What is cash flow and why is it important?

What is cash flow?

Cash flow refers to the net cash and cash equivalents moving in and out of a business, generated from a company's core business activities, taking into account money spent on expenses related to producing the business goods and services.

Cash flow, measured over a specific time period, can be positive or negative. 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 needs. Negative cash flow, on the other hand, means that a company's cash position is deteriorating, which can lead to financial difficulties if not addressed.

Importance of cash flow for a business

Cash flow is the lifeblood of a business and helps keep business operations running smoothly. It measures the cash coming in and money paid out, assessed over a specified period, lasting from a day to a fiscal year or any time within. Cash flow measures the cash available to meet obligations, invest in growth, and sustain operations; hence, it is a more important gauge of a business's health than profit.

After covering all operating expenses and capital investments, the remaining cash available for distribution to shareholders or reinvestment in the business is referred to as free cash flow. Free cash flow is a subset of cash flow that represents the cash a company generates after accounting for its Capital Expenditures (CapEx).

Cash flow is a critical indicator of a company's financial health, revealing its liquidity position, financial flexibility, and overall operating efficiency. A solid financial health (i.e., a consistent and stable flow of cash in and out) equips businesses with resilience to withstand economic downturns.

A cash flow statement is a financial roadmap that charts this cash movement. It clearly shows where a company's cash comes from (inflows) and where it goes (outflows). The cash flow statement offers invaluable insights into a company's financial health by meticulously tracking these transactions, providing a blueprint for fiscal year-end income tax preparation.

Cash flow statement

A cash flow statement (C/F statement) is an accounting reconciliation of the company's income and balance sheets, quantitatively analyzing cash inflows and outflows. It provides a comprehensive overview of a company's liquidity and solvency by classifying cash flows into operating, investing, and financing activities.

Types of cash flow statements

1. Direct method: This method directly reports cash inflows from operating activities, such as cash received from customers and cash outflows of payments made to suppliers and employees. 2. Indirect method: This method adjusts net income for non-cash items (such as depreciation, amortization, and gains/losses on asset disposal) and changes in working capital accounts to determine net cash provided by operating activities.

Note: While both methods yield the same net cash flow from operating activities, the direct method provides more granular detail about cash inflows and outflows.

Cash Flow statements categorize a company's cash inflows and outflows into the following three primary activities:

1. Operating activities

These activities reflect the cash generated or used in a company's core business operations. This includes cash received from customers for goods or services, cash paid to suppliers and employees, operating expenses, and income tax payments.

Operating cash flow can be calculated by adjusting the net income for non-cash items and changes in working capital. Operating cash flow is a critical metric for assessing a company's liquidity, solvency, and ability to sustain operations and fund growth initiatives without external financing.

2. Investing activities

This section of a cash flow statement outlines cash flows related to acquiring or disposing of long-term assets and investments. It includes cash spent on property, machinery, and equipment, investments in other companies, and proceeds from asset sales.

Investments related to cash flow provide insights into a company's capital allocation decisions. Positive cash flow from investing activities often indicates effective management of assets, while negative cash flow might signal significant investments in growth opportunities or asset impairments.

When it comes to investing, there is something called discounted cash flow (DCF), a valuation method used to estimate the attractiveness of an investment opportunity. DCF is commonly used to value companies, projects, or assets and is based on the assumption that an investment's value is determined by its ability to generate cash flows in the future. The discount rate used in DCF analysis reflects the time value of money and the risk associated with the investment.

3. Financing activities

Financing activities involve cash flows related to a company's capital structure. This encompasses cash inflows from issuing stocks or bonds, cash outflows for debt repayments, dividend payments, and repurchasing shares.

By analyzing these three components, the cash flow statement provides a comprehensive picture of a company's cash generation and utilization, aiding in assessing its liquidity, solvency, and overall financial health.

Essentially, the cash flow statement bridges the gap between the Profit and Loss (P&L) account (from the Income Statement) and the Balance Sheet by providing a clear picture of how cash is generated and used within a specific period, usually the company's financial year.

Cash flow as an indicator of business health

Cash flow assessment is crucial for several reasons:

1. A positive cash flow ensures a company has enough cash to meet its short-term obligations, such as paying bills and salaries.

2. A strong cash flow provides a buffer against unexpected expenses or economic downturns, allowing companies to adapt and take advantage of opportunities.

3. A positive cash flow enables companies to invest in growth initiatives, such as expanding operations, developing new products, or acquiring other businesses.

4. Monitoring cash flow helps businesses identify spending patterns and areas for cost reduction. For instance, a service-based company might analyze its cash flow to pinpoint unnecessary expenses, such as excessive subscriptions or underutilized resources, allowing it to streamline operations and improve profitability.

5. Lenders and investors often use cash flow as a key metric when evaluating a company's creditworthiness and financial health. A company demonstrating strong cash flow is more likely to attract investment or secure loans.

How to calculate the cash flow

To calculate the cash flow of your business, you can use the formula:

CF = CIF - COF

CF = Cash flow

CIF = Cash inflow

COF = Cash outflow

Example of cash flow:

Month	Savings
January	$250
February	$80
March	$420

Date	January	February	March
Starting Cash Balance	$20,000,000	$43,150,000	$60,500,000
Cash Recieved
Cash From Operations	$15,000,000	$16,000,000	$20,500,000
Cash From Sales	$40,000,000	$33,000,000	$41,000,000
Subtotal Cash From Operations	$55,000,000	$49,000,000	$61,500,000
Additional Cash Recieved
New Long-Term Liabilities
Sales of Current Assets	-	$9,000,000	$650,000
New Investments Recieved	$3,500,000	-	-
Subtotal Cash Recieved	$3,500,000	-	-
Total Cash Recieved	$58,500,000	$58,000,000	$62,150,500
Expenditures
Expenditures from Operations	($21,000,000)	($5,000)	($22,000,000)
Bill Payments	($2,500,000)	($2,000,000)	($1,200,000)
Additional Cash Spent
Repayment of current borrowing	($1,000,000)	($1,000,000)	($1,000,000)
Purchase of Current Assets	-	($15,000,000)	($6,000,000)
Purchase of Long-Term Assets	-	-	($1,500,000)
Subtotal of Cash Spent	($1,000,000)	($16,000,000)	($8,500,000)
Total Cash Spent	($5,600,000)	($18,500,000)	($31,700,000)
Net Cash Flow	$52,900,000	$39,500,000	$30,450,500
Ending Cash Balance	$72,900,000	$82,650,000	$90,950,500

The image shows the cash flow statement of a company that is doing well financially. It started with a cash balance before proceeding with the cash received from sales and other activities; within the specific period, other expenses were made, and it was all added to the cash flow statement to understand the relative financial stability of the company.

Bottom line

Cash flow is a critical business metric, measuring the actual cash generated from operations, investing, and financing activities. A positive cash flow ensures liquidity, financial flexibility, and growth opportunities, while a negative cash flow can lead to financial difficulties. Understanding cash flow and its components is essential for making informed financial decisions and maximizing shareholder value.