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Cash Flow: Definition, Types, Examples, Ratios, and Metrics
It is commonly believed that profit is the most important element of a strong business. However, experienced investors and entrepreneurs will often state that it is better to look at cash flow (CF), first and foremost.
QUOTE
Making more money will not solve your problems if cash flow management is your problem.
Big ideas
- Many regard cash flow as the most important metric when assessing company performance, even more important than profit in certain circumstances.
- A company’s cash flow is measured by its revenue (inflows) and expenses (outflows). Cash flow is a good indicator of a company's liquidity, flexibility, and financial performance.
- There are many subcategories of cash flow which will have distinct formulas for calculation. These subcategories need to be looked at in tandem with the total cash flow figure.
What is Cash Flow?
Cash flow refers to the net movement of cash (and cash equivalents) into and out of a business, covering every single cash transaction. It is more than just revenue "coming in" and expenses "going out" because it includes operational activities (revenue and expenses), investing activities (purchase and sale of assets), and financing activities (raising and repaying capital).
Positive cash flow means that a company has more money coming into it than going out of it. Negative cash flow means a company has less money coming in than out.
A positive cash flow is a very healthy sign for a company, indicative of improved financial performance.
Positive cash flow means that a company has more money coming into it than going out of it. Negative cash flow means a company has less money coming in than out.
A positive cash flow is a very healthy sign for a company, indicative of improved financial performance.
DEFINITION
Cash flow is the net amount of cash and cash equivalents being transferred in and out of a company.
Key Drivers of Cash Flow
Companies with a positive cash flow are much better prepared in the event of an economic downturn or an adverse financial circumstance. You might also want to take a look at cash reserves in this regard. Berkshire Hathaway (BRK), for instance, had $42 billion in cash on hand for Q2, 2024 (2024 Second Quarter Report).
Cash flow is one of the most important and commonly used metrics for accounting and finance purposes. It is used to calculate the net present value, internal rate of return, cash flow per share, and price-to-cash flow ratio.
Positive cash flow can be utilised for capital expenditures, dividend payments, and funding gaps. It is a great measure of a company’s financial liquidity.
Positive cash flow can be utilised for capital expenditures, dividend payments, and funding gaps. It is a great measure of a company’s financial liquidity.
Cash Flow Formula and Calculation
Cash flow is an easily derived formula. It is merely the inflows minus the outflows.
FORMULA
Cash Flow = TCI - TCO
Where:
- TCI = Total cash inflow
- TCO = Total cash outflow
Where:
- TCI = Total cash inflow
- TCO = Total cash outflow
However, this is a very broad cash flow figure and there are different calculations for the various kinds of cash flow, outlined in more detail below. How cash flows are calculated also depends on whether the direct or indirect method is used.
What is a Cash Flow Statement?
A company demonstrates its cash flow on a cash flow statement, which is distinct from both the income statement (P&L) and the balance sheet. Cash flow has its own set of accounting rules that need to be followed. The cash flow statement can be used to reconcile the income statement and balance sheet.
Key Components of a Cash Flow Statement
The cash flow statement has three distinct sections:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
Cash Flow Statements (CFS)
Cash from Operations | Cash from Investing | Cash from Financing |
(+) Net Income | (-) Capital Expenditures (CapEx) | (+) Equity and Debt Issuances |
(+) Non-Cash Expenses (e.g. Depreciation & Amortization) | (-) Long-Term Investments and Business Acquisitions | (-) Share Buybacks and Dividends |
(-) Increase in Net Working Capital (NWC) | (+) Divestitures | (-) Debt Repayment |
Cash Flow from Operating Activities (CFO)
Cash flow from operating activities shows the cash generated or used by a company’s core business operations. It includes cash receipts from sales, payments to suppliers, wages, and other operational expenses. Positive cash flow from operations typically signals a healthy, profitable business.
Formula
Cash Flow from Operating Activities (CFO) = Net Income + Non-Cash Expenses − Changes in Working Capital
Cash Flow from Investing Activities (CFI)
Cash flow from investing activities covers cash spent on or received from investments in long-term assets like property, equipment, or securities. This section of the cash flow statement indicates how much the company is investing in its future growth. A negative figure usually means the company is investing heavily, while a positive figure may suggest asset sales or a reduction in investment activities.
Formula
Cash Flow from Investing Activities (CFI) = Proceeds from Sale of Assets − Capital Expenditures − Purchase of Investments
Cash Flow from Financing Activities (CFF)
Cash flow from financing activities details cash transactions related to raising or repaying capital. It includes issuing and repurchasing stock, borrowing, and repaying debt, as well as paying dividends. Positive cash flow from financing activities typically suggests the company is raising capital by issuing debt or equity, while negative cash flow may indicate that the company is repaying debt or distributing dividends.
Formula
Cash Flow from Financing Activities (CFF) = Cash Inflows from Issuing
Debt or Equity − Dividends Paid − Repurchase of Debt and Equity
Debt or Equity − Dividends Paid − Repurchase of Debt and Equity
Direct vs Indirect Cash Flow Statement
The direct and indirect methods are two approaches to preparing a cash flow statement.
The direct method lists all cash receipts and payments directly, showing how cash flows in and out of the business. This method provides a clear picture of cash transactions but is less common due to the detailed tracking required.
The indirect method starts with net income and adjusts for non-cash items, such as depreciation, and changes in working capital to calculate operating cash flow. It is more widely used because it ties easily with the income statement and balance sheet, even though it may obscure individual cash transactions.
The indirect method starts with net income and adjusts for non-cash items, such as depreciation, and changes in working capital to calculate operating cash flow. It is more widely used because it ties easily with the income statement and balance sheet, even though it may obscure individual cash transactions.
QUOTE
Never take your eye off of the cash flow because it is the lifeblood of the business.
Apple Inc. Consolidated Statements of Cash Flows (2023)
Source: Apple Inc.Types of Cash Flow
There are various kinds of cash flow metrics, each providing a more granular understanding of where the money is being received from and paid towards.
This is useful for investors who need to understand the various cash flows in detail. Taking the overall cash flow figure can sometimes lead to erroneous conclusions.
The most important types of cash flow are operating cash flow, investing cash flow, and financing cash flow, and they are covered below.
This is useful for investors who need to understand the various cash flows in detail. Taking the overall cash flow figure can sometimes lead to erroneous conclusions.
The most important types of cash flow are operating cash flow, investing cash flow, and financing cash flow, and they are covered below.
Operating Cash Flow (OCF)
Operating cash flow represents the cash generated from a company's regular business operations. It reflects the ability of the company to generate enough revenue to maintain or expand operations. OCF includes cash receipts from sales, payments to suppliers, and wages paid to employees.
A positive OCF indicates healthy operations, while a negative figure may suggest difficulties. OCF is often considered a more accurate measure of financial health than net income, as it excludes non-cash expenses.
A positive OCF indicates healthy operations, while a negative figure may suggest difficulties. OCF is often considered a more accurate measure of financial health than net income, as it excludes non-cash expenses.
FORMULA & EXAMPLE
Operating Cash Flow (OCF) = Net Income + Non-Cash Expenses - Increase in Net Working Capital
Steps to calculate OCF:
1. Start with Net Income, which represents the profit after all expenses.
2. Add back Non-Cash Expenses such as depreciation and amortization since these do not involve actual cash outflows.
3. Adjust for changes in Net Working Capital (NWC), which includes accounts receivable, inventory, and accounts payable.
Example:
Let’s say a company has the following information for the year:
• Net Income: £150,000
• Depreciation (Non-Cash Expense): £25,000
• Increase in Accounts Receivable: £10,000 (cash outflow)
• Increase in Inventory: £5,000 (cash outflow)
• Increase in Accounts Payable: £15,000 (cash inflow)
To calculate the Investing Cash Flow (ICF):
1. Net Income: £150,000
2. Add back Depreciation (Non-Cash Expense): £25,000
3. Adjust for changes in Net Working Capital (NWC):
• Increase in Accounts Receivable: -£10,000 (reduces cash)
• Increase in Inventory: -£5,000 (reduces cash)
• Increase in Accounts Payable: £15,000 (increases cash)
4. Calculate the OCF:
OCF = £150,000 + £25,000 − £10,000 − £5,000 + £15,000 = £175,000
Explanation:
• Net Income (£150,000) is the company’s profit after all expenses.
• Depreciation (£25,000) is added back because it’s a non-cash expense.
• Accounts Receivable (£10,000) and Inventory (£5,000) increases are subtracted because they represent cash outflows.
• Accounts Payable (£15,000) increase is added because it represents a cash inflow (the company is delaying payments to suppliers).
Thus, the Operating Cash Flow (OCF) for the year is £175,000, indicating that the company generated £175,000 in cash from its regular business operations. This positive OCF suggests that the company has a healthy cash flow, which can be used to support ongoing operations or expand the business.
Steps to calculate OCF:
1. Start with Net Income, which represents the profit after all expenses.
2. Add back Non-Cash Expenses such as depreciation and amortization since these do not involve actual cash outflows.
3. Adjust for changes in Net Working Capital (NWC), which includes accounts receivable, inventory, and accounts payable.
Example:
Let’s say a company has the following information for the year:
• Net Income: £150,000
• Depreciation (Non-Cash Expense): £25,000
• Increase in Accounts Receivable: £10,000 (cash outflow)
• Increase in Inventory: £5,000 (cash outflow)
• Increase in Accounts Payable: £15,000 (cash inflow)
To calculate the Investing Cash Flow (ICF):
1. Net Income: £150,000
2. Add back Depreciation (Non-Cash Expense): £25,000
3. Adjust for changes in Net Working Capital (NWC):
• Increase in Accounts Receivable: -£10,000 (reduces cash)
• Increase in Inventory: -£5,000 (reduces cash)
• Increase in Accounts Payable: £15,000 (increases cash)
4. Calculate the OCF:
OCF = £150,000 + £25,000 − £10,000 − £5,000 + £15,000 = £175,000
Explanation:
• Net Income (£150,000) is the company’s profit after all expenses.
• Depreciation (£25,000) is added back because it’s a non-cash expense.
• Accounts Receivable (£10,000) and Inventory (£5,000) increases are subtracted because they represent cash outflows.
• Accounts Payable (£15,000) increase is added because it represents a cash inflow (the company is delaying payments to suppliers).
Thus, the Operating Cash Flow (OCF) for the year is £175,000, indicating that the company generated £175,000 in cash from its regular business operations. This positive OCF suggests that the company has a healthy cash flow, which can be used to support ongoing operations or expand the business.
Investing Cash Flow (ICF)
Investing cash flow tracks cash used for investments in assets like property, equipment, or securities. It can also include proceeds from the sale of these assets. A negative ICF usually indicates that a company is investing heavily in growth, such as purchasing new equipment or acquiring other businesses.
Positive ICF could mean the company is selling assets or scaling back investments. Investors watch ICF to understand a company's growth strategy and capital expenditures.
Positive ICF could mean the company is selling assets or scaling back investments. Investors watch ICF to understand a company's growth strategy and capital expenditures.
FORMULA & EXAMPLE
Investing Cash Flow (ICF) = Proceeds from Sale of Assets − Capital Expenditures − Purchase of Investments
Steps to calculate ICF:
1. Identify the cash inflows from the sale of assets.
2. Subtract capital expenditures - the cash spent on acquiring or maintaining long-term assets.
3. Subtract any additional cash outflows for purchasing investments.
Example:
Let’s say a company has the following transactions related to investing activities:
• Proceeds from the sale of equipment: £500,000 (cash inflow)
• Purchase of new machinery: £300,000 (cash outflow)
• Purchase of additional investments (e.g., securities): £200,000 (cash outflow)
To calculate the Investing Cash Flow (ICF):
1. Identify cash inflows from asset sales:
• Proceeds from the sale of equipment: £500,000
2. Identify cash outflows for capital expenditures and investments:
• Purchase of new machinery: £300,000
• Purchase of additional investments: £200,000
3. Calculate the ICF:
ICF = £500,000 − £300,000 − £200,000 = £0
Explanation:
• The Proceeds from Sale of Assets (£500,000) represents the cash inflow from selling equipment.
• The Capital Expenditures (£300,000) represents the cash outflow for purchasing new machinery.
• The Purchase of Investments (£200,000) represents the cash outflow for additional investments.
Thus, the Investing Cash Flow (ICF) for the period is £0, indicating that the cash inflows from the sale of assets were fully offset by the cash outflows for new investments and capital expenditures.
This neutral ICF suggests that the company balanced its asset sales and investments during the period, without generating or consuming additional cash from investing activities.
Steps to calculate ICF:
1. Identify the cash inflows from the sale of assets.
2. Subtract capital expenditures - the cash spent on acquiring or maintaining long-term assets.
3. Subtract any additional cash outflows for purchasing investments.
Example:
Let’s say a company has the following transactions related to investing activities:
• Proceeds from the sale of equipment: £500,000 (cash inflow)
• Purchase of new machinery: £300,000 (cash outflow)
• Purchase of additional investments (e.g., securities): £200,000 (cash outflow)
To calculate the Investing Cash Flow (ICF):
1. Identify cash inflows from asset sales:
• Proceeds from the sale of equipment: £500,000
2. Identify cash outflows for capital expenditures and investments:
• Purchase of new machinery: £300,000
• Purchase of additional investments: £200,000
3. Calculate the ICF:
ICF = £500,000 − £300,000 − £200,000 = £0
Explanation:
• The Proceeds from Sale of Assets (£500,000) represents the cash inflow from selling equipment.
• The Capital Expenditures (£300,000) represents the cash outflow for purchasing new machinery.
• The Purchase of Investments (£200,000) represents the cash outflow for additional investments.
Thus, the Investing Cash Flow (ICF) for the period is £0, indicating that the cash inflows from the sale of assets were fully offset by the cash outflows for new investments and capital expenditures.
This neutral ICF suggests that the company balanced its asset sales and investments during the period, without generating or consuming additional cash from investing activities.
Financing Cash Flow (CFF)
Financing cash flow deals with cash flow related to raising and repaying capital. It includes cash from issuing stocks, borrowing loans, or paying dividends and repurchasing shares.
A positive CFF suggests the company is raising capital, while a negative CFF may indicate debt repayment or dividend distribution. Monitoring CFF helps investors understand how a company finances its operations and whether it relies more on equity or debt to fund its activities.
A positive CFF suggests the company is raising capital, while a negative CFF may indicate debt repayment or dividend distribution. Monitoring CFF helps investors understand how a company finances its operations and whether it relies more on equity or debt to fund its activities.
FORMULA & EXAMPLE
Financing Cash Flow (CFF) = Cash Inflows from Issuing Equity or Debt - (Cash Paid as Dividends + Repurchase of Debt and Equity)
Steps to calculate CFF:
1. Add the cash inflows from the issuing of debt or equity.
2. Add all cash outflows from stock repurchases, dividend payments, and debt repayment.
3. Subtract the total cash outflows from the total cash inflows to determine the cash flow from financing activities for the period.
Example:
Let’s say a company has the following information in the financing activities section of its cash flow statement:
• Repurchase of stock: £800,000 (cash outflow)
• Proceeds from issuing long-term debt: £2,500,000 (cash inflow)
• Payments to long-term debt: £600,000 (cash outflow)
• Payments of dividends: £300,000 (cash outflow)
To calculate the Cash Flow from Financing (CFF):
1. Identify cash inflows:
• Proceeds from issuing long-term debt: £2,500,000
2. Identify cash outflows:
• Repurchase of stock: £800,000
• Payments to long-term debt: £600,000
• Payments of dividends: £300,000
3. Calculate the CFF:
CFF = £2,500,000 − £1,700,000 = £800,000
Explanation:
• CED (£2,500,000) represents the cash inflow from issuing long-term debt.
• CD (£300,000) represents the cash paid out as dividends.
• RP (£800,000 + £600,000 = £1,400,000) represents the total cash outflows for repurchasing stock and repaying debt.
Thus, the Cash Flow from Financing (CFF) for the period is £800,000, indicating that the company has a net cash inflow from its financing activities during this period.
Steps to calculate CFF:
1. Add the cash inflows from the issuing of debt or equity.
2. Add all cash outflows from stock repurchases, dividend payments, and debt repayment.
3. Subtract the total cash outflows from the total cash inflows to determine the cash flow from financing activities for the period.
Example:
Let’s say a company has the following information in the financing activities section of its cash flow statement:
• Repurchase of stock: £800,000 (cash outflow)
• Proceeds from issuing long-term debt: £2,500,000 (cash inflow)
• Payments to long-term debt: £600,000 (cash outflow)
• Payments of dividends: £300,000 (cash outflow)
To calculate the Cash Flow from Financing (CFF):
1. Identify cash inflows:
• Proceeds from issuing long-term debt: £2,500,000
2. Identify cash outflows:
• Repurchase of stock: £800,000
• Payments to long-term debt: £600,000
• Payments of dividends: £300,000
3. Calculate the CFF:
CFF = £2,500,000 − £1,700,000 = £800,000
Explanation:
• CED (£2,500,000) represents the cash inflow from issuing long-term debt.
• CD (£300,000) represents the cash paid out as dividends.
• RP (£800,000 + £600,000 = £1,400,000) represents the total cash outflows for repurchasing stock and repaying debt.
Thus, the Cash Flow from Financing (CFF) for the period is £800,000, indicating that the company has a net cash inflow from its financing activities during this period.
Free Cash Flow (FCF)
Free cash flow is the cash generated by a company after accounting for capital expenditures necessary to maintain or expand its asset base. It is a key metric for investors as it indicates the cash available for dividends, debt repayment, or reinvestment in the business.
Companies with strong free cash flows are often viewed as financially stable and capable of sustaining growth. The free cash flow is an important indicator of a company's ability to generate shareholder value over the long term.
Companies with strong free cash flows are often viewed as financially stable and capable of sustaining growth. The free cash flow is an important indicator of a company's ability to generate shareholder value over the long term.
FORMULA & EXAMPLE
Free Cash Flow (FCF) = Operating Cash Flow − Capital Expenditures
Steps to calculate OCF:
1. Start with Operating Cash Flow (OCF), which represents the cash generated from the company's core business operations.
2. Subtract Capital Expenditures (CapEx), which are the funds used to purchase, upgrade, or maintain physical assets such as property, buildings, or equipment.
Example:
Let’s say a company has the following financial data for the year:
• Operating Cash Flow (OCF): £200,000
• Capital Expenditures (CapEx): £50,000
To calculate the Free Cash Flow (FCF):
1. Operating Cash Flow (OCF): £200,000
2. Capital Expenditures (CapEx): -£50,000
3. Calculate the OCF:
FCF = £200,000 − £50,000 = £150,000
Explanation:
• Operating Cash Flow (£200,000) represents the cash generated from the company’s regular business operations.
• Capital Expenditures (£50,000) are subtracted because they represent the cash spent on maintaining or expanding the company's asset base.
Thus, the Free Cash Flow (FCF) for the year is £150,000. This means the company has £150,000 in cash available after covering its capital expenditures. This cash can be used for various purposes, such as paying dividends, repaying debt, or reinvesting in the business. A strong FCF indicates that the company is financially healthy and has the flexibility to pursue growth opportunities or return value to shareholders.
Steps to calculate OCF:
1. Start with Operating Cash Flow (OCF), which represents the cash generated from the company's core business operations.
2. Subtract Capital Expenditures (CapEx), which are the funds used to purchase, upgrade, or maintain physical assets such as property, buildings, or equipment.
Example:
Let’s say a company has the following financial data for the year:
• Operating Cash Flow (OCF): £200,000
• Capital Expenditures (CapEx): £50,000
To calculate the Free Cash Flow (FCF):
1. Operating Cash Flow (OCF): £200,000
2. Capital Expenditures (CapEx): -£50,000
3. Calculate the OCF:
FCF = £200,000 − £50,000 = £150,000
Explanation:
• Operating Cash Flow (£200,000) represents the cash generated from the company’s regular business operations.
• Capital Expenditures (£50,000) are subtracted because they represent the cash spent on maintaining or expanding the company's asset base.
Thus, the Free Cash Flow (FCF) for the year is £150,000. This means the company has £150,000 in cash available after covering its capital expenditures. This cash can be used for various purposes, such as paying dividends, repaying debt, or reinvesting in the business. A strong FCF indicates that the company is financially healthy and has the flexibility to pursue growth opportunities or return value to shareholders.
Net Cash Flow (NCF)
Net cash flow is the total change in a company’s cash position over a specific period. It is calculated by summing operating, investing, and financing cash flows. Positive net cash flow indicates that a company is generating more cash than it is spending, which can be a sign of financial health.
EXAMPLE
A company has the following metrics for the year:
• Net income: £100,000
• Depreciation: £20,000
• Change in accounts receivable: -£10,000 (increase)
• Change in inventory: -£5,000 (increase)
• Change in accounts payable: £15,000 (increase)
• Capital expenditures: £25,000
• Proceeds from the sale of equipment: £10,000
• Purchase of new investments: £15,000
• New debt issued: £50,000
• Debt repayment: £20,000
• Dividends paid: £10,000
Operating Cash Flow Calculation (OCF)
Net Income (£100,000) + Depreciation (£20,000) - Increase in Accounts Receivable (£10,000) - Increase in Inventory (£5,000) + Increase in Accounts Payable (£15,000) = £120,000
Investing Cash Flow Calculation (ICF)
Proceeds from Sale of Equipment (£10,000) - Capital Expenditures (£25,000) - Purchase of New Investments (£15,000) = -£30,000
Financing Cash Flow Calculation (CFF)
New Debt Issued (£50,000) - Debt Repayment (£20,000) - Dividends Paid (£10,000) = £20,000
Net Cash Flow (NCF)
Operating Cash Flow (£120,000) + Investing Cash Flow (-£30,000) + Financing Cash Flow (£20,000) = £110,000
• Net income: £100,000
• Depreciation: £20,000
• Change in accounts receivable: -£10,000 (increase)
• Change in inventory: -£5,000 (increase)
• Change in accounts payable: £15,000 (increase)
• Capital expenditures: £25,000
• Proceeds from the sale of equipment: £10,000
• Purchase of new investments: £15,000
• New debt issued: £50,000
• Debt repayment: £20,000
• Dividends paid: £10,000
Operating Cash Flow Calculation (OCF)
Net Income (£100,000) + Depreciation (£20,000) - Increase in Accounts Receivable (£10,000) - Increase in Inventory (£5,000) + Increase in Accounts Payable (£15,000) = £120,000
Investing Cash Flow Calculation (ICF)
Proceeds from Sale of Equipment (£10,000) - Capital Expenditures (£25,000) - Purchase of New Investments (£15,000) = -£30,000
Financing Cash Flow Calculation (CFF)
New Debt Issued (£50,000) - Debt Repayment (£20,000) - Dividends Paid (£10,000) = £20,000
Net Cash Flow (NCF)
Operating Cash Flow (£120,000) + Investing Cash Flow (-£30,000) + Financing Cash Flow (£20,000) = £110,000
Negative net cash flow might suggest cash management issues. Investors use net cash flow to assess the overall liquidity and financial flexibility of a company.
Unlevered Free Cash Flow (UFCF) vs Levered Free Cash Flow (LFCF)
Unlevered Free Cash Flow (UFCF) is the cash flow available to all stakeholders before interest payments. It measures a company's financial performance without considering its capital structure.
Levered Free Cash Flow (LFCF), on the other hand, represents the cash flow available to equity holders after debt obligations are met. UFCF is useful for valuing a company as a whole, while LFCF is more relevant for equity investors assessing the return on their investment.
Levered Free Cash Flow (LFCF), on the other hand, represents the cash flow available to equity holders after debt obligations are met. UFCF is useful for valuing a company as a whole, while LFCF is more relevant for equity investors assessing the return on their investment.
Analysing Cash Flow
Analysing cash flow involves examining how a company generates and uses cash from its operating, investing, and financing activities. By looking at the cash flow statement, one can assess whether the business is generating enough cash to cover its obligations and invest in assets for the future.
Key Ratios for Cash Flow Analysis
Several key ratios and metrics are used in cash flow analysis to evaluate a company's financial performance. These include:
Operating Cash Flow Ratio
Operating cash flow ratio measures how well a company can cover its current liabilities using the cash generated from its core business operations.
A higher ratio suggests that the company has strong liquidity, meaning it is better equipped to meet its short-term financial obligations. This indicates financial stability and a solid ability to manage cash flow effectively.
A higher ratio suggests that the company has strong liquidity, meaning it is better equipped to meet its short-term financial obligations. This indicates financial stability and a solid ability to manage cash flow effectively.
FORMULA
Operating Cash Flow Ratio = Cash from Operations / Current Liabilities
Cash Flow Coverage Ratio (CFCR)
Cash flow coverage ratio compares operating cash flow to total debt. It indicates the company’s ability to cover debt obligations with cash generated from operations.
FORMULA
Cash Flow Coverage Ratio (CFCR) = Operating Cash Flow / Total Debt
Cash Conversion Cycle (CCC)
Cash Conversion Cycle measures the time it takes for a company to turn its investments in inventory and other resources into cash through sales. It looks at the entire process from purchasing inventory to selling products and collecting payment from customers.
A company with a shorter CCC can quickly convert its investments into cash, meaning it generates cash faster and manages its working capital more efficiently. In other words, the shorter the cycle, the less time the company's cash is tied up in the production and sales process, leading to better cash flow management and financial health.
A company with a shorter CCC can quickly convert its investments into cash, meaning it generates cash faster and manages its working capital more efficiently. In other words, the shorter the cycle, the less time the company's cash is tied up in the production and sales process, leading to better cash flow management and financial health.
FORMULA
Cash Conversion Cycle (CCC) = Days Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding
These ratios help investors assess the efficiency of cash management, the sustainability of operations, and the company’s ability to meet its financial commitments.
Common Pitfalls in Cash Flow Analysis
When analysing cash flow, some common pitfalls can lead to misleading conclusions:
- Ignoring non-recurring Items - large, one-time gains or losses can distort cash flow figures. It is essential to adjust for these when necessary to get a true picture of ongoing operations.
- Overlooking changes in working capital - fluctuations in accounts receivable, inventory, or payables can impact cash flow significantly. Focusing only on net income without considering these changes can give an incomplete view.
- Focusing solely on net income - net income includes non-cash items like depreciation. Relying only on it can obscure cash flow issues. Cash flow statements should be analysed separately to understand the actual cash generated.
- Not considering debt levels - high operating cash flow is good, but if it is due to excessive borrowing, it may indicate potential future problems. It is important to analyse cash flow in conjunction with the company’s debt structure.
Avoiding these pitfalls requires careful attention to detail and a comprehensive view of the entire cash flow statement. This helps ensure a more accurate assessment of the company’s financial health and sustainability.
Recap of Cash Flow
Cash flow is just as important as profit when it comes to analysing a business. But you need to use both and understand each of them, as they tell different stories.
A startup might have great cash flow but fail to make a profit. Conversely, a large company can have a negative cash flow but still make a profit. You need to put each metric in context to extract a truly accurate meaning.
A startup might have great cash flow but fail to make a profit. Conversely, a large company can have a negative cash flow but still make a profit. You need to put each metric in context to extract a truly accurate meaning.
FAQ on Cash Flow
Q: Is cash flow the same as profit?
No, cash flow is the movement of money in and out of a business, while profit is the amount left after all expenses are subtracted from revenue. Profit includes non-cash items, whereas cash flow focuses solely on actual cash transactions.
Q: What can cash flow tell you?
Cash flow shows a company’s liquidity, its ability to meet obligations, and how well it generates cash from operations, investments, and financing activities. It provides insight into financial health beyond just profitability.
Q: How to create cash flow?
Cash flow is created by generating revenue from sales, managing expenses, collecting receivables promptly, and optimising the timing of payments to suppliers. Efficiently managing operations and investments also contribute to positive cash flow.
Q: Why is cash flow important?
Cash flow is crucial because it determines a company’s ability to pay bills, invest in growth, and survive in challenging times. Without sufficient cash flow, even profitable companies can face financial difficulties.
Q: Does a positive cash flow result in profit?
Not necessarily. A company can have positive cash flow due to borrowing or selling assets, but it may still operate at a loss. Conversely, a profitable company might have negative cash flow if it has high capital expenditures or delayed payments.
- Liquidity: The ability of a company to meet its short-term financial obligations by converting assets into cash quickly. A business with high liquidity has sufficient cash or easily accessible assets to cover immediate expenses.
- Capital Expenditures (CapEx): Funds used by a company to acquire, upgrade, or maintain physical assets such as property, equipment, or technology. These investments are essential for business expansion and long-term growth.
- Net Working Capital (NWC): The difference between a company’s current assets (such as cash, accounts receivable, and inventory) and current liabilities (such as accounts payable and short-term debt). It measures a company’s short-term financial health and operational efficiency.
- Depreciation & Amortization: Accounting methods used to allocate the cost of tangible and intangible assets over their useful lives. Depreciation applies to physical assets like machinery, while amortization is used for intangible assets like patents and trademarks.
