The cash flow statement tells you whether earnings are real. You read the reported statement, convert it into the performance and coverage cash flow ratios analysts use, and calculate the two free cash flow measures that valuation models start from.
Start with cash flow from operating activities (CFO), cash flow from investing activities (CFI), and cash flow from financing activities (CFF). Look first at the relationship between CFO and net income (NI). Persistent CFO above net income suggests conservative accruals. Persistent CFO below net income suggests aggressive revenue recognition or rising working capital.
Next, analyze the major sources and uses. A mature firm funds capital expenditure (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
- Adding back gross interest. The correct FCFF add-back is Int(1 − t). With $20M interest and a 25% rate, you add $15M, not $20M. Trap: Beacon's FCFF of $38M instead of $33M.
- Subtracting interest twice for FCFE. Under US GAAP, CFO already reflects interest paid. From CFO, FCFE = CFO − FCInv + Net Borrowing. Trap: $88M − $15M − $70M + $20M = $23M instead of $38M (both before preferred dividends). Only the FCFF route subtracts interest, because FCFF added it back.
- Using EBIT/Interest as cash coverage. You calculate cash coverage as (CFO + Interest paid + Taxes paid) / Interest paid when both payments were deducted in CFO. For Beacon, EBIT/Interest = $100M / $20M = 5.0×, a trap against the correct 6.4×. Dividing CFO alone by interest (4.4×) is the other trap.
Bottom line
- Common-size CFS: divide every line by revenue, 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)
- When interest paid is deducted in CFO, FCFE = CFO − FCInv + Net Borrowing; otherwise subtract the interest payment too. Equivalently, FCFE = FCFF − Int(1 − t) + Net Borrowing.
- Cash interest coverage = cash flow before interest and taxes / Interest paid. Add back only interest and taxes already deducted in CFO
Exam shortcut
For FCFF from CFO, add after-tax interest and subtract FCInv when interest paid is in CFO. If interest is in CFF and its tax saving remains in CFO, subtract that saving and FCInv instead. From NI, add non-cash charges and after-tax interest, then subtract fixed and working capital investment. For FCFE from CFO, subtract FCInv, add net borrowing, then subtract interest paid outside CFO and preferred dividends.
The full lesson (about 3,673 words, 24 min read) adds 4 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- analyzing cash flows II
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