Cash flow is a metric for the amount of cash currency that a business can generate during an accounting period. It does not represent profit or loss, the business’s net worth, or its value.
Cash flow is a “net quantity.” It puts a value on cash coming into the business and accounts for money going out.
In other words, the final measure of cash flow represents money coming in after money going out has been subtracted.
In this way, cash flow can be positive or negative depending on which side of the equation is greater. For example, if a business has more money coming in than out, it will have a positive cash flow. If more money is going out than coming in, the business will have a negative cash flow.
Cash flow is an indicator of a business’s liquid assets or liquidity. Liquidity refers to the amount of actual cash a business can generate. Many businesses own things that have monetary value, such as real property, buildings, trademarks, machinery, or equipment.
These are long-term, or non-liquid, assets because they cannot be easily converted to cash in less than a year.
All businesses need cash to operate. Cash allows the business to fulfill its payroll obligations, purchase goods and supplies, and pay its bills and taxes.
Therefore, cash flow is an important measure of a business’s ability to meet its day-to-day obligations.
Cash flow is more just the amount of actual dollars and cents that come into a cash register in the course of the day. In the modern business world, there are many variables that help calculate a business’s cash flow.
Cash flow will be reported on the business’s cash flow statement. The statement focuses on the exchange of money between the business, its customers, and its vendors. It does not look at assets and liabilities or profit and loss. It only examines the ability of the business to generate cash.
Cash flow statements will list all manner of financial activities that impact cash, such as accounts receivable (money owed to the business by its customers), accounts payable (money the business is obligated to pay out to vendors and other businesses), inventory, unearned revenue, and net income. The information in a cash flow statement is typically arranged in three sections:
Operating cash flow details all of the business’s principal revenue producing activities including sales to customers, minus expenses for things like taxes, salaries, utilities, and vendor invoices.
Investing cash flow refers to financial transactions involving the selling of assets, such as property, plant, and equipment, otherwise known as PP&E. These are also referred to as “capital expenditures.” Investing cash flow also details transactions pertaining to other non-current assets, such as lending money or selling investments in a stock portfolio.
Financing activities include all transactions related to the financing of the business, such as receiving or paying off bank loans, issuing stocks or bonds, and paying dividends.
Cash flow is an important indicator of a business’s ability to meet its daily obligations. A business with a healthy, positive cash flow will be able to function, reinvest in itself, and grow.
A business with a minimal or negative cash flow will not be able to meet these obligations.
Therefore, cash flow is an important indicator of the business’s performance and viability, and one that potential investors will examine. Even if a business owns many long-term assets, if it does not have a healthy cash flow, it may be underperforming and may not be considered viable.
There are many different types of cash flow, as reflected in the different sections of the cash flow statement. Each type represents a different aspect of the business’s cash generating activities, which contribute to its overall cash flow.
These cash flow figures help analyze different aspects of the business:
Cash from Operating Activities represents cash that is generated by a company’s core business activities, including sales, purchases, and other expenses. It does not include cash flow from investing, such as the sales of, or dividends from, stock investments.
Free Cash Flow to Equity (FCFE) represents the cash that’s available for potential distribution to shareholders. It is calculated by subtracting capital expenditures (money reinvested back into the business) from operating cash flow and adding net debt issued (cash from debt after obligations have been paid). It is represented by the equation: FCFE = Cash From Operations - Capital Expenditures + Net Debt Issued.
Free Cash Flow to the Firm (FCFF) represents the amount of cash that is available to the business (as opposed to shareholders). It is calculated by subtracting a number of expenses from operating cash flow. These expenses include depreciation expenses, taxes, working capital (the difference between current assets and liabilities), and investments.
Net Change in Cash is an important accounting metric that measures the change in the amount of cash flow from one accounting period to the next. Whether cash flow is increasing or decreasing from one month to the next can be an important indicator of long-term trends in the business.
There are two methods for calculating cash flow:
The direct cash flowmethod, or income statement method, tracks the flow of cash that comes in and goes out of a company in a specific period, typically on a monthly accounting basis. It is typically used by smaller businesses.
The more common way, the indirect cash flowmethod, is calculated by adjusting net income by adding or subtracting differences resulting from non-cash transactions, including the sale of land, increases in accounts payable and accounts receivable, depreciation, stock transactions, financing, and other non-cash financial activity.