Cash flow is the net cash being transferred into and out of your business. Cash received represents incoming money, while money spent is outgoing.
A company's ability to create value for shareholders is determined by its abilities to generate positive cash flows or more specifically by maximizing long-term free cash flow (FCF). FCF is the cash a company generates from its normal business operations after subtracting any money spent on capital expenditures (CapEx).
5 Cash flow pointers
- There are three types of cash flow: Cash flows from operations, investing, and financing.
- Operating cash flow incorporates all cash generated by a company's main business activities.
- Your cash flow includes all purchases and investments in the business.
- Financing cash flow includes all proceeds gained from issuing debt and equity as well as payments made by the company.
- A company's profitability is best assessed by looking at how much cash it has left over after business expenses.
After the brief explanation, we will now get into the specific topics to fine-tune your understanding.
Statement of Cash Flows
There are three major parts of a company's financial statements: the balance sheet, income statement, and cash flow statement. The balance sheet gives a one-time snapshot of what the company is worth, its current assets, and liabilities. The income statement indicates how profitable the business was in total during a certain period of time.
Unlike the other financial statements, the cash flow statement is more like a corporate checkbook that helps reconcile all transactions. Cash flow records the company's cash inflow and cash outflows of cash during a particular period of time.
However, the cash flow does not show all of a company’s expenses. Expenses that have not been paid are accrued but will be recorded as an outflow in subsequent transactions.
The bottom line is the last reported figure from an income report. The net increase/decrease in CCE (cash and cash equivalents) shows the change in cash over a period of time. Since current assets are found on the balance sheet and the statement of cash flows, you can figure out what CCE is. If this amount changes over time, you should find the difference between now and last year or quarter to see if they match.
Positive Cash Flow
Positive cash flow means that a company's assets are increasing, enabling it to cover its obligations and provide funds for reinvestment in the business. Companies with strong liquidity can take advantage of favorable investment opportunities, but they're also better able to weather downturns without encountering costly financial distress.
Each statement shows the cash balance of a business at the start and finish of its period. In simple terms, this may be described as the "amount of cash held in the bank" however a more appropriate interpretation would reflect all near-cash assets including bonds and gold bullion. If a business has had an increase in its cash from these movements then it is most likely that the business has been successful in its profit-making ventures. On the other hand, if a business has experienced a decrease in its cash from these movements then it is most likely that the business has been unsuccessful in some way and may need to approach external investors or file for bankruptcy protection. This is known as negative cash flow.
Why is a positive cash flow important?
A positive cash flow indicates that a company has enough working capital to cover its bills and will not require additional funding over the period that a statement covers. Another inference from having this metric is that the company shares/stocks will rise in value for shareholders; it may not always be true, but statistically speaking, it typically holds true.
Business owners have a right to celebrate with cake and balloons after hitting their targets, but they should think about whether it might be masking a problem. For example, having positive cash flow could just mean that the business has access to loads of loan capital or needs selling off the stocks, instead of indicating that it is profitable.
Improve your analysis of the business by examining its cash position. Start with all three sections in the Cash Flow Statement; they are broken down into Assets/Liabilities on the left side, Income Statement on top, and Capital Expenditures/Debt Repayment at the bottom.
- Operating cash flows (i.e. activities related to an operation's day-to-day business e.g. sale of products or suppliers)
- Investing cash flows (i.e. activities related to investments, such as purchasing machinery)
- Financing cash streams (i.e. activities related to various sources of capital, including loans
Anyone can quickly take a look at the categories to tell if the business has an unexpected and sudden cash flow from its core operating activities or if it uses funds created by borrowing.
Negative Cash Flow
A business with negative cash flow cannot cover its expenses solely from sales. Instead, the company needs money coming in from investments or loans in order to keep operating.
For example, if you had $5,000 in revenue and $10,000 in operating expenses in April, you had negative cash flow
A negative cash flow is common for new businesses, but this bad habit can be disastrous in the long term. If you fail to earn enough profit overtime to cover expenses, your funds will eventually dry up.
Negative Cash Flow example
The cash flow analysis statement below shows the annual expenditure and income of one business.
Cash Flow Statement
Operations
Cash receipts from customers $70,000
Cash paid ($50,000)
Investing
Cash receipts from the sale of vehicle $10,000
Cash paid for equipment ($15,000)
Financing
Cash paid for loan payment ($20,000)
Net Decrease in Cash ($5,000)
Note: Figures in parenthesis are negative.
Operating Cash Flow
Operating cash flow (OCF) is an accounting term that represents the amount of money you generate from day-to-day operations. OCF tells if your company can pay for its operating costs and grow without investing outside money or borrowing externally.
Understanding Operating Cash Flow (OCF)
When net income is reported, it indicates the company’s ability to generate cash. Net Income appears as the first section on a statement of cash flows.