Profit is an opinion; cash is a fact. That line is a little unfair to accountants, but it captures something real: the income statement depends on estimates and timing choices, while the cash flow statement records money that actually moved.
The cash flow statement reconciles net income with the change in cash. It has three parts: operating activities (the business itself), investing activities (capital spending, acquisitions) and financing activities (debt, buybacks, dividends, share issues).
What to look at
- Operating cash flow (OCF) is cash generated by the business before investment.
- Capital expenditure (capex) is spending on equipment, buildings and capitalized software.
- Free cash flow (FCF) = OCF − Capex. It is the cash available to repay debt, buy back stock or pay dividends.
- Compare FCF with net income over several years. Consistently lower FCF can signal aggressive accounting or heavy reinvestment.
- Stock-based compensation is added back to OCF as a non-cash cost, but it dilutes shareholders. Treat it as a real expense.
The shape of it
Free cash flow = Operating cash flow − Capital expenditure
An example
A retailer reports $500m of net income but only $150m of operating cash flow, because inventory rose by $400m. Either it is preparing for strong demand, or it has stock it cannot sell. The next two quarters will tell you which.
Where people go wrong
A company can report growing profits for years while burning cash. If free cash flow never shows up, ask where the earnings are going.
When the income statement and the cash flow statement disagree, the cash flow statement is usually closer to the truth. Make it the second thing you look at, right after revenue.