Cash Flow: Lifeblood of a Business

Cash flow is simply the movement of money into and out of a firm. Yet, there are special considerations related to it, which you can find out in this article.

A recent article in yahoo!finance recommends investing in companies who have a healthy cash level, i.e., a high level of cash flow in and out of the business, and not just lay a wager on stocks based on profit figures. What is a cash flow and what is actually the difference between cash flow and profit? 

Cash flow is the amount of money that flows in and goes out of a company. It can be negative when the amount leaving the company is higher than the incoming amount. A business can generate money through sales revenues, interest, investments, licensing agreements, and other means. Not all earnings are received immediately by a company. In addition, it is not always for certain how much money will come from a certain source. Therefore, assessing these aspects is essentially assessing cash flow performance and, for that matter, the liquidity, resilience, and financial health of a company. 

The importance of positive cash flows is linked to increasing the liquidity of a company. If your business has more liquid assets, what this boils down to are higher capacity and certainty to meet obligations, reinvest in businesses, pay shareholders, cover expenses, and more resilience in front of global situations challenging economies such as a pandemic and geopolitical tensions. Cash flow to a company is simply what blood is to a living organism.

 

Cash Flow vs Profit

It comes as no surprise that the concepts of profit and cash flow are sometimes confused. They are both figures generally showing how much money a company is dealing with. Nonetheless, it should be remembered that profit is the money left after subtracting all expenses and obligations to be paid from the revenues made. Cash flow, on the other hand, is the money coming in and going out of a company and not necessarily the money earned as a profit.

Cash flow statements provide cash-generating and cash-requiring activities or sources within the business. But before talking about a cash flow statement, it is useful to know which overall types of cash flow are differentiated in a business world.

 

Operating Cash Flow

Cash flow from operations (CFO) is money moving in and out because of ordinary operations of a company such as the production and sale of goods and services. Higher inflows indicate a company can continue its operations in the long term since it generates more money than what goes into operating expenses. Operating cash flow can also point to a need for external funds to maintain or expand the business operations.

To calculate CFO, one needs to subtract cash payments in a period for operating expenses from sales revenues.  

 

Investing Cash Flow

Cash flow from investing (CFI) is understood to be cash generated from or spent for investment-type activities. Investment-related activities may include investing in assets and securities or selling owned ones as well as investing in long-term success enablers such as research and development (R&D). Since you do not immediately receive cash after investing, your CFI may be negative in a specific period without necessarily being an alarm sign.

 

Financing Cash Flow

Cash flow from financing (CFF) activities is another source from which money can come or to which cash can flow. Such activities have to do with the capital structure of a company – how much it spends to issue debt and equity or what part of cash profits it pays to shareholders as dividends. 

As can be seen, most items under CFF will be negative or cash outflow with few sources generating cash. 

 

The Cash Flow Statement

The cash flow statement is one of three critical financial statements each company prepares. The balance sheet is a snapshot view of a company’s assets and liabilities. An income statement is an indicator of business profitability during a time period. A cash flow statement is neither of these – it records cash transactions of a company that has occurred during a certain period. 

One difference between an income statement and a cash flow statement is that the former shows all accrued expenses and receivables in a period, but the latter (cash flow statement) shows only those income and expenses that have happened as a transaction. 

If you check the current assets group in a balance sheet, you can find a line dedicated to cash and cash equivalents. Subtracting the previous period figure for CCE from the current CCE, you will obtain a net increase or decrease in CCE. This number is at the bottom of a cash flow statement. So, one can think of cash flow statements as having a reconciliation role for balance sheet and income statements.

In many countries, companies are legally obliged to report their cash flow statement as it is a necessary indicator of the financial health of a business, and as mentioned above, it reconciles the other financial statements.

 

 

Photo: Teguh Jati Prasetyo/Shutterstock

 


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