Cash flow is the movement of cash into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used
- to determine a project's rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such as internal rate of return, and net present value.
- to determine problems with a business's liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable.
- as an alternate measure of a business's profits when it is believed that accrual accounting concepts do not represent economic realities. For example, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a case, the company may be deriving additional operating cash by issuing shares, or raising additional debt finance.
- cash flow can be used to evaluate the 'quality' of Income generated by accrual accounting. When Net Income is composed of large non-cash items it is considered low quality.
- to evaluate the risks within a financial product. E.g. matching cash requirements, evaluating default risk, re-investment requirements, etc.
Cash flow is a generic term used differently depending on the context. It may be defined by users for their own purposes. It can refer to actual past flows, or to projected future flows. It can refer to the total of all the flows involved or to only a subset of those flows. Subset terms include 'net cash flow', operating cash flow and free cash flow.
Statement of cash flow in a business's financials
The (total) net cash flow of a company over a period (typically a quarter or a full year) is equal to the change in cash balance over this period: positive if the cash balance increases (more cash becomes available), negative if the cash balance decreases. The total net cash flow is the sum of cash flows that are classified in three areas:
- Operational cash flows: Cash received or expended as a result of the company's internal business activities. It includes cash earnings plus changes to working capital. Over the medium term this must be net positive if the company is to remain solvent.
- Investment cash flows: Cash received from the sale of long-life assets, or spent on capital expenditure (investments, acquisitions and long-life assets).
- Financing cash flows: Cash received from the issue of debt and equity, or paid out as dividends, share repurchases or debt repayments.
Ways Companies Can Augment Reported Cash Flow
Common methods include:
- Sales - Sell the receivables to a factor for instant cash. (leading)
- Inventory - Don't pay your suppliers for an additional few weeks at period end. (lagging)
- Sales Commissions - Management can form a separate (but unrelated) company and act as its agent. The book of business can then be purchased quarterly as an investment.
- Wages - Remunerate with stock options.
- Maintenance - Contract with the predecessor company that you prepay five years worth for them to continue doing the work
- Equipment Leases - Buy it
- Rent - Buy the property (sale and lease back, for example).
- Oil Exploration costs - Replace reserves by buying another company's.
- Research & Development - Wait for the product to be proven by a start-up lab; then buy the lab.
- Consulting Fees - Pay in shares from treasury since usually to related parties
- Interest - Issue convertible debt where the conversion rate changes with the unpaid interest.
- Taxes - Buy shelf companies with TaxLossCarryForward's. Or gussy up the purchase by buying a lab or O&G explore co. with the same TLCF.
|Description||Amount ($)||totals ($)|
|Cash flow from operations||+10|
|Sales (paid in cash)||+30|
|Cash flow from financing||+40|
|Cash flow from investments||-10|
The net cash flow only provides a limited amount of information. Compare, for example, the cash flows over three years of two companies:
|Company A||Company B|
|Year 1||Year 2||year 3||Year 1||Year 2||year 3|
|Cash flow from operations||+20M||+21M||+22M||+10M||+11M||+12M|
|Cash flow from financing||+5M||+5M||+5M||+5M||+5M||+5M|
|Cash flow from investment||-15M||-15M||-15M||0M||0M||0M|
|Net cash flow||+10M||+11M||+12M||+15M||+16M||+17M|
Company B has a higher yearly cash flow. However, Company A is actually earning more cash by its core activities and has already spent 45M in long term investments, of which the revenues will only show up after three years.