Cash flow definition
/What is Cash Flow?
Cash flow is the net amount of cash that an entity receives and disburses during a period of time. A positive level of cash flow must be maintained for an entity to remain in business, while positive cash flows are also needed to generate value for investors. In particular, investors want to see positive cash flows even after payments have been made for capital expenditures (which is known as free cash flow). The time period over which cash flow is tracked is usually a standard reporting period, such as a month, quarter, or year.
What Causes Cash Inflows?
Cash inflows come from the sources noted below. An alternative way to calculate the cash flow of an entity is to add back all non-cash expenses (such as depreciation and amortization) to its net after-tax profit, though this approach only approximates actual cash flows.
Cash Flow from Operations
Cash inflows from operations is cash paid by customers for services or goods provided by the entity. It includes the primary revenue-generating activities of an entity, such as cash received from the sale of goods or services, royalties on the use of company-owned intellectual property, commissions for sales on behalf of other entities, and cash paid to suppliers. The bulk of all cash flows will likely be reported within this category. The cash flow from operations needs to be positive over the long term, or else a business will need to resort to alternative forms of financing to ensure that it has enough cash to stay in operation.
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Cash Flow from Financing Activities
Cash inflows from financing activities come from debt incurred by the entity. Items that may be included in financing activities are the sale of stock, issuance of debt, and donor contributions restricted to long-term use. It can be acceptable for a business to take on substantial amounts of new financing, if it is using the funds internally to expand operations or acquire other organizations.
Cash Flow from Investment Activities
Cash inflows from investment activities come from gains on invested funds. Items that may be included in investing activities include the sale of fixed assets, the sale of investment instruments, the collection of loans, and the proceeds from insurance settlements.
What Causes Cash Outflows?
Cash outflows originate with the sources noted below.
Cash Flow from Operations
Cash flow from operations is comprised of expenditures made as part of the ordinary course of operations. Examples of these cash outflows are payroll, the cost of goods sold, rent, and utilities. Cash outflows can vary substantially when business operations are highly seasonal.
Cash Flow from Financing Activities
Cash flow from financing activities are caused by the interest and principal payments made by the entity, or the repurchase of company stock, or the issuance of dividends. Large debt payments or stock repurchases can cause substantial one-time financing cash outflows.
Cash Flow from Investment Activities
Cash flow from investment activities are caused by payments made into investment vehicles, loans made to other entities, or the purchase of fixed assets. Cash outflows related to fixed asset purchases can spike shortly after the start of a new fiscal year, right after the annual capital budget has been approved.
Understanding Cash Flows
Since a business cannot operate without cash, it needs to closely monitor every aspect of cash inflows and outflows. In order to ensure that its cash balance remains sufficient to deal with all expected obligations (plus a buffer for unexpected ones), management should monitor the timing of cash inflows and outflows, as well as any uncertainties associated with those cash flows. A key source of cash flow uncertainty is the timing of cash receipts from accounts receivable. When a business only sells to customers in excellent financial condition, the payments from them are much more likely to arrive on time. Conversely, if a business were to sell to customers in more suspect financial condition, their payments may be substantially delayed or they may not pay at all - which negatively impacts the predictability of cash flows.
When cash flows are stable and increasing in size, it is easier for a business to invest excess cash in longer-term investments that deliver a higher yield. Management can also pour money back into the business, as long as the resulting returns are greater than the firm’s cost of capital. A further advantage of stable cash flows is having the ability to build a cash reserve, which it can draw upon during periods of financial hardship.
When cash flows are not stable, a business is forced to obtain a line of credit, so that it can access debt when the cash balance is expected to go negative. This imposes an interest cost on the business that reduces its overall profit. The interest payments made also reduce its cash reserve, making the organization less financially viable.
The statement of cash flows is used to assess the cash flows of a business. This is one of the three financial statements (the other two are the income statement and balance sheet). Smaller organizations may not release a statement of cash flows on a monthly basis, since some additional effort is required to create it. This can mean that the statement is only available for the full-year, as part of a firm’s audited financial statements. Any ratio or other analysis derived by a lender or creditor concerned an organization’s cash flows is probably derived from the statement of cash flows.
How to Analyze Cash Flows
By taking information from the statement of cash flows and the other financial statements, it is possible to gain insights into issues associated with the cash flows of a business. In the following ratios, we combine information from the income statement and balance sheet to determine the adequacy of cash flows.
Cash Flow Return on Sales
When a business uses the accrual basis of accounting to record its performance, it is entirely possible that various accruals will twist the reported results to such an extent that the net profit ratio (net profit divided by sales) will not accurately reflect the amount of profit from each dollar of sales. If there is a disparity between cash flows and net profit reported, consider using the cash flow return on sales instead. This approach focuses on the amount of cash generated from each dollar of sales, and so provides a more accurate representation of the results of a business.
To calculate the cash flow return on sales, we must first convert the net income figure into an approximation of cash flows by adding back non-cash expenses (though this does not factor in changes in working capital or fixed assets), and divide by net sales for the measurement period. The formula is:
(Net profit + Non-cash expenses) ÷ Total net sales
Cash Flow Return on Assets
In an asset-intensive industry, it makes sense to measure the productivity of the large investment in assets by calculating the amount of cash flow generated by those assets. When linked to a performance measurement system, the likely result is a continual reduction in the amount of fixed assets and inventory in proportion to sales.
To calculate the cash flow return on sales, we must first convert the net income figure into an approximation of cash flows by adding back non-cash expenses (though this does not factor in changes in working capital or fixed assets), and divide by total assets as of the end of the measurement period. The formula is:
Net profit + Non-cash expenses ÷ Total Assets
Cash Flow from Operations Ratio
Ideally, the bulk of the cash flow generated by a business should come from its core operations. The cash flows from ancillary activities should be quite minor. Otherwise, the entity is relying on non-core activities to support its core activities.
The calculation of this ratio first requires the derivation of cash flow from operations, which excluded non-cash revenues and non-cash expenses. An example of non-cash revenue is deferred revenue that is being recognized over time, such as an advance payment on services that will be provided over several months. Once cash flow from operations has been derived, we then divide it by the total net income for the entity. The calculation is:
Cash flow from operations ÷ Net income
Cash Flow vs. Profits
It is easy to confuse the concepts of cash flow and profit. They refer to two different things, so you should understand the differences when making business decisions. In essence, profits represent the excess of revenues over expenses, while cash flows represent the difference between the amount of cash received and cash paid. There can be substantial differences between the cash flows and profits reported by a business, especially when it uses the accrual basis of accounting. Under accrual accounting, revenues may be recognized even when the corresponding cash has not yet been received, while expenses may be recognized even though the corresponding amount of cash has not yet been paid out.
Over the short term, always give preference to cash flow information, since a business with positive cash flows can survive even when it is reporting losses. Over the long term, profit information is more important, since it indicates whether the business model being used can reliably generate profits.
How to Improve Cash Flow
There are multiple ways for a business to improve its cash flow. One option is to adjust prices upward on goods that are in high demand or for which there are no competing products, since this increases the profit and cash flow generated from each sale. Another option is to concentrate purchases with a smaller number of suppliers, if doing so qualifies the company for volume purchase discounts. Also, consider redesigning products to use common parts, so that the company can reduce its investment in different types of inventory. Yet another possibility is to outsource production, so that the company no longer has to invest in raw materials or work-in-process inventory. Further, ask suppliers for longer payment terms. Finally, consider tightening the company’s credit policy, so that customers must pay within a shorter period of time, and the amount of credit granted is restricted for customers in more difficult financial situations. These actions will have a positive effect on the cash flows generated by a business.
Impact of Negative Cash Flows
A persistent, ongoing negative cash flow based on operational cash flows should be a cause of serious concern to the business owner, since it means that the business will require an additional infusion of funds to avoid bankruptcy. The owners will also need to examine whether prices can be increased or costs reduced in order to begin generating a profit. If it is not possible to do so, then the business should be sold off or shut down.
How are Cash Flows Reported?
A summary of the cash flows of an entity is formalized within the statement of cash flows, which is a required part of the financial statements under both the GAAP and IFRS accounting frameworks. It is reported as part of the financial statements, which include the income statement and balance sheet. The statement of cash flow shows the main categories of cash flows, which are defined as cash flows from operations, investing activities, and financing activities.
Problems with Cash Flow Reporting
Investors tend to rely on the statement of cash flows as being the only true measure of the financial stability of a business, since it reveals underlying cash flows. However, the reported cash flows do not take into account future cash outflows related to expenses that have been accrued but not yet paid for. The reported cash flows also do not take into account future cash inflows related to accrued or billed revenues for which payments have not yet been received. Thus, it does not provide a complete picture of the cash flows of a business. The impact of these other items may not be reflected in the statement of cash flows for one or more subsequent reporting periods.
What is Free Cash Flow?
Free cash flow is the net change in cash generated by the operations of a business during a reporting period, minus cash outlays for working capital, capital expenditures, and dividends during the same period. This is a strong indicator of the ability of an entity to remain in business, since these cash flows are needed to support operations and pay for ongoing capital expenditures. There can be a variety of situations in which a company can report positive free cash flow, and which are due to circumstances not necessarily related to a healthy long-term situation. Examples of these situations are the sale of corporate assets, delaying the payment of accounts payable, and reducing marketing expenditures.
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