Cash Flow and Liquidity Analysis
Core concepts
Cash flow analysis focuses on the statement of cash flows, split into operating, investing, and financing activities. Candidates should understand the indirect method (starting from net income, adjusting for non-cash items and working capital changes) and the direct method. Key concepts include free cash flow (operating cash flow minus capital expenditures), cash conversion, and the quality of earnings-whether reported profit is backed by cash.
Traps to watch
- Working capital direction: An increase in receivables or inventory consumes cash; an increase in payables provides cash. Reversing these signs is a classic error.
- Non-cash add-backs: Depreciation and amortization are added back but are not cash inflows in themselves.
- Investing vs. operating: Gains on asset sales are removed from operating and appear in investing.
- Free cash flow definitions: Some definitions deduct dividends; know which convention a question uses.
Rule of thumb
Compute free cash flow as operating cash flow minus capital expenditures, then compare it to net income over several periods. Persistent free cash flow below net income suggests accrual-heavy or low-quality earnings. Worked example: operating cash flow $180,000, capital expenditures $120,000, net income $150,000. Free cash flow = $60,000, well below net income-a signal to investigate working capital buildup or aggressive revenue recognition.