The cash flow statement tells you whether earnings are real. This lesson takes the reported statement and shows you how to analyze and interpret it, converting it into the ratios analysts actually use, plus the two free cash flow measures every valuation model demands.
Start with the three-section structure: operating (CFO), investing (CFI), financing (CFF). Look first at the relationship between CFO and net income. Persistent CFO above net income suggests conservative accruals. Persistent CFO below net income suggests aggressive revenue recognition or rising working capital.
Next, identify the major sources and uses. A mature firm funds capex and dividends from CFO, with CFF showing debt repayment and buybacks. A growth firm typically shows negative CFI (heavy capex) financed by positive CFF (debt or equity issuance). A distressed firm shows weak CFO, asset sales in CFI, and new borrowing in CFF.
KEY: The pattern of signs across CFO, CFI, and CFF tells a story. Positive CFO, negative CFI, negative CFF is the classic mature profitable firm.
Common mistakes
- Forgetting the (1 − t) on interest in the FCFF add-back. The correct add-back is Int(1 − t), not gross interest. With $20M interest and a 25% rate, you add $15M, not $20M. Adding gross interest double-counts the tax shield and inflates FCFF.
- Subtracting interest twice when computing FCFE from CFO. Under US GAAP, CFO already reflects after-tax interest. Going from CFO to FCFE, the formula is CFO − FCInv + Net Borrowing. Do not subtract interest a second time.
- Using EBIT/Interest as a cash flow interest coverage ratio. The cash version is (CFO + Interest paid + Taxes paid) / Interest paid. EBIT/Interest is the accounting version, not cash-based.
Bottom line
- Common-size CFS: divide every line by revenue (preferred), or express each inflow as a percent of total inflows and each outflow as a percent of total outflows
- FCFF = NI + NCC + Int(1 − t) − FCInv − WCInv, or equivalently CFO + Int(1 − t) − FCInv (US GAAP)
- FCFE = CFO − FCInv + Net Borrowing. FCFE is residual cash to common equity after debt service
- Coverage ratios put CFO in the numerator; cash interest coverage = (CFO + Interest paid + Taxes paid) / Interest paid
Exam shortcut
For FCFF from CFO, remember "add after-tax interest, subtract capex." For FCFE from CFO, remember "subtract capex, add net borrowing." If CFO is significantly below NI for multiple years, the answer to "is earnings quality high or low" is always low. For sign patterns, positive CFO with negative CFI and CFF is the mature firm answer.
The full lesson (about 2,052 words, 14 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- analyzing cash flows II
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