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A deep understanding of cash flow is a fundamental business requirement. Why? Because cash flow is at the heart of several important financial metrics, such as free cash flow (FCF), free cash flow to equity (FCFE), and free cash flow to firm (FCFF). Cash flow refers to the net balance of cash moving in and out of a business, which can be positive or negative. It includes both money received by a company (inflow) and money spent by it (outflow). And just to be clear, the ‘cash’ in cash flow means not just cash in hand and in the bank, but also 'cash equivalents', which are a company’s most liquid assets that can be easily and quickly converted into cash (within three months or less).
Follow this detailed guide to discover the meaning of cash flow, the various types of cash flow in use, and learn how to calculate cash flow.
What is a cash flow statement?
When we talk about cash flow, we automatically think of cash flow statement. The statement of cash flows is a financial report that shows the cash generated and spent by a company during a specific period. The cash flow statement documents how money flowed in and out of a business during a given period (a month, quarter, or year). Also called a statement of cash flow, it provides insights into all the areas that generated cash for a company and those where it spent cash. The cash flow statement is one of three financial statements businesses routinely prepare, the other two being the income statement and balance sheet.
How is the cash flow statement used?
Preparing a cash flow statement is the most common way for companies to assess their cash flow. The other way is by performing a cash flow forecast. Unlike a cash flow statement that records actual cash inflows and outflows for a prior period, a cash flow forecast – or cash flow projection – estimates future cash flows based on historical records.
A cash flow statement assists in assessing the company's true financial health and operational efficiency. It can serve multiple purposes, depending on who’s assessing the business. Business owners use cash flow statements to evaluate the performance of their initiatives and projects. Managers refer to cash flow statements to see if budgets are being adhered to. Team leaders use them to monitor their departments’ contributions to company performance and profits. Cash flow statements help investors determine if a company is worth investing in. Furthermore, banks and other lenders widely use cash flow statements to check if businesses seeking loans have the requisite funds to cover their expenses and repay their debts on time.
A cash flow statement depicts a company’s cash flow as being positive or negative. Positive cash flow happens when more money is flowing into than out of a business. It is an ideal situation as the excess cash can be used to repay debts or re-invest in the business. In contrast, negative cash flow is when more cash is spent than received. However, when analysing cash flow statements, one must remember that positive cash flow doesn’t necessarily translate to profit. Similarly, a company can have negative cash flow for a short period of time and still be profitable because its high expenses might be a deliberate strategy to expand the business. This means that analysing cash flow statements must be a continuous effort rather than a one-off. Only by monitoring changes in cash flow from one period to another can you accurately assess a company’s overall performance.
Components of a cash flow statement
A cash flow statement classifies cash flow by source and is, therefore, divided into three sections. Net cash flow is calculated as the sum of cash flow from operating activities, investing activities, and financing activities, providing a comprehensive overview of a company's overall cash movement.
1. Cash flow from operating activities
This section is made up of cash flows associated with a company’s primary activities, such as the production and sale of its products and services. Operating cash flow includes earnings from and expenses incurred on a company's main business operations.
2. Cash flow from investing activities
This section covers cash flow from the sale or purchase of assets, such as property and equipment. While positive cash flow from investing activities is certainly welcome, investors and stakeholders prefer companies that generate more cash from their operations rather than from investing and financing activities.
3. Cash flow from financing activities
This final section of the cash flow statement deals with inflow and outflow associated with financing activities, such as raising money and repaying loans.
How to prepare cash flow statement
The first step is to remember this simple cash flow formula:
Cash flow = Total cash inflow - Total cash outflow
Keeping this cash flow formula in mind, you can prepare a cash flow statement in just five steps:
- Identify the starting balance of your company’s cash and cash equivalents for a given period. This value is easily found in the income statement.
- Now, calculate operating cash flow. There are two methods to go about this – the direct method and the indirect method.
- Under the direct method, you take all cash generated from operations and deduct all operational expenses for the specified reporting period, including cash paid to suppliers and salaries. This approach involves recording cash paid out in salaries and to suppliers as part of the operational expenses, offering a clear view of cash flow from the business's core activities. While fairly simple to understand, the direct method requires the collection of data at a granular level, making it a cumbersome and time-consuming exercise.
- The second and more widely used calculation is the indirect method, where you take net income (sales minus cost of goods sold, operating expenses, selling, general and administrative expenses, depreciation, interest, taxes, etc), and add or subtract non-cash items. Because it uses easily available data from the income statement and balance sheet, the indirect method is generally preferred. Both methods give the same result though.
- Calculate investing cash flow.
- Calculate financing cash flow.
- Using the information gathered, determine the ending balance of your cash and cash equivalents.
Example of cash flow statement
(Accounting period is a financial year. Figures in SGD)
Types of cash flow
Other than by source (operating, investing, and financing activities), there are other ways to classify and assess cash flow:
Free cash flow
Free cash flow (FCF) is what is left of operating cash flow after accounting for capital expenditures. Capital expenditures (CapEx for short) represent payments made in cash or credit for the purchase of long-term fixed assets used in business operations. The formula is:
Free cash flow = Operating cash flow - Capital Expenditures
The term ‘free’ cash flow implies cash that is available for the company to use at its discretion – using it to expand the business, repay its debts, pay dividends to shareholders, or in any other way. Free cash flow measures how good a business is at generating money. Investors assign great value to a company’s free cash flow as it is often used to reward investors. Given its importance, regularly monitoring and analysing free cash flow is good practice in cash flow management.
Free cash flow to equity
Free cash flow to equity (FCFE) is what's available after taking care of expenses, re-investments and debts. The formula to calculate it is:
Free cash flow to equity = Operating cash flow – Capital expenditures + Net debt issued
Free cash flow to equity also represents cash that can potentially be distributed to shareholders. This is why analysts often use free cash flow to equity to determine the equity value of a company.
Free cash flow to the firm
Free cash flow to the firm (FCFF) is operating cash flow minus depreciation expense, tax, working capital, and investment. Simply put, it is cash left after accounting for all recurring operating expenses and re-investments but excluding debt payments. Free cash flow to the firm also represents money that is potentially available to be paid to investors.
While there are multiple ways to calculate free cash flow to the firm, let’s use this formula:
Free cash flow to the firm = NI + NC + (I x (1 – TR)) – LI – IWC
Here, NI stands for net income (found in the income statement), NC for non-cash charges, I for interest, TR for tax rate, LI for long-term investments, and IWC for investments in working capital.
Free cash flow to the firm is used to assess operational performance. As a reliable indicator of future profitability, it can also size up the company's ability to pay dividends. This makes it a vital tool in discounted cash flow analysis, which is a method used to find the value of an investment (stock, company, project, etc) on the basis of estimated future cash flows. Free cash flow to the firm is a hypothetical figure but one the investment industry places great value on.
Cash flow versus EBITDA
A term often used synonymously with cash flow is EBITDA, which stands for earnings before interest, taxes, depreciation, and amortisation. While both EBITDA and cash flow (specifically, operating cash flow) measure operational efficiency, there is a distinct difference. Operating cash flow accounts for both interest expense and taxes (as cash outflows) while EBITDA does not. As a metric to determine an enterprise's true worth, EBITDA is extensively used because it evaluates business operations in its purest form, excluding all non-cash expenses such as depreciation and amortisation as well as any other factors that the business owners have control over (debt financing, taxes, etc).
FCF vs FCFE vs FCFF vs EBIDTA
Limitations of cash flow statement
A cash flow statement captures only the cash position of a business. It ignores non-cash transactions – such as depreciation in the value of assets over time or the purchase of assets through the issuing of shares, for example. Thus, it may be said that a cash flow statement does not capture a company’s actual financial position, making it a not-so-reliable indicator of profitability. Else, how does one explain a company with positive cash flow that is struggling to make a profit? Conversely, a company's current negative cash flow might be due to strategic investment decisions that are highly likely to earn it handsome returns in the near future.
Cash flow statements are prepared using cash basis accounting, which means that transactions are recorded in financial statements not when they are made but when the money is received. Cash flow statements ignore accrual accounting, a basic accounting principle that recognises and records transactions when they are made and not when payment is received. The benefit of using accrual accounting is that it identifies not only past transactions but also cash resources to be received in the future, painting a more realistic cash flow picture.
Despite its limitations, the cash flow statement is key to effective cash flow management. Analysing it alongside the income statement and balance sheet will lead to the best results.
Frequently asked questions
What does positive cash flow mean?
Positive cash flow means a business has more cash coming in than being spent. It indicates that a company is capable of running its operations and paying its debts on time.
What does negative cash flow mean?
Negative cash flow is when a company spends more than it earns. While it certainly sounds like a less than ideal situation, there might be a perfectly good reason for it – for example, heavy investments made with the aim of growing the business, or payments being due long before income is received. In both cases, companies can correct their cash flow positions after some time has passed. However, if cash flow remains negative for a prolonged period, it should raise some serious red flags.
How do you increase cash flow?
Without a good reason for it, negative cash flow is often the result of poor cash flow management, incorrect pricing, and unnecessary investments. Some ways to improve cash flow include sending invoices on time, incentivising early payments, offering multiple payment options, focusing on essential investments only, and increasing product prices. Furthermore, regularly conducting cash flow forecasts can help you budget and plan better, leading to healthier cash flow.
Cash flow statement vs income statement vs balance sheet
The cash flow statement tracks cash movement from three types of activities – operations, investments, and financing activities. It shows increases and decreases in cash as well as the starting and ending cash balance for a given period. The income statement captures a company’s revenue and expenses over a period and is mainly used to assess profitability. The balance sheet comprises three sections – assets, liabilities, and shareholders’ equity. It shows the company’s financial position at a given point of time (and not a period). All three financial statements are closely linked and dependent on each other. How? Net income from the bottom line of the income statement is the starting point for operating cash flow on the cash flow statement, and is also used to calculate retained earnings, which can be found in the shareholders’ equity section on the balance sheet. This is just one instance of a data overlap in the three financial statements.
What is a cash flow forecast?
A cash flow forecast – also called a cash flow projection – estimates the amount of cash flowing in and out of a business during a given period in the future. It helps businesses predict cash positions in the future, thereby helping them avoid cash crunches before they occur. A cash flow forecast is the opposite of a cash flow statement, which records cash inflows and outflows for a prior period.
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