Cash flow (CF) is the net amount of cash and cash equivalents being transferred into as well as out of a business. The cash received represents inflows, whereas money spent represents outflows. Cash flow only covers cash and cash equivalent aspects of the operation. So, it does not necessarily indicate that a company is profitable or unprofitable.
At a fundamental level, a company’s ability to create value for its shareholders is up to the company’s ability to generate positive cash flows or, more precisely, maximize long-term free cash flow (FCF). It the cash that a company generates from its normal business operations after subtracting any money spent on capital expenditures (CapEx).
A business takes in money from sales as revenues and spends its funds on expenses. Companies may also receive income from interest, investment, royalties, etc. Assessing the amounts, timing, as well as uncertainty of cash flows, is one of the important objectives of financial reporting. It is important for assessing a company’s flexibility, liquidity, and overall financial performance.
Positive cash flow indicates that a company’s liquid assets are increasing, enabling it to pay for various expenses. Interestingly, companies with strong financial flexibility can take advantage of profitable investments. Furthermore, such companies also fare better in downturns, by avoiding the costs of financial distress.
People can analyze cash flows using the cash flow statement. It is a standard financial statement that reports on a company’s sources and usage of cash over a specified time period.
Categories of cash flow
The three categories of cash flows are CFO, CFI, and CFF. CFO, or operating cash flow, describes money flows involved directly with the production as well as the sale of goods from ordinary operations. CFO indicates whether or not a company has enough funds coming in to pay for various expenses. To put it another way, there must be more operating cash inflows than cash outflows for a company to be financially feasible in the long term.
CFO is calculated by taking cash received from sales and subtracting operating expenses that were paid in cash for the period. CFO goes on a company’s cash flow statement, which they then include in reports for both quarterly and annual basis. It indicates whether a company can generate enough cash flow to maintain and expand operations. But it can also indicate when a company needs external financing for capital expansion.
Note that CFO is quite useful in segregating sales from the cash received. If, for instance, a company generated a large sale from a client it would boost revenue as well as earnings. Nonetheless, the additional revenue doesn’t necessarily improve CF if there is difficulty collecting the payment from the customer.
Another category is CFI or cash flows from investing. The CFI reports how much cash has been generated or spent from various investment-related activities in a specific period. Investing activities cover purchases of speculative assets, investments in securities, or the sale of securities or assets.
The third and last category is CFF or cash flows from financing. CFF shows the net flows that fund the company and its capital. Financing activities include transactions involving issuing debt, equity, as well as paying dividends.
Statement of Cashflows
There are three important parts of a company’s financial statements: the balance sheet, the income statement, and the cash flow statement. Let’s start with the balance sheet. It gives a one-time snapshot of a company’s assets and liabilities. The income statement shows the business’s profitability during a certain period.
The CF statement differs from the other financial statements because it acts as a corporate checkbook that reconciles the other two statements. The CF statement records the company’s cash transactions (inflows and outflows) during the given period. The cash flow statement shows whether all of the revenues booked on the income statement have been collected. In the meantime, the CF does not necessarily show all the company’s expenses because not all expenses the company accrues are paid right away.
The first item to note on the CF statement is the bottom line item. Notably, this is likely to be the “net increase/decrease in cash and cash equivalents (CCE)”. The bottom line reports the overall change in the company’s cash as well as its equivalents over the past period. If you check under current assets on the balance sheet, you will find cash and cash equivalents (CCE).
Cash flows and useful tips
It is possible to use the cash flow statement in conjunction with other financial statements. Even a profitable company can fail if its operating activities don’t generate enough cash to stay liquid. This can happen if profits are tied up in outstanding accounts receivable as well as overstocked inventory. A company spends too much on capital expenditures, it could also encounter problems.
Creditors and investors, therefore, want to know if the company has enough CCE to deal with short-term liabilities. To see if a company can meet its current liabilities with the cash it generates from operations, analysts are looking at the debt service coverage ratio. However, liquidity only tells us so much. Companies might have cash because they are mortgaging their future growth potential by selling off their long-term assets or taking on unsustainable levels of debt.
To understand the true profitability of a business, experts look at free cash flow (FCF). It is a really useful measure of financial performance. A fresh cash flow tells a better story than net income because it shows what money the company has, which it can use to expand the business or return to shareholders, after paying dividends, etc.
For a measure of the gross FCF generated by a company, people should use unlevered free cash flow. This is a company’s CF excluding interest payments. It shows how much cash is available to the company before taking financial obligations into account. The difference between levered as well as unlevered FCF is expenses. The difference shows if the business overextends or if it is operating with a healthy amount of debt.