Why is Formula for Cash Flow Important?
A formula for cash flow is an analytical way of investigating into the flow of funds in a business. Of course, every business will constantly have money flowing in and out of it. But unless such flow is scrutinized with a technical eye, no conclusions can be drawn from it.
There is more to the movement of funds in a business than meets the eye. The frequency with which working capital rotates, operating activities sucking out cash, liquidity blocked in current assets is some of the instances which require a deep dive into working. Thus, this is where the formula for cash flow steps in.
There exist a variety of ratios and indicators that solely indicate the cash flow health of an organization. Reading ahead will provide you with a small insight into the plethora of formulas for cash flow that exists.
Cash Flow Statement
A cash flow statement encapsulates all movement of cash in a business for a period. Therefore, studying the components of a cash flow statement makes a good starting point for understanding how money movement takes its course in an organization.
Also Read: Cash Flow from Operating Activities
Cash Flow from Operating Activities
This segment lists out the point of inflows and outflows related to the core business activity of the organization. This section denotes the cash-generating potential of a business solely from its operations. Therefore, it reverses all profits that a business may have earned by alternative investments.
Cash flow from operating activities forms the most important segment of the three that constitute a cash flow statement. Even if cash flow from financing and investing activities may be positive, a negative or less than desired flow from operating activities must ring a fire alarm with the management. Since an operating fund flow in the red signifies that the profitability and longevity of the business are in jeopardy, therefore, it requires the managers to initiate immediate problem-solving.
The format for cash flow from the operating activity is given below.
| Profit before tax | X |
| Investment income | (X) |
| Finance cost | X |
| Depreciation | X |
| Less capital government grants released | (X) |
| Amortisation of intangible assets | X |
| Impairment loss charged in profit or loss | X |
| Loss on disposal of assets (profit) | X/(X) |
| Increase in provisions (decrease) | X/(X) |
| Changes in working capital | |
| Increase/decrease in inventory | X/(X) |
| Increase/decrease in receivables and prepayments | X/(X) |
| Increase/decrease in trade payables and accruals | X/(X) |
| Cash generated from operations | X |
| Interest paid | (X) |
| Taxation paid | (X) |
| Net cash from operating activities | X |
Cash Flow from Investing Activities
This segment of cash flow from investing activities indicates the capital expansion and long-term investments undertaken by the entity during the period. Investments in property, plants, and equipment will reflect here. A negative cash flow in investing activities may not necessarily be a bad sign since it indicates that the company has made commitments to expand and grow. Thus, this is a happy signal for the stakeholders since they can expect an increase in profits and appreciation in share prices owing to the incremental income flowing from the investments.
Given below is the format for cash flow from investing activities.
| Payments to buy PPE / Intangibles / Investments | (X) |
| Proceeds from the sale of PPE / Intangibles / Investments | X |
| Dividends received from investments | X |
| Capital government grants received | X |
| Net cash used in investing activities | X |
Cash Flow from Financing Activities
This segment of cash flow from financing activities explains the changes that have been made to the permanent capital structure of the business. It informs the shareholders of the cash the company is sitting on owing to debt and equity.
Also Read: Cash Flow Vs. Fund flow
Instances of a positive cash flow are when more capital is raised, either by the issue of fresh capital or taking on new debt. Negative cash flow examples include paying back debt, interest on debt, etc. Even dividend payments are recorded as a part of the financing activity since they are an outflow from the permanent capital.
Given below is the format for cash flow from financing activities.
| Proceeds from an equity share issue | X |
| Dividends paid | (X) |
| Proceeds from the issue of new debt | X |
| Repayment of debt | (X) |
| Capital repayment of finance lease obligations | (X) |
| Net cash from/used in financing activities | X/(X) |
Formula for Cash Flow
There exist several ratios and formulas to determine an organization’s cash efficiency, liquidity, and solvency. While each ratio covers different facets of an organization, they are each equally significant. Below mentioned are some of the major formulas for cash flow.
Liquidity Ratios
Current Ratio
This ratio measures the ability of a business to meet its short-term liabilities with the current assets in hand. Generally, 2:1 is considered ideal. But there may be industry variations.
CR (Current Ratio) = Current Assets/Current Liability
Current Assets = Stock, Debtor, Cash and bank, receivables, loan and advances, and other current assets.
Current Liability = Creditor, Short-term loan, bank overdraft, outstanding expenses, and other current liability
Defense Interval Ratio
This ratio states the number of days a business can continue its operations without access to non-current assets. This ratio is more practical and relevant since it plots the current assets only against the actual expenses and not the current liabilities as a whole. A stakeholder thus gets a real picture of a company’s ability to pay off its routine expenditure.
Defensive Interval Ratio = Quick Assets/Daily Cash Expenses
Quick Assets= Cash + Cash Equivalents + Marketable Securities + Receivables
Solvency Ratios
It is a variant of a formula for cash flow that indicates whether the business generates sufficient cash flow to meet its long-term obligations.
Solvency Ratio = Net Profit (After Tax) + Depreciation/ Short Term + Long Term Liabilities
Depreciation, a non-cash item, is added back.
Coverage Ratios
Coverage ratios typically convey “how many times” a particular expenditure can be covered with the income or cash balances under consideration.
Cash Coverage Ratio (CCR)
This formula for cash flow pits only the hard cash balance against the interest expense. It is a very conservative and far-fetched way of evaluating the interest payment potential since no other current assets are considered.
CCR= Cash Balance/ Interest Expense
For example, a CCR of 1.5 would mean that a firm currently holds 1.5 times the cash balance of its interest liability.
Debt Service Coverage Ratio (DSCR)
This formula for cash flow finds a huge application in the banking sector since financial institutions rely on this formula to evaluate the creditworthiness of a loan applicant. DSCR basically evaluates the potential of the business to uphold the terms of debt, i.e., timely repayment of principal and interest.
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