Reading Cash Flow Statements

The lifeblood of any company is its cash so understanding the cash flow statement is critical

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The statement of cash flows (or “cash flow statement”) shows the cash inflows and outflows of a company over a specific period of time. It starts with cash at the beginning of the period, shows the period’s activity, and then the ending cash balance.

Understanding a company’s cash position and how money flows in/out is critical for any business, but software companies have unique considerations. Every operator and investor needs to understand how to read cash flows statements.

Free cash flow (“FCF”) is a key cash metric for software companies as it represents the cash available to fund normal operations. FCF is used in a lot of investor metrics so you need to understand what it actually means. While it is not a GAAP metric, most software companies define it as the following:

In this post I will walk through a cash flow statement and explain each of the components of free cash flow.

The Cash Flow Statement

The cash flow statement shows the activity between a period’s beginning cash balance and ending cash balance.

The difference between a cash flow statement and income statement primarily relates to 1) cash versus accrual accounting and 2) non-cash expenses.

There are two types of accounting methods:

1. Cash Accounting: transactions are recognized only when cash is received or paid

2. Accrual Accounting: recognizes revenue when earned and expenses when incurred

Example: Company ABC holds a marketing event on December 31st that cost $10K, but didn’t pay the $10K until January 15th. 

Cash basis: The expense is reported in January when cash is paid

Accrual basis: The expense is reported in December when expense is incurred

Almost all software companies with any meaningful scale (Series A and beyond) report their financials on an “accrual” basis. This is a major reason why a company’s income statement will not be the same as the cash flow statement.

The cash flow statement is one of three primary financial statements:

• Balance Sheet - How to Read Balance Sheets

• Income Statement - How to Read Income Statements

• Statement of Cash Flow - You are reading my guide!

Think of the cash flow statement as a bridge between the balance sheet and the income statement.

When you build a cash flow statement you start with net income/loss from the income statement, adjust for non-cash and other P&L items, and then use all the changes in the balance sheet accounts to explain the change in cash.

Relationship between the P&L and Balance Sheet

The income statement shows activity over a period of time (2023) versus the balance sheet which is “as of” a certain period of time (as of 12/31/2023). The income statement “closes” into the balance sheet each period (see below). This is how the balance sheet balances.

Once combined, the balance sheet then contains all activity of the business at the end of a period. If you want to understand the change in cash then you can look at the change in all balance sheet accounts except for cash in order to explain the change in cash. This is essentially what the cash flow statement does with certain adjustments from the P&L (like non-cash items).

The Statement of Cash Flows (SoCF)

Below are the sections of the cash flow statement:

1. Operating Cash Flow - cash in/out from the main business activities

2. Investing Cash Flow - cash in/out from investments

3. Financing Cash Flow - cash in/out between owners and creditors

4. Foreign Exchange & Other - cash impact from foreign currency exchange and other required disclosures

What is cash?

Sounds like a stupid question, but it isn’t as clear as many people think. A lot of times we say “cash” to refer to the financial title “cash and cash equivalents”.

1. Cash: money sitting in a company’s bank account that can be used anytime

2. Cash Equivalents: short-term, highly liquid investments that mature in 3 months or less from the time of purchase. Some common examples include:

   1. Treasury bills

   2. Certificates of deposit

   3. Commercial paper

   4. Money market funds

Everything outside of the above is not within the “cash and cash equivalents” line but will be included within another line on the asset section of the balance sheet. The cash flow statement only explains the change of the “cash and cash equivalents”. All investments with maturities greater than 3 months is not included in “cash and cash equivalents”.

Companies frequently will refer to “cash, cash equivalents, and short-term investments” when referring to their liquidity because short-term investments with maturities > 90 days is still basically cash.

Cash Flow from Operating Activities

There are two ways that cash flow from operations can be prepared: 1) direct method or 2) indirect method. But literally everyone (particularly within the software industry) uses the indirect method so that’s what I will cover below.

I will walk through the most typical operating activity items found from the example below of SentinelOne’s 10-K:

Net Income (loss)

The operating activity section shows the cash inflows and outflows from normal business operations and starts with net income/loss (from the income statement). Since the income statement is prepared on an accrual basis net income/loss must be adjusted to reflect the actual cash impact.

Non-cash adjustments

These are adjustments to net income/loss to get to the actual cash activity for the period. These adjustments fall into the following buckets:

1. Never will impact cash

   1. Stock-based compensation (SBC)

      SBC is an expense on the income statement related to providing equity awards to employees/consultants but it does not directly impact cash since they just receive equity. While cash is not impacted, remember that SBC does cause dilution to shareholders. An important metric investors look at is FCF/share because it tells you how dilution impacts your share of FCF.

2. Previous/future impact to cash

   1. Depreciation and amortization

      This results from prior cash outflows from purchases such as property, equipment, intangible assets, etc., but the expense on the income statement is recognized over time as the assets are used.

      Example: If a company buys computer equipment then those assets are paid for in cash when purchased but expensed over 3 years as it is used.

   2. Amortization of deferred contract acquisition costs

      The name is confusing but just think of this as expensing sales commission costs over a longer period of time and not when paid. Software companies are typically required to capitalize (delay expensing on the income statement) a large percentage of sales commissions and then expense those commissions over some period of time (typically 3 - 5 years). Note - this accounting rule can make some SaaS metrics misleading if not properly adjusted.

3. 1. Other Non-Cash Stuff

      There are a bunch of other stuff that might be included in this section, but it follows the same concept as above, cash is paid/received before it is an expense/gain on the income statement so it must be adjusted.

Changes in Operating Assets and Liabilities

The changes in operating assets and liabilities during the period represent the required changes to net income to get to the cash impact. In the below image, you can see how movements in assets and liabilities impact cash. It is somewhat intuitive. For example, if assets increase because you are purchasing assets then cash goes down.

Typical examples of what is included in the operating cash flow section of a software company are seen in the SentinelOne example below.

For a typical growing company you normally expect assets to be increasing (so cash impact is negative) and liabilities to increase (cash impact to be positive).

Cash Flow from Investing Activities

The investing activities section shows how much cash has been generated or spent from various investment-related activities.

Some of the most common examples of items in this section are below from Crowdstrike’s 10-K:

• Purchases of property and equipment:

  • office stuff

  • computer stuff

  • leasehold improvement stuff

• Capitalization of internal-use software

  This is the amount of engineering time spent on developing new software functionality. There are subjective accounting rules that govern how much can be capitalized. For SaaS companies, this is usually only a small fraction of overall engineering time (often somewhere close to ~3-5% of R&D spend). Once capitalized, internal-use software costs are expensed over time (typically over 3-5 years).

• Cash paid for strategic investments and acquisitions

  This is cash paid to make investments in other companies or to acquire entire companies.

• Purchases of intangibles

  • acquired technology

  • trademarks

  • patents

• Purchases, sales and maturities of marketable securities

  This represents the cash movement of investments that are not considered cash as discussed at the beginning of this post.

Cash Flow from Financing Activities

Cash from financing activities includes the sources and payments of cash with investors and creditors.

Some of the most common examples of items in this section are below from SentinelOne’s 10-K:

• Proceeds from preferred stock

  Money from equity financing - VC, PE, public markets (IPO)

• Debt

  Money obtained from debt sources and the repayment of that debt.

• Proceeds from exercise of stock options and warrants

  When stock options are issued to employees or warrant to banks, they typically have an exercise price amount that must be paid to in order for them to own the shares.

4th Section of Cash Flow Statement

The last section of the statement of cash flows shows:

• Any foreign currency exchange impact

• Required supplemental information on interest and income taxes paid

• Non-cash investing and financing activity disclosures

See the SentinelOne example below:

Concluding Thoughts

Ultimately, a company’s goal is to generate consistently positive and growing cash flows for investors. This is often measured on a per share basis (FCF/share) because if the cash generated isn’t growing faster than dilution from issuing more shares than the company isn’t providing a positive return for investors.

Great capital allocation and cash management is often what separates the amazing companies from the failures. Understanding the statement of cash flows is a critical part in doing both of these really well.

Does your team understand cash flow statements? Probably should share this with them :)

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Footnotes:

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