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What Is Cash Flow?

Business woman at a desk considering her cash flow

Cash flow is the amount of money (cash) or cash equivalents that move in and out of business. In other words, it’s the increase or the decrease of the amount of cash held by a business. Cash flow (CF) is a factor that people use to determine the viability of a business. If a company can generate positive CF on a regular basis, it’s beneficial for long-term success. On the other hand, businesses experiencing ongoing cash flow shortages are at risk of failure.

Understanding the cash flow statement

The three crucial objectives of financial reporting are— assessing the costs, timing, and uncertainty of cash flows. If you want to know the liquidity of a company, it’s important to understand operating cash flow, as well as financial and investing cash flow. You can get this information by checking a company’s cash flow statement. Besides providing information about a company’s liquidity, the cash flow statement also gives details about the financial performance and flexibility of a firm. 

Positive cash flow indicates that a firm is increasing its liquid assets. It also signals that a company can repay its debts and indicates that they can reinvest it in their business.

 Some companies choose to return a portion of profits to the shareholders, take it as owner’s equity or save it for a rainy day. Managing the flow of cash is one way for companies to build their financial health and flexibility.

 If a company’s operating activities don’t generate sufficient cash, it’s likely to fail. This can occur when too much money is tied up in inventory or accounts receivable. A company that spends too much money on capital expenditures can also end up short of cash. Companies of all sizes need to keep these issues in mind when considering their financial management.

Use different reports to get a clear picture

Investors, as well as creditors, check other financial statements in addition to the cash flow statement to understand how a business is performing. These include the balance sheet and income statement (also known as the profit and loss statement). In addition to these reports, financial ratios can help you understand if a company has enough cash or cash equivalents on hand to cover short-term liabilities. This includes using service coverage ratios to see if a firm can repay current liabilities without difficulty. 

 A company might have sufficient liquid cash by getting loans secured with business assets. This won’t appear on the cash flow statement but on the reports mentioned earlier. For this reason, business lenders will want to check other reports, not just the CF statement, to get a clear picture of a company’s financial position. 

Free cash flow (FCF)

Free cash flow (FCF) shows if a company is profiting from its operations. This provides more relevant information about financial performance than net income alone. This metric shows how much cash is left after taking care of business operations. 

 A company can use the remaining money (profits) to either expand their operations or choose to pay a portion to the owners, shareholders in the form of dividends. They can also use these funds to buy back shares or repay the debt.

Types of cash flow

There are several types of cash flows, including: 

  1. Cash from Operating Activities: This refers to money that comes from the core business activity of a firm and does not apply to money that comes from the company’s investment. You can see this on the CF statement.  
  2.  Free Cash Flow to Equity (FCFE): This refers to the amount of money left after reinvesting a portion of it back into the business or capital expenditure.
  3. Free Cash Flow to the Firm (FCFF): This shows that a company doesn’t have any debt or leverage. It’s used primarily for valuation purposes or financial modelling.
  4.  Net Change in Cash: This is the change in CF from one accounting period to another. You can find it at the bottom of a CF statement.

Cash flow versus income

Businesses and investors spend a lot of time studying CF, as it is the lifeblood of a firm. Enterprises can use it for financial planning, to reduce costs or to mitigate the expenses apart from prudently using working capital. It is a crucial factor for companies in reaching their long-term goals. 

 Profit and income are derived by using accrual accounting principles. The net earnings or net income of a company may be entirely different from net cash flow. This depends on many factors, such as revenue recognition policies as well as the matching principles. 

 A company can better manage its finances when it conducts a cash flow analysis. Large companies have internal finance teams that create and analyse CF statements. Small businesses can use accounting software and consult with accounting professionals to ensure that this important aspect of financial management is readily available for review. If there are signs of trouble, business owners and managers can take appropriate steps to overcome these challenges

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All the thoughts, ideas and musings from the Moula team! Covering everything from work/life balance to general finance tips plus everything in between!

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