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Cash Flow and Cash Flow Statements
As the name suggests, cash flow means the amount of cash flowing in and out of the company. In order to keep a record of the cash flows, organizations prepare a cash flow statement. Hence we can say that cash flow statement provides information about a company’s cash receipts and cash payments during an accounting period.
Importance of Cash Flow Statement
In sophisticated terms, cash flow statement provides cash based information, whereas an income statement provides accrual-based information. What does that mean? Let’s understand it with a comparison. For example, the income statement shows revenues when earned rather than when cash is collected. Suppose, Company X did a sale transaction of USD 500.00 on January 1, 2019, with a credit period of 30 days. The income statement will reflect the sale as on January 1, 2019; however, the cash flow statement will reflect this transaction after the company receives payment for the goods, i.e. on or after January 30, 2019.
So one may ask – how is this useful for me? As an investor, a cash flow statement is an extremely important tool to diagnose the financial health of a company. Let’s take a hypothetical example of a company who is doing extremely good sales at a very good margin never collects any payment for its sales. The company’s income statement will show how good the revenue and earnings are, however when we look at its cash flow, we will realize that the cash flow is negative, and negative cash flow is not sustainable. In order to survive, companies need cash, even better when companies are cash rich, and the indicator of cash is a cash flow statement.
Types of Cash Flows
Now that we understand the importance of cash flows, let’s see the types of cash flows in that are in use:
Operating Cash Flow
The cash flow generated from operating activities is termed as operating cash flow. Operating activities include a company’s day-to-day activities, for example, purchasing raw material or making sales. Cash inflows result from cash sales and collection of accounts receivable. This is basically the revenue generation from the main activity of the business, for example, Apple Inc.’s revenue comes from sales of its electronics. To generate these revenues, companies have to undertake operations such as purchasing raw material, manufacturing inventory, paying employees, etc. Thus cash outflows resulting from cash payments for raw material, salaries, taxes, etc.
Finally, the cash outflows are subtracted from cash inflows, and the resultant amount is operating cash flow or net cash flow from operating activities.
The formula can be derived as –
Operating Cash Flow = Cash inflow from operating activities – Cash outflow from operating activities
Investing Cash Flow
The cash flow generated from investing activities is termed as investing cash flow. Investing activities include purchase and sale of long term assets and other investments. Cash outflows are generated from investments in long-term assets and other investments include property, plant, and equipment; intangible assets; both long-term and short-term investments in equity and debt issued by other organizations; etc. The cash flow generated from the purchase of securities or assets solely for the trading purpose or for the primary business activity of the company is not included in investing cash flow. For example, if an Indian exporter hedges US dollars to minimize the effect of USD-INR price fluctuation in his current orders than the flow of cash from this hedging will go to operating cash flows and not investing cash flows.
Cash inflows include sale of non-trading securities; property, plant, and equipment; intangibles; and other long term assets. Thereafter the cash outflows are subtracted from cash inflows, and the resultant amount is investing cash flow or net cash flow from investing activities. The formula is –
Investing Cash Flow = Cash inflow from investing activities – Cash outflow from investing activities
Financing Cash Flow
Financing cash flow comes from conducting financing activities for the business. In other words, financing cash flow includes obtaining or repaying capital, be it equity or long term debt. Cash inflows in this category include cash receipts from issuing stock or bonds and from borrowing through long term loans. Cash outflows include cash payments to repurchase stock and to repay bonds and other borrowings.
Subsequently, the cash outflows are subtracted from cash inflows, and the resultant amount is financing cash flow or net cash flow from financing activities. The formula is –
Financing Cash Flow = Cash inflow from financing activities – Cash outflow from financing activities
These are the basic three cash flows. However, the term free cash flow confuses many people. So we are going to understand free cash flow as we proceed.
Free Cash Flow
Free cash flow is not a different type of cash flow, but it is more like a measure of performance. It is not specifically mentioned in any cash flow statement, so it has to be calculated separately while analyzing a company’s cash flow statement.
Free Cash Flow – Definition
So what exactly is free cash flow? Generically, the excess of operating cash flow over capital expenditure is considered as free cash flow. In layman terms, after all the operating expenses are paid, the amount of cash available to debt providers and equity holders of the company is termed as free cash flow.
Importance of Free Cash Flow
Free cash flow is a very important tool for investors. It measures the liquidity available to investors. The higher the free cash flow, the more cash-rich the company is. All this cash can be further invested in the growth of the company or can be paid a dividend. Eventually, it will increase the value of the company, and that leads to growing investor portfolio.
Calculating free cash flow to the firm can get a little tricky as the formula is a little lengthy and requires strong analytical skills. Following is the formula:
A formula for Free Cash Flow to the Firm
Free Cash Flow to the Firm = Net Income
+ Non-cash Charges (example – depreciation and amortization)
+ Interest (1-Tax Rate)
– Capital Expenditures (fixed capital such as equipment)
– Working Capital Expenditures
The resultant amount is the free cash flow available to equity and debt holders in the company.
- Financial Reporting and Analysis – CFA Institute