One thing that separates fledgling investors from the pros is reading financial statements. For amateurs, comparing the so-called headline numbers — sales and earnings — to estimates is the full extent of research into a company, whereas in more experienced hands, they are just a starting point. If you want to become a better investor, make like a pro and digest the financials. It's the best way to truly understand a company's performance. In the lead up to the start of earnings season later this month, we've put together a five-part series to help Club members better understand all the tables and charts and how to analyze them. Here's Part 3: Cash flow analysis. Part 3: Cash flow analysis The cash flow statement is the middle child in a financial report — it gets overlooked. And for good reason: It's the least straightforward of the three main parts, which includes the income statement and the balance sheet — covered in Part 1 and Part 2, respectively — and can, therefore, be the most confusing. But cash flow should get more attention, because it's arguably the most important section. It's all about quality control, and explains the real strength (or weakness) of a company's earnings. Profits backed by actual cash are higher quality than those backed by what are essentially IOUs. Another way of looking at the cash flow statement is as a polygraph, or lie detector: it reveals the truth. The cash flow statement is divided into three sections: operating cash flow (represented in red: cash generated in the course of a company's normal operations), investing cash flow (represented in blue: funds used for investments) and financing cash flows (represented in black: money pulled in to run the company). While all three sections are important, the operating section is arguably the most crucial of the three as it demonstrates the company's ability to generate cash internally. Once again, we'll use Apple's recent earnings report as an example. We will be reviewing what is known as the "indirect method," which is what most companies use. It involves backing into free cash flow by starting with net income and making adjustments for income and balance sheet items that did, or did not, require the use of cash. One thing to keep in mind: Companies pay for and sell things via credit or cash but in the end, cash is how all debts must be settled. As a result, generating positive cash flow is of the utmost importance to the long-term sustainability of a business. Final cash flow matters most, everything else is simply part of the equation. As an investor, the more you understand the better, but you don't need to have a forensic accountant level of understanding to make smart decisions. As you review the financials of your holdings, try not to lose yourself in the weeds. Keep an eye on the big picture total cash flows; an emerging company may be forgiven for burning cash to grow, but eventually must generate positive cash flow to survive without constantly taking on more debt or selling equity (and diluting existing investors). The other thing to watch out for is large fluctuations from period to period after accounting for normal seasonality; for example, a large uptick in inventory is normal ahead of the holiday shopping season. Largely consistent numbers are ideal. Operating cash flow This is net income that is adjusted for items on the income and balance sheets that did not involve spending or receiving actual cash. Apple breaks the operating cash flow into two categories, "adjustments to reconcile net income to cash generated by operating activities" (income statement) and "changes in operating assets and liabilities" (balance sheet). Let's start with " adjustments to reconcile net income to cash generated by operating activities ." Depreciation and Amortization : These expenses reduce net income, but they are not expenses that come in the form of a cash outlay. Instead, this represents the gradual decline in an asset's value, similar to how one's car loses value over time. Given that it reduces net income but does not require a cash outlay, we add it back to net income. Why you should care: While the cash may not be laid out every period, depreciated assets must eventually be replaced and that does require cash. These are very real expenses. Additionally, this is a line item that investors should especially pay attention to when companies report metrics not used under the Generally Accepted Accounting Principles (GAAP). Often management teams will attempt to focus on earnings before interest, taxes, depreciation & amortization (EBITDA), rather than operating income (EBIT). And to be clear, we often will focus on EBITDA when companies report because it's the metric the market uses to value companies. For example, the Street often uses enterprise value-to-EBITDA. Share-based compensation expense : This is wages paid in stock rather than actual cash. While this expense would be included in the selling, general and administrative (SG & A) expense line of the income statement, because it is not an actual cash outlay, it is added back to net income. Why you should care: This is certainly one to take note of when companies report "adjusted non-GAAP" earnings because one of those adjustments may very well be to exclude stock-based compensation. Again, while we will focus on those adjusted figures because that is simply what the market has determined acceptable (and, as a result, what the stock tends to trade on), it likely impacts the bottom line. This is not the case with Apple or any other company that only reports and trades on GAAP numbers. Investors may be inclined to accept this as an expense to be adjusted out, but there are two important factors to consider. First, every time payment is made with stock, it dilutes existing shareholders. Second, if a company is conducting buybacks, they won't be as meaningful to reducing the share count if the company is buying back shares from the open market with its left hand and paying employees in stock with its right. Deferred income tax expense/(benefit) : Income taxes that were charged on the income statement but the cash has not yet been laid out. Had this been the use of a tax benefit — a case in which the company was able to reduce taxes in a way that resulted in a net benefit to income — it would be a negative on the cash flow statement because it increases income without any actual cash being received. Other : A catch all that incorporates any miscellaneous items that impacted the bottom line but did not include cash transactions, Next, let's take a look at the effect of " changes in operating assets and liabilities ." For those of you doing the math, you may notice that the numbers here may not add up exactly to the changes seen in the balance sheet. They are close, but not always exact. The reason for this is due to minor fluctuations that impact the individual line items. For example, a quick look at Apple's 10-Q notes that the "accounts receivables" line item in the balance sheet is adjusted to reflect an allowance for credit losses; at the same time, the 10-Q notes that the inventory line of the cash flow statement relates only to those inventories "associated with underlying transactions that are classified as operating activities." Why you should care: Generally, this is not a cause for alarm. But it does make clear the importance of a fully audited annual report. In Apple's case, a quick look at its 2021 10-K (under the section titled "Report of Independent Registered Public Accounting Firm") tells us that the company's independent auditor, Ernst & Young, provided an "unqualified opinion," which said the statements provided are fairly and appropriately reported, without exception, and comply with GAAP. Accounts receivable, net : When sales are made on credit, the company will record the full amount as a sale. But cash has not actually been received and as a result is logged as a receivable on the balance sheet. Because no cash has been received, we would subtract this amount if receivables have increased, and add this amount if receivables have decreased. Because the company is constantly receiving cash from sales made on credit while making new sales on credit, it is the net number that is important. For example, if net receivables increased, it tells us that more new sales were made on credit than total cash collected from prior sales made on credit; put another way, the bottom line saw a greater benefit than cash actually received. The reverse is also true. If more cash from old credit sales was received than new sales were made on credit, then receivables would decrease and we would see this number added back into the equation. More cash was actually pulled in than what the income statement would indicate. Inventories : If cash is used to purchase inventory, then it means cash flowed out and inventory came in. On the balance sheet, that may not indicate any change in the level of assets. For example a $100 decrease in cash and $100 increase in inventory would leave total assets unchanged. However, it does mean that actual cash has flown out from the company and that change is reflected here. Vendor non-trade receivables : As noted in our review of the balance sheet, vendor non-trade receivables represent components that Apple purchases directly from suppliers and then sells to its manufacturing vendors for assembling into the final products. So this line is simply telling us how much of that activity was actually conducted with cash. Other current and non-current assets : A catch-all for any balance sheet asset fluctuations that involved cash that do not fit the definitions of the other line items. Accounts payable : This is almost the exact opposite of the accounts receivable line item noted above. Recall, Apple may purchase inventory on credit. When that happens, the accounts payables line item of the balance sheet (a current liability) would increase because it is a payment Apple must make in the next year. That purchase would read as an expense on the income statement. However, given that the purchase was made with credit, no cash has actually left the company. In this case, we would see payables increase and the cash flow statement add back that increase to net income to represent that no cash was used on that expense. On the other hand, when that payable is ultimately settled, cash has indeed left, and the payables line item decreases to reflect the reduction of that debt. In this scenario, the reduction is subtracted from the cash flow equation to indicate a cash outflow. Deferred revenue : As noted in our study of the balance sheet, deferred revenue represents money that has been collected in advance of a product or service being delivered. While that future sale may not have been recorded on the income statement — which only represents sales actually made and delivered on in the period — it does represent an inflow of cash. That inflow is reflected here. Other current and non-current liabilities : A catch-all for any balance sheet liability fluctuations that involved cash that do not fit the definitions of the other line items. Once we add up all of these figures (after starting with net income), our end result is the net total amount of cash that Apple has either pulled in or paid out in the period. Why you should care: Before moving on to investing and financing cash flows, we want to address a popular non-GAAP metric that investors should be aware of that we do place a high level of importance on: Free cash flow. While there are a few ways to calculate this metric, most companies will simply define it as operating cash flow (the number we just backed into) less capital expenditures — typically expenses for items including property, plant and equipment (PP & E), a line item we will see in our analysis of investing cash flows. Here's why we care about this number: While expenditures on PP & E may not be categorized as an operating expense because they do not relate directly to operations in the period in question, without these investments a company would find itself hard pressed to continue operations going forward. After all, as we alluded to above, once an asset used in day-to-day operations is fully depreciated it must be replaced. Good luck creating future iPhones with outdated plants and equipment. Investing cash flow This is much more straightforward than operating cash flows, where we indirectly backed into the number by starting with net income and adjusting for non-cash expenses or fluctuations in balance sheet assets and liabilities. Here we simply see a recording of cash used in activities that are not part of the company's core operations. As most of these are self-explanatory, we will keep it as brief as possible. In general, given that these items represent investments, the end result is a cash outflow; after all, investing is all about exchanging cash for assets one expects to appreciate over time. Purchases of marketable securities : As noted in our study of the balance sheet, in addition to actual cash, companies will hold extremely liquid non-cash securities that can quickly be converted into cash if needed, such as stocks, bonds, derivatives and other similar investments. When those securities are purchased, cash moves out of the cash line item of the balance sheet and the value of the purchased asset moves into the marketable securities line item. In that instance, while the total asset value may be unchanged, cash has decreased. That outflow is recorded here. Proceeds from maturities of marketable securities : Where as the line item above calls out "purchases," here we see "proceeds," simply indicating the exact opposite activity; cash is coming in. We also see the term "maturities," which indicates that these flows relate to securities that have reached their maturity dates, such as corporate paper, bonds or some form of derivative. When these securities mature, the marketable securities line item of the balance sheet (which includes all marketable securities, stocks included) would decrease while cash increases, in which case we would see an inflow here. Proceeds from sales of marketable securities : This is very similar to the above line item but since these sales are not the result of maturing securities, we can assume that equity holdings sold for cash would be recorded here, as well as any other securities sold prior to maturity. Why you should care: For all three of the above line items, an easy way to picture the dynamic is to think of your own investing account. When you first started, it was funded with cash, you then exchanged your cash for securities (be they stocks, bonds , or some derivative instrument such as options or futures contracts). With every purchase, cash diminished while the value of these "marketable securities" increased. The only way you got your cash back was to sell the securities, or in the case of bonds and derivatives, let them mature (if not sold prior to maturity). The same thing is happening here. Payments for acquisitions of property, plant and equipment : These are the cash outlays made in the period for the purchase of property, plant and equipment. That doesn't necessarily mean the assets were purchased (think expensed) in the period, but represents any cash outlay associated with those purchase during the period. Payments made in connection with business acquisitions, net : Here we see any cash paid out or pulled in as a result of mergers and acquisitions. Other : A catch-all for any investments involving cash that do not fit the definitions of the other line items. Why you should care: Adding all of these line items up provides us with a net total of all cash pulled in or used in investing activity for the period. Financing cash flow Payments for taxes related to net share settlement of equity awards : Essentially cash tax payments related to equity-based compensation. Payments for dividends and dividend equivalents : Cash dividend payments made to shareholders. Repurchases of common stock : Those juicy buybacks we love so much? Here we see the cash outflow related to them. Proceeds from issuance of term debt, net : Cash pulled in due to the selling of debt with a maturity more than a year out. Repayments of term debt : Cash outlays related to the repayment of debt that initially has a maturity of greater than one year, either due to the repurchase of that debt prior to maturity or as a result of that debt maturing. Proceeds from commercial paper, net : Cash pulled in due to the selling of debt with a maturity of less than one year. Other : A catch-all for any financing activity involving cash that does not fit the definitions of the other line items. Why you should care: Adding all of these line items up provides us with a net total of all cash pulled in or used in financing activity for the period. Decrease in cash, cash equivalents and restricted cash : The sum total of operating cash flow, investing cash flow and financing cash flow, which on a net basis will increase or decrease the total cash level of the balance sheet. Bottom line While these statements can be intimidating when viewed as a whole, they're much easier to digest line by line. We encourage all members to keep the big picture in mind and not be overly concerned should a line here or there be particularly confusing. If you have at least a decent understanding of what these statements are saying, you are well on your way to becoming a more knowledgeable investor. We encourage members to keep this series handy and review them every earnings season in conjunction with the quarterly analysis we provide for each of our holdings. While we do our best to highlight the most important dynamics in any given quarter, it is simply not possible to provide members with a line-by-line analysis of all financial statements (nor is it necessary every quarter). However, this guide equips members with a fine-toothed comb to use as they would like. Lastly, as a reminder, if ever you have a question or desire to dig even deeper, a company's annual report (10-K for U.S. companies) is a great place to look. Moreover, in every annual report is a section called "Management's Discussion and Analysis of Financial Condition and Results of Operations" that provides a great context for the data seen in these financial statements. We highly encourage members to take the time to review it alongside their review of these statements. Here's Part 4 in our financial statement series for the Investing Playbook, where we will go over Apple's cash flow statement . (Jim Cramer's Charitable Trust is long AAPL. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.
