Reading: The Cash Flow Statement

The second step of the investigation looks at the firm's investment activities. The purchase of property, plant, and equipment entails (often significant) cash outflows, which we have not considered so far. Similarly, firms that liquidate long-term assets (for example with a divestiture) generate cash inflows with their investment policy.

How much does firm X invest in Year 1? 

To find an answer, we have to combine the information from the balance sheet and the income statement. Here are the relevant steps: 

• We know from before that the firm incurs Depreciation and amortization charges of 3'000 and that such charges reduce the book value of the firm's long-term assets. 
• However, when we look at the long-term assets in the balance sheet, we see that their book value does not decrease by 3'000.  Instead, we see that it  increases by 500 from 15'500 to 16'000.  
• Increases in the value of long-term assets are the result of new investments. To compensate for the depreciation charges of 3'000 and to generate an increase in the book value of long-term assets of 500, the firm's net investments during 2013 must be 3'500:

This is the cash flow from investment activities. To secure the assets that are necessary for the firm's operating activities, the firm invests a total of 3'500 in Year 1.

We can combine the operating cash flow with the investment cash flow to derive the so-called Free cash flow:

The Free cash flow is the most important cash flow figure in firm valuation. It tells us how much money is left over from the operating activities after the firm has made the necessary investments to maintain or expand its assets in place. Because this money is not tied up in the operating or investment activities, it can, in principle, be distributed to the providers of capital (debt and equity).