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Cash Flow
by WealthEffect Staff


Gross Cash Flow minus...
  Capital Expenditures & Working Capital equal...  
  Free Cash Flow  

When you buy shares of stock, you put up cash. In return, you own a piece of the cash flow a company generates each year. Essentially, when you buy stock, you are exchanging a fixed amount of cash now for an uncertain stream of cash into the future. Estimating that uncertain cash flow is an important part of investing, and the statement of cash flows an important resource.

The first step is to determine the gross cash flow, which is the net income plus depreciation. Net income is based on accrual accounting — revenues and costs are recorded when the company's products are sold, not when they are actually paid in cash. Also, large expenditures for building factories and purchasing equipment are not recorded in the income statement when these capital expenditures are incurred. Instead, a portion of the total expense is recognized each year over the useful life of these factories and equipment. This expense item is known as depreciation. Depreciation is a non-cash expense, and is added determine gross cash flow.


From gross cash flow, deduct capital expenditures, which is a cash expense. By adding back depreciation and subtracting capital expenditures, you are putting the books on a cash basis.

The next step in the process is to deduct the additional working capital which the business required for its operations. An increase in current assets, such as accounts receivable and inventories, tie up cash. An increase in current liabilities, such as accounts payable and income taxes payable, free up cash. An increase in accounts receivable, for example, means that some of the sales which were recognized in the income statement haven't been paid by the customer yet — these sales may have generated accounting profit, but they didn't generate cash. The changes in working capital are listed in the statement of cash flow under "increases and decreases in operating assets and liabilities."


Deducting capital expenditures and additional working capital from gross cash flow results in free cash flow. This represents the cash left over once the company has spent all the cash necessary to run its business and to grow its business.

You may find it helpful to read the "Liquidity and Financial Condition" section, which provides details behind the cash flow numbers. This section is part of "Management's Discussion and Analysis" in the annual report.

Analyzing cash flows is a valuable part of investing and a confusing one, as well. Further complicating the analysis is the fact that (1) not all capital expenditures should be viewed the same and (2) there are additional non-cash charges, known as in-process R&D and goodwill amortization. These topics are the focus of the next two articles, also not easy reading but worth your time.

Suggestion: Go to Capital Expenditures