What Is Cash Flow?

Cash flow refers to the movement of money in and out of a business or individual's account over a certain period of time. It represents the inflows and outflows of cash and can have a significant impact on the financial health and stability of a business or individual.

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).

KEY TAKEAWAYS

• Cash flow is the movement of money in and out of a company.

• Cash received signifies inflows, and cash spent signifies outflows.

• The cash flow statement is a financial statement that reports on a company's sources and usage of cash over some time.

• A company's cash flow is typically categorized as cash flows from operations, investing, and financing.

There are several methods used to analyze a company's cash flow, including the debt service coverage ratio, free cash flow, and unlevered 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.

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.

How to Analyze Cash Flows

Analyzing cash flow is important for businesses and individuals to understand their financial health and make informed decisions. To analyze cash flow, it's helpful to create a cash flow statement that lists all of the inflows and outflows of cash over a certain period of time. This can help identify areas where cash flow is positive or negative and can inform decisions about how to improve financial stability.

Using the cash flow statement in conjunction with other financial statements can help analysts and investors arrive at various metrics and ratios used to make informed decisions and recommendations.

Debt Service Coverage Ratio (DSCR)

Even profitable companies can fail if their operating activities do not generate enough cash to stay liquid. This can happen if profits are tied up in outstanding accounts receivable (AR) and overstocked inventory, or if a company spends too much on capital expenditures (CapEx).

Investors and creditors, therefore, want to know if the company has enough CCE to settle short-term liabilities. To see if a company can meet its current liabilities with the cash it generates from operations, analysts look at the debt service coverage ratio (DSCR).

Debt Service Coverage Ratio = Net Operating Income / Short-Term Debt Obligations (or Debt Service)

But liquidity only tells us so much. A company might have lots of cash because it is mortgaging its future growth potential by selling off its long-term assets or taking on unsustainable levels of debt.

Free Cash Flow (FCF)

Analysts look at free cash flow (FCF) to understand the true profitability of a business. FCF is a really useful measure of financial performance and tells a better story than net income because it shows what money the company has left over to expand the business or return to shareholders, after paying dividends, buying back stock, or paying off debt.

Free Cash Flow = Operating Cash Flow - CapitalEx

Unlevered Free Cash Flow (UFCF)

Use unlevered free cash flow (UFCF) for a measure of the gross FCF generated by a firm. This is a company's cash flow excluding interest payments, and it shows how much cash is available to the firm before taking financial obligations into account. The difference between levered and unlevered FCF shows if the business is overextended or operating with a healthy amount of debt.

By understanding what cash flow is, how it works, and how to analyze it, businesses and individuals can make informed decisions about their financial health and stability. Whether it's reducing expenses, increasing income, or managing debt, understanding cash flow is an important step in achieving financial success............