A company’s cash flows can be revealed by the figures that appear on its statement of cash flows, which shows how a company spends its money (cash outflows) and from where a company receives its money (cash inflows).
The cash flow statement includes all cash inflows a company receives from its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given quarter. These include cash flows from operating activities (CFO), but also cash flows from investing (CFI) and financing (CFF) activities.
This article will explain the cash flow statement and how it can help you analyze a company for investing.
- The statement of cash flow depicts where a company receives its money from and how it expends its money.
- The three main components of a cash flow statement are cash flow from operations, cash flow from investing, and cash flow from financing.
- The two different accounting methods, accrual accounting and cash accounting, determine how a cash flow statement is presented.
- A company’s cash flow can be defined as the number that appears in the cash flow statement as net cash provided by operating activities.
- Important indicators in cash flow analysis include the operations/net sales ratio, free cash flow, and comprehensive free cash flow coverage.
Why the Cash Flow Statement Is Important
There are two forms of accounting that determine how cash moves within a company’s financial statements. They are accrual accounting and cash accounting.
Accrual accounting is used by most public companies and is the accounting method where revenue is reported as income when it’s earned rather than when the company receives payment. Expenses are reported when incurred, even though no cash payments have been made.
For example, if a company records a sale, the revenue is recognized on the income statement, but the company may not receive cash until a later date. From an accounting standpoint, the company would be earning a profit on the income statement and be paying income taxes on it. However, no cash would have been exchanged.
Also, the transaction would likely be an outflow of cash initially, since it costs money for the company to buy inventory and manufacture the product to be sold. It’s common for businesses to extend terms of 30, 60, or even 90 days for a customer to pay the invoice. The sale would be an accounts receivable with no impact on cash until collected.
Cash accounting is an accounting method in which payment receipts are recorded during the period they are received, and expenses are recorded in the period in which they are paid. In other words, revenues and expenses are recorded when cash is received and paid, respectively.
Earnings and cash are two completely different terms. Earnings happen in the present when a sale and expense are made, but cash inflows and outflows can occur at a later date. It is important to understand this difference when managing any business payments.
A company’s profit is shown as net income on the income statement. Net income is the bottom line for the company. However, because of accrual accounting, net income doesn’t necessarily mean that all receivables were collected from their customers.
From an accounting standpoint, the company might be profitable, but if the receivables become past due or uncollected, the company could run into financial problems. Even profitable companies can fail to adequately manage their cash flow, which is why a cash flow statement is a critical tool for analysts and investors.
Cash Flow Statement
A cash flow statement has three distinct sections, each of which relates to a particular component—operations, investing, and financing—of a company’s business activities. Below is the typical format of a cash flow statement.
Cash Flow From Operations
This section reports the amount of cash from the income statement that was originally reported on an accrual basis. A few of the items included in this section are accounts receivables, accounts payables, and income taxes payable.
If a client pays a receivable, it would be recorded as cash from operations. Changes in current assets or current liabilities (items due in one year or less) are recorded as cash flow from operations.
Cash Flow From Investing
This section records the cash flow from sales and purchases of long-term investments like fixed assets that include property, plant, and equipment. Items included in this section are purchases of vehicles, furniture, buildings, or land.
Typically, investing transactions generate cash outflows, such as capital expenditures for plant, property, and equipment; business acquisitions; and the purchase of investment securities.
Cash inflows come from the sale of assets, businesses, and securities. Investors typically monitor capital expenditures used for the maintenance of, and additions to, a company’s physical assets to support the company’s operation and competitiveness. In short, investors can see how a company is investing in itself.
Cash Flow From Financing
Debt and equity transactions are reported in this section. Any cash flows that include payment of dividends, the repurchase or sale of stocks, and bonds would be considered cash flow from financing activities. Cash received from taking out a loan or cash used to pay down long-term debt would be recorded in this section.
For investors who prefer dividend-paying companies, this section is important since it shows cash dividends paid since cash, not net income, is used to pay dividends to shareholders.
Cash Flow Analysis
A company’s cash flow can be defined as the number that appears in the cash flow statement as net cash provided by operating activities, or “net operating cash flow.” However, there is no universally accepted definition. For instance, many financial professionals consider a company’s cash flow to be the sum of its net income, depreciation, and amortization (non-cash charges in the income statement).1 While often coming close to net operating cash flow, the shortcut can be inaccurate, and investors should stick with using the net operating cash flow figure.
If your cash flow analysis shows that you are about to be low on cash and not able to make your payments, you can adapt by obtaining financing, cutting costs, or trying to increase income. This is why cash flow analysis is important.
While cash flow analysis can include several ratios, the following indicators provide a starting point for an investor to measure the investment quality of a company’s cash flow.
Operating Cash Flow/Net Sales
This ratio, which is expressed as a percentage of a company’s net operating cash flow to its net sales, or revenue (from the income statement), tells us how many dollars of cash are generated for every dollar of sales.
There is no exact percentage to look for, but the higher the percentage, the better. It should also be noted that industry and company ratios will vary widely. Investors should track this indicator’s performance historically to detect significant variances from the company’s average cash flow/sales relationship along with how the company’s ratio compares to its peers. It is also essential to monitor how cash flow increases as sales increase since it’s important that they move at a similar rate over time.2
Free Cash Flow
Free cash flow (FCF) is often defined as the net operating cash flow minus capital expenditures. Free cash flow is an important measurement since it shows how efficient a company is at generating cash. Investors use free cash flow to measure whether a company might have enough cash, after funding operations and capital expenditures, to pay investors through dividends and share buybacks.
To calculate FCF from the cash flow statement, find the item cash flow from operations—also referred to as “operating cash” or “net cash from operating activities”—and subtract capital expenditures required for current operations from it.
You can go one step further by expanding what’s included in the free cash flow number. For example, in addition to capital expenditures, you could also include dividends for the amount to be subtracted from net operating cash flow to arrive at a more comprehensive free cash flow figure. This figure could then be compared to sales, as shown earlier.
As a practical matter, if a company has a history of dividend payments, it cannot easily suspend or eliminate them without causing shareholders some real pain. Even dividend payout reductions, while less injurious, are problematic for many shareholders.3 For some industries, investors consider dividend payments to be necessary cash outlays similar to capital expenditures.
It’s important to monitor free cash flow over multiple periods and compare the figures to companies within the same industry. If free cash flow is positive, it should indicate the company can meet its obligations, including funding its operating activities and paying dividends.
Comprehensive Free Cash Flow Coverage
You can calculate a comprehensive free cash flow ratio by dividing the free cash flow by net operating cash flow to get a percentage ratio. Again, the higher the percentage, the better.
Do you have enough money to pay your bills next month or next quarter? Not sure? Then it’s time to add cash flow forecasting to your planning mix.
If you can’t pay your bills, then you need to know ahead of time. Even if your business is profitable, if you run out of liquid cash, simply because the flow of cash into your business isn’t balanced by the flow of cash out of your business, you can quickly run out of cash.
For this, you need a cash flow forecast (aka a cash flow projection or cash budget).
Cash flow projection gives you a clear look at when money comes in, when it goes out and what money you are left with at the end of each month after you have paid your expenses and recorded your income.
Here are some tips for building a basic cash flow model and how some basic analysis can put those numbers to good use:
Start with Incoming Cash
Cash flow forecasting starts with input from your sales forecast (including cost of goods sold). Of course, no projection is entirely accurate, these are just estimates. Who knows if a client will pay on-time one month and late another? What if a new client in your pipeline negotiates net 60 days or extended credit? All you can make are assumptions at this point, although taking a look at trends from the past 12 months can help predict patterns.
Tackle Your Outgoings
From payroll to office supplies, utilities bills to marketing. Take some time to determine what your expenses are each month. Some may be quarterly, of course, like taxes. You’ll also have occasional expenses like new software, office furniture, vehicle maintenance, etc.
Don’t Forget Inventory
You’ll also need to review your inventory assets against your sales forecast. Ideally inventory purchases are made when the sales pipeline calls for it (and with your cash flow situation in mind).
Use Accounting Software or Pre-Baked Templates
Plug your number into a blank worksheet (SCORE offers a free 13-month cash flow projection template), alternatively you can use your accounting software to create a forecast based on data from the past 12 months and run analytical reports against it.
You’ll need to decide what your ideal ending balance needs to be each month (cash in hand) and aim to keep that number constant month-to-month.
Analyze Your Findings
Of course, you want the monthly flow of cash into your business to be greater than your out-flow. If your assumptions are right and your cash flow looks like it might be negative down the road, you’ll need to come up with a plan. This might include setting up a line of credit with your bank ahead of time or borrowing money from friends or family. Just be sure to look ahead and gauge when you’ll be cash flow positive so that you can reassure lenders that you’ll be able to repay the loan.
Your forecast can also help you plan purchases, such as the right time to make large buying decisions or whether to cut an expense.