better, beacause it means the company earned a lot of money! Since a company needs cash to pay its bills, employees and so on it's in great danger of bankruptcy when it's unable to generate enough cash throughout the year. To show the real amount of money earned the cash flow is calculated by adding depreciation and amortization to the net income (this is the most simple type of cash flow, there are other types that require more items to be included).

Due to the many ways a company can change its economic appearance by using the various accounting instruments the net income doesn't tell you that much - except you want to know wether there is a chance to get a dividend this year. The cash flow however can't be manipulated by accounting tricks, so it is much more important for the investor. Don't get fooled by the income - it's worth nothing without cash. As you can see, there isn't that much to say about cash flow (at least at the beginning), you just have to know the difference between cash flow and net income and the importance of this figures.

Link:
Investopedia: The Essentials Of Cash Flow
Investopedia: Operating Cash Flow: Better Than Net Income?

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