What Is Cash Flow?

The term cash flow refers to the net amount of cash and cash equivalents being transferred in and out of a company. Cash received represents inflows, while money spent represents outflows. A company’s ability to create value for shareholders is fundamentally determined by its ability to generate positive cash flows or, more specifically, to maximize long-term free cash flow (FCF). FCF is the cash generated by a company from its normal business operations after subtracting any money spent on capital expenditures (CapEx).

Understanding Cash Flow

Understanding Cash Flow

Cash flow is the amount of cash that comes in and goes out of a company. Businesses take in money from sales as revenues and spend money on expenses. They may also receive income from interest, investments, royalties, and licensing agreements and sell products on credit, expecting to actually receive the cash owed at a late date.

Assessing the amounts, timing, and uncertainty of cash flows, along with where they originate and where they go, is one of the most important objectives of financial reporting. It is essential for assessing a company’s liquidity, flexibility, and overall financial performance.

Positive cash flow indicates that a company’s liquid assets are increasing, enabling it to cover obligations, reinvest in its business, return money to shareholders, pay expenses, and provide a buffer against future financial challenges. Companies with strong financial flexibility can take advantage of profitable investments. They also fare better in downturns, by avoiding the costs of financial distress.

Cash flows can be analyzed using the cash flow statement, a standard financial statement that reports on a company’s sources and usage of cash over a specified time period. Corporate management, analysts, and investors are able to use it to determine how well a company can earn cash to pay its debts and manage its operating expenses. The cash flow statement is one of the most important financial statements issued by a company, along with the balance sheet and income statement.

Cash flow can be negative when outflows are higher than a company’s inflows.

Special Considerations

As noted above, there are three critical parts of a company’s financial statements:

  • The balance sheet, which gives a one-time snapshot of a company’s assets and liabilities
  • The income statement, which indicates the business’s profitability during a certain period
  • The cash flow statement, which acts as a corporate checkbook that reconciles the other two statements. It records the company’s cash transactions (the inflows and outflows) during the given period. It shows whether all of the revenues booked on the income statement have been collected.

But the cash flow does not necessarily show all the company’s expenses. That’s because not all expenses the company accrues are paid right away. Although the company may incur liabilities, any payments toward these liabilities are not recorded as a cash outflow until the transaction occurs.

The first item to note on the cash flow statement is the bottom line item. This is likely to be recorded as the net increase/decrease in cash and cash equivalents (CCE). The bottom line reports the overall change in the company’s cash and its equivalents (the assets that can be immediately converted into cash) over the last period.

If you check under current assets on the balance sheet, that’s where you’ll find CCE. If you take the difference between the current CCE and that of the previous year or the previous quarter, you should have the same number as the number at the bottom of the statement of cash flows.

Types of Cash Flow

Cash Flows From Operations (CFO)

Cash flow from operations (CFO), or operating cash flow, describes money flows involved directly with the production and sale of goods from ordinary operations. CFO indicates whether or not a company has enough funds coming in to pay its bills or operating expenses. In other words, there must be more operating cash inflows than cash outflows for a company to be financially viable in the long term.

Operating cash flow is calculated by taking cash received from sales and subtracting operating expenses that were paid in cash for the period. Operating cash flow is recorded on a company’s cash flow statement, which is reported both on a quarterly and annual basis. Operating cash flow indicates whether a company can generate enough cash flow to maintain and expand operations, but it can also indicate when a company may need external financing for capital expansion.

Note that CFO is useful in segregating sales from cash received. If, for example, a company generated a large sale from a client, it would boost revenue and earnings. However, the additional revenue doesn’t necessarily improve cash flow if there is difficulty collecting the payment from the customer.

Cash Flows From Investing (CFI)

Cash flow from investing (CFI) or investing cash flow reports how much cash has been generated or spent from various investment-related activities in a specific period. Investing activities include purchases of speculative assets, investments in securities, or the sale of securities or assets.

Negative cash flow from investing activities might be due to significant amounts of cash being invested in the long-term health of the company, such as research and development (R&D), and is not always a warning sign.

Cash Flows From Financing (CFF)

Cash flows from financing (CFF), or financing cash flow, shows the net flows of cash that are used to fund the company and its capital. Financing activities include transactions involving issuing debt, equity, and paying dividends. Cash flow from financing activities provide investors with insight into a company’s financial strength and how well a company’s capital structure is managed.

Cash Flow vs. Profit

Contrary to what you may think, cash flow isn’t the same as profit. It isn’t uncommon to have these two terms confused because they seem very similar. Remember that cash flow is the money that goes in and out of a business.

Profit, on the other hand, is specifically used to measure a company’s financial success or how much money it makes overall. This is the amount of money that is left after a company pays off all its obligations. Profit is whatever is left after subtracting a company’s expenses from its revenues.

Cash Flow

An increase or decease in money over a period of time

What is Cash Flow?

Cash Flow (CF) is the increase or decrease in the amount of money a business, institution, or individual has. In finance, the term is used to describe the amount of cash (currency) that is generated or consumed in a given time period. There are many types of CF, with various important uses for running a business and performing financial analysis. This guide will explore all of them in detail.

 

What is Cash Flow?

 

Types of Cash Flow

There are several types of Cash Flow, so it’s important to have a solid understanding of what each of them is. When someone refers to CF, they could mean any of the types listed below, so be sure to clarify which cash flow term is being used.

Types of cash flow include:

  1. Cash from Operating Activities – Cash that is generated by a company’s core business activities – does not include CF from investing. This is found on the company’s Statement of Cash Flows (the first section).
  2. Free Cash Flow to Equity (FCFE) – FCFE represents the cash that’s available after reinvestment back into the business (capital expenditures). Read more about FCFE.
  3. Free Cash Flow to the Firm (FCFF) – This is a measure that assumes a company has no leverage (debt). It is used in financial modeling and valuation. Read more about FCFF.
  4. Net Change in Cash – The change in the amount of cash flow from one accounting period to the next. This is found at the bottom of the Cash Flow Statement.

 

Uses of Cash Flow

Cash Flow has many uses in both operating a business and in performing financial analysis. In fact, it’s one of the most important metrics in all of finance and accounting.

The most common cash metrics and uses of CF are the following:

  • Net Present Value – calculating the value of a business by building a DCF Model and calculating the net present value (NPV)
  • Internal Rate of Return – determining the IRR an investor achieves for making an investment
  • Liquidity – assessing how well a company can meet its short-term financial obligations
  • Cash Flow Yield – measuring how much cash a business generates per share, relative to its share price, expressed as a percentage
  • Cash Flow Per Share (CFPS) – cash from operating activities divided by the number of shares outstanding
  • P/CF Ratio – the price of a stock divided by the CFPS (see above), sometimes used as an alternative to the Price-Earnings, or P/E, ratio
  • Cash Conversion Ratio – the amount of time between when a business pays for its inventory (cost of goods sold) and receives payment from its customers is the cash conversion ratio
  • Funding Gap – a measure of the shortfall a company has to overcome (how much more cash it needs)
  • Dividend Payments – CF can be used to fund dividend payments to investors
  • Capital Expenditures – CF can also be used to fund reinvestment and growth in the business

 

Cash Flow vs Income

Investors and business operators care deeply about CF because it’s the lifeblood of a company.  You may be wondering, “How is CF different from what’s reported on a company’s income statement?” Income and profit are based on accrual accounting principles, which smooths-out expenditures and matches revenues to the timing of when products/services are delivered. Due to revenue recognition policies and the matching principle, a company’s net income, or net earnings, can actually be materially different from its Cash Flow.

Companies pay close attention to their CF and seek to manage it as carefully as possible. Professionals working in finance, accounting, and financial planning & analysis (FP&A) functions at a company spend significant time evaluating the flow of funds in the business and identifying potential problems.

Learn more from Harvard about the difference between Cash Flow and Net Income here.

 

Cash Flow Generation Strategies

Since CF matters so much, it’s only natural that managers of businesses do everything in their power to increase it. In the section below, let’s explore how operators of businesses can try to increase the flow of cash in a company. Below is an infographic that demonstrates how CF can be increased using different strategies.

 

Cash Flow Strategies

Managers of business can increase CF using any of the levers listed above. The strategies for improving CF fall into one of three categories: revenue growth, operating margins, and capital efficiency.  Each of those can then be broken down into higher volume, higher prices, lower cost of goods sold, lower SG&A, more efficient property plant & equipment (PP&E), and more efficient inventory management.

 

Definition of ‘Cash Flow’

 

Definition: The amount of cash or cash-equivalent which the company receives or gives out by the way of payment(s) to creditors is known as cash flow. Cash flow analysis is often used to analyse the liquidity position of the company. It gives a snapshot of the amount of cash coming into the business, from where, and amount flowing out.

Description: As discussed cash flows can either be positive or negative. It is calculated by subtracting the cash balance at the beginning of a period which is also known as opening balance, form the cash balance at the end of the period (could be a month, quarter or a year) or the closing balance.

If the difference is positive, it means you have more cash at the end of a given period. If the difference is negative it means that you have less amount of cash at the end of a given period when compared with the opening balance at the starting of a period.

To analyse where the cash is coming from and going out, cash flow statements are prepared. It has three main categories – operating cash flow which includes day-to-day transactions, investing cash flow which includes transactions which are done for expansion purpose, and financing cash flow which include transactions relating to the amount of dividend paid out to stockholders.

However, the level of cash flow is not an ideal metric to analyse a company when making an investment decision. A Company’s balance sheet as well as income statements should be studied carefully to come to a conclusion.

Cash level might be increasing for a company because it might have sold some of its assets, but that doesn’t mean the liquidity is improving. If the company has sold off some of its assets to pay off debt then this is a negative sign and should be investigated further for more clarification.

If the company is not reinvesting cash then this is also a negative sign because in that case it is not using the opportunity to diversify or build business for expansion.