Forecasting the cash flow statement is the final stage in developing a 3-statement financial model in what was a linked and iterative process. The figures on the cash flow statement will in large part be driven by the changes in amounts on the balance sheet as well as certain non-cash income statement items. As we talk about cash movements in and out of a business, the general rules investors should keep in mind are laid out below.

General Rules for Cash Flow Movements

• Growth in assets year-over-year on the balance sheet will be associated with a cash outflow as money is spent to acquire that assets. A basic example of this will be the cash outflow associated with purchasing new fixed assets or inventory.

• Growth in liabilities and equity year-over-year on the balance sheet will be associated with a cash inflow, as cash is received or saved in return for the liability or equity in the business. A basic example of this would be the cash inflow from issuing debt or the cash saved from not paying suppliers of inventory immediately.

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CASH FLOWS FROM OPERATIONS

Cash flows from operations begins with net income, which is directly linked from the income statement already forecasted, and then adjusts for non-cash items. Let’s get into some of the most common items seen in cash flow from operations.

Changes in Working Capital – The cash flow impact associated with changes in working capital will be driven by changes on the balance sheet in accounts receivable, accounts payable, and inventory. These balance sheet items are all part of working capital and are commonly shown as one line item on the cash flow statement. The cash flow impact associated with working capital items can be calculated as seen below.

Cash Outflow (Inflow) = Ending Working Capital – Beginning Working Capital

where, Working Capital = Accounts Receivable + Inventory – Accounts Payable

Depreciation & Amortization – Both depreciation and amortization are non-cash expenses that need to be added back on the cash flow statement. The amount of depreciation and amortization will come from the fixed asset schedule that was built to determine how to much assets are needed to support the sales of the company. This fixed assets schedule was discussed in more detail in the article on balance sheet forecasting but the underlying equation for that schedule is shown below.  

Ending Fixed Assets = Beginning Fixed Assets + Capital Expenditures – Depreciation

Stock-based Compensation –  Stock based compensation is a common item to see on cash flow statements but will be extra meaningful for younger companies which tend to issue more capital to employees in order to save cash. In terms of the general cash flow rules discussed at the beginning of this article, stock-based compensation increases equity on the balance sheet and saves the company cash as employees are being given equity, instead of cash, in return for their services. Stock based compensation can be forecasted based on historical averages as seen below.

Stock Based Compensation = Selling, General, and Administrative Expenses x Historical Average (%)

where, Historical Average (%) = Prior Year’s Stock-based Compensation / Prior Year’s Selling, General & Administrative Expenses

CASH FLOWS FROM INVESTING ACTIVITIES

It is completely normal for a company to have negative cash flows from investing activities as companies are always making capital investments in new assets in order to maintain and grow operations.

Investments in Property, Plant, and Equipment – The net amount of cash spent on purchasing new property, plant, and equipment (PP&E), less any reduction of PP&E through sales, will be a cash outflow as under the general rules discussed earlier, assets on the balance are being increased. This amount will once again come from the fixed asset schedule discussed in more detail in the article on balance sheet forecasting but the underlying equation for that schedule is shown below. 

Ending Fixed Assets = Beginning Fixed Assets + Capital Expenditures – Depreciation

Acquisitions – Most of the time acquisitions are one-off items that do not need to be included in forecasts. That being said, some companies make acquisitions a regular part of their business strategy where they constantly buy small competitors in order to maintain their economic moat. In such a case, acquisitions should be part of the fixed asset schedule alongside investments in PP&E.

Ending Fixed Assets = Beginning Fixed Assets + Capital Expenditures  +  Acquisitions – Depreciation

CASH FLOW FROM FINANCING ACTIVITES

The financing section of the cash flow statement includes capital items such as the net issuances (reductions) of debt and equity capital as well as the payment of cash dividends to shareholders.

Debt Issuance (Repayment) – Growth in debt capital on the balance sheet year-over-year will be associated with a cash inflow from financing activities. The level of debt and new borrowings can be linked to ratios (such as debt-to-assets ratio) and is calculated in a separate debt schedule as discussed in more detail in the article on balance sheet forecasting.

Equity Issuance (Repurchased) – Growth in equity capital on the balance sheet year-over-year from issuing new shares will be associated with a cash inflow from financing activities. Equity issuances will be important when the company is growing quickly and needs to issue both debt and equity capital. Repurchases will be important if the company practices share buybacks as a way to return cash to shareholders.

Side Note: The amount of share capital being issued is not to be confused with retained earnings which is built up from the amount of net income not paid out as dividends. The amount of equity outstanding in a business can quickly get confusing and deserves it’s own supporting equity schedule. In fact, while analysts generally talk about a 3-statement financial model, in real life, financial statement contain 4 parts with the Statement of Changes to Shareholders’ Equity getting neglected when it comes to financial modeling.

Dividend Payments – Cash dividends paid out of retained earnings will show up as financing activities on the statement of cash flows. Dividends can be forecasted as a total dollar figure, but it is best practice to calculate dividend growth on a per share basis and then multiply by the number of shares outstanding to find the total dividend amount paid. This is especially important when share buybacks are part of the company’s strategy to return cash to shareholders. These amounts can come from the supporting equity schedule discussed earlier.

Dividends = Prior Year Dividends per Share x (1+ Growth %) x # of Share Outstanding

Now that the cash flow statement is complete, investors can use their robust and integrated 3-statement financial model to conduct discounted cash flows to calculate a company’s intrinsic value!