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What Is Cash Flow?
The name says it all: Cash flow refers to the movement of cash into and out of a company. Inflows refer to the money that’s going into a business, while outflows describe the money leaving a business. When inflows exceed outflows, a business is considered healthy.
Cash flow, along with other quantitative metrics like debt-to-equity and P/E ratios, make up an important part of fundamental analysis, which is a process investors use to value companies. Positive cash flow means that a company’s liquidity—which measures how easily a company’s assets can be converted to cash—is growing. Liquidity is an integral component of a company’s cash flow because it is the sum of the tangible assets that a company needs to run its operations, pay its wages and debts, etc.
Cash Flow Example
Let’s say you own a shoe store. Your assets would include items like your shoes and the building your store is located in. Your total revenues (i.e., your cash inflows) would be your shoe sales. Your outflows would be what you pay your employees, your operating expenses (such as inventories, rent, and utilities), and what you owe your creditors.
What Are the Three Types of Cash Flows?
There are three types of cash flow for a business:
Operational Cash Flow (OCF) measures the short-term financial health of a business. It’s the total amount of cash that a business produces from daily operations. You can calculate this by using net income, which is cash inflows from accounts receivable subtracted from expenses from accounts payable.
Cash Flow From Financing Activities (CFF) measures the cash flow between a company and its owners or creditors—people who provide long-term funds to a business. These items include the repayment of debt or loans, the sale of stocks or stock repurchases, bond issuance, and dividend payments.
- Cash Flow From Investing Activities (CFI) is the total of a company’s long-term investment gains or losses plus the purchase or sale of fixed assets. These can include a company car, equipment, a building, etc. Cash flow from investing activities is calculated by simply adding up money received from the sales of securities and long-term assets subtracted from the cost of purchasing the assets.
Can Cash Flow Be Negative?
Yes. If a company has a negative cash flow, that means it cannot cover its liabilities, and so it must borrow against the value of its assets to meet its expenses. Startups are one type of company where negative cash flow is considered acceptable. Mature companies may also experience negative cash flow when they make dividend payments or stock repurchases.
But left unchecked, negative cash flow can tear apart the very fabric of a business. For example, when negative cash flow results in a company’s failure to make payments on a loan, that makes the company less attractive for future capital investment. In addition, its stock is considered to have higher interest rate risk.
When a business is running low on cash, it could experience a cash crunch, which has an impact on daily operations. In order to overcome this, the business would need to secure emergency financing or raise cash, perhaps by asking its customers if they can pay up front instead of on credit. If insolvency persists, the business may need to lay off workers. Worst-case scenario, the company might even need to declare bankruptcy, which means it must cease operations, go out of business, and sell off its assets to pay its debts.
It’s always advisable for a business to pay close attention to its cash flow as well as hold a percentage of its assets in reserves—in case the unthinkable ever happens.
Are Cash Flow and Profit the Same?
Cash flow and profit are not the same concepts. Profit is what’s left over after expenses, while cash flow is the net flow of cash into and out of a business. Some say that cash flow is even more important than profit because positive cash flow gives a business more opportunities to grow. Here, the saying “cash is king” is apt—the more cash a business has, the more liquid it is, and the easier it will be to secure financing, attract investors, etc.
How Can Investors Interpret a Cash Flow Statement?
Knowing how to read a cash flow statement can help an investor understand the financial health of a company, and thus whether or not they should invest in it. Cash flow statements illustrate which stage of the business cycle a company is in, be it a young and growing start-up or a more mature and profitable enterprise. It can also shed light on whether a company is facing financial difficulties or in a state of decline.
Cash Flow Statement FAQs
We’ve put together the nuts and bolts about cash flow statements.
What Is a Cash Flow Statement?
Lenders, investors, and shareholders all look at a company’s financial documents to gauge its health. These documents include the balance sheet, which illustrates the company’s assets, the income statement, which tells you how profitable the business is over any given period, and the cash flow statement. Some say the cash flow statement serves like a bridge between the balance sheet and income statement since it describes how cash is moving during a specific timeframe. Thus, the cash flow statement tells us how the business has raised and spent its cash.
How Is a Cash Flow Statement Created?
Accountants create a cash flow statement by subtracting the non-cash items from the income statement.
What Is a Cash Flow Forecast?
Cash flow forecasts, also prepared by the accounting team, can help companies gauge future expectations of profit and loss—especially when there is a lag between having to pay for a product and receiving income from a customer. This timeframe is known as the cash flow gap.
Personal Cash Flow Calculator
We’ve discussed ways that analysts and accountants calculate a company’s cash flow; how is cash flow measured in individual terms? The Financial Industry Regulatory Authority (FINRA), a non-governmental agency authorized by the U.S. government to oversee brokers, has created a cash flow calculator that can help individuals control their spending. It’s available on the FINRA website. By inputting your salary and expenses, it can help you calculate your monthly net income and determine whether your cash flow will be positive or negative.
