When analyzing a company’s financial health, many investors focus on net income, earnings per share, or revenue growth. However, seasoned investors like Warren Buffett know that the cash flow statement is the real “truth-teller” of a business. While profits on paper can be manipulated with accounting tricks, a company’s cash flow tells you whether it is actually generating real money.
The cash flow statement is one of the three core financial statements, alongside the income statement and balance sheet. It tracks how cash moves in and out of a business, divided into three sections: operating cash flow, investing cash flow, and financing cash flow. Unlike net income, which can be affected by non-cash expenses like depreciation or stock-based compensation, cash flow shows the actual liquidity available to run and grow a business.
For long-term investors, understanding cash flow is essential. A company can report strong earnings but still face financial trouble if it isn’t generating enough cash to sustain operations. On the other hand, businesses with steady and growing free cash flow (FCF) are often the best investments over time. In this article, we’ll break down why the cash flow statement matters, how to read it, and what investors should look for when analyzing a company’s financials.
What Is a Cash Flow Statement?
The cash flow statement (CFS) is a financial report that details how much cash a company generates, spends, and retains over a given period. It consists of three main sections:
- Operating Cash Flow (OCF): Measures cash generated from a company’s core business operations.
- Investing Cash Flow (ICF): Tracks cash spent or received from buying/selling assets like property, equipment, or investments.
- Financing Cash Flow (FCF): Shows cash movements related to debt, dividends, and stock issuance or buybacks.
Unlike the income statement, which includes non-cash expenses (e.g., depreciation, stock-based compensation), the cash flow statement strictly tracks actual cash movements. This makes it a more reliable indicator of financial health.
Why Cash Flow Matters More Than Net Income
1. Profits Can Be Manipulated, Cash Flow Cannot
Companies use various accounting methods to influence reported earnings. They might:
- Accelerate or delay revenue recognition.
- Adjust depreciation schedules.
- Use aggressive accounting assumptions.
For example, WeWork once reported strong revenue growth but struggled with negative cash flow, leading to financial instability. Meanwhile, companies like Apple (AAPL) and Microsoft (MSFT) consistently generate positive free cash flow, making them financially resilient.
2. A Business Can Be Profitable but Still Fail
A company might show positive net income but still run out of cash if:
- Customers delay payments (increasing accounts receivable).
- It has large debt payments due.
- It spends too much on expansion.
Retailers like Bed Bath & Beyond and Toys “R” Us collapsed not because they lacked sales, but because they couldn’t generate enough cash to sustain operations.
3. Free Cash Flow (FCF) Drives Long-Term Value
Free cash flow (FCF) = Operating Cash Flow – Capital Expenditures
- High FCF: Indicates a company can reinvest in growth, buy back shares, or pay dividends.
- Negative FCF: Could signal high reinvestment or financial distress.
Warren Buffett looks for companies with strong and consistent FCF, as it provides flexibility and resilience during downturns.
How to Read a Cash Flow Statement (Step-by-Step Guide)
To analyze a cash flow statement, follow these steps:
1. Look at Operating Cash Flow (OCF)
- Is OCF positive? A company should generate more cash than it spends from operations.
- Compare OCF to net income. If net income is rising but OCF is declining, it’s a red flag.
Example: Tesla (TSLA) struggled with negative OCF in its early years but turned cash-flow positive as production scaled.
2. Analyze Investing Cash Flow (ICF)
- Negative ICF? Could be good (investing in growth) or bad (poor investment decisions).
- Positive ICF? Might indicate asset sales, which isn’t always a good sign.
Example: Amazon (AMZN) often has negative ICF due to reinvesting in infrastructure.
3. Examine Financing Cash Flow (FCF)
- Stock Buybacks: A sign of confidence if done sustainably.
- High Debt Issuance: Could indicate financial trouble.
- Dividends Paid: Reliable dividends often mean strong cash flow.
Example: Coca-Cola (KO) has stable financing cash flows with regular dividends.
Common Cash Flow Statement Red Flags
- Negative Operating Cash Flow Over Multiple Quarters
- If OCF is negative consistently, the company may struggle to sustain operations.
- Example: Peloton (PTON) burned through cash despite strong revenue.
- Rising Net Income But Declining Cash Flow
- This could signal earnings manipulation or aggressive accounting.
- Huge Discrepancies Between Earnings and Cash Flow
- Compare OCF vs. Net Income—if profits are rising but cash flow isn’t, investigate further.
- Excessive Stock-Based Compensation
- Many tech companies, like Snapchat (SNAP), report earnings that look better due to high stock-based compensation, which doesn’t affect cash flow immediately but dilutes shareholders.
How to Use Cash Flow in Your Investment Strategy
✅ Look for Companies with Strong Free Cash Flow (FCF)
- Businesses that generate consistent, growing FCF can reinvest, pay dividends, or buy back stock.
- Example: Apple (AAPL) and Microsoft (MSFT) have some of the highest FCF in the world.
✅ Avoid Companies with Constant Negative Cash Flow
- If a company burns cash for years without a clear path to profitability, be cautious.
- Example: Uber (UBER) had negative cash flow for years but improved as it cut costs.
✅ Compare Cash Flow to Net Income
- If cash flow is consistently lower than net income, dig deeper into accounting choices.
✅ Check the Cash Flow Statement in 10-K Reports
- Where to find it? SEC filings (10-K, 10-Q) under “Financial Statements”.
Final Thoughts: Why the Cash Flow Statement Is the Ultimate Truth-Teller
The cash flow statement is the most reliable indicator of a company’s financial health. While net income can be manipulated, cash flow reveals the true picture. By focusing on operating cash flow, investing cash flow, and financing cash flow, investors can spot strong businesses and avoid financial pitfalls.
Warren Buffett and other successful investors prioritize free cash flow (FCF) because it shows how much cash a company can actually use. Whether you’re a beginner or an experienced investor, understanding cash flow will help you make smarter investment decisions.
Happy Investing!