Lately, several new startup entrepreneurs have asked me to define cash flow. Cash flow is the term used to describe the movement of cash into and out of a business during a specific period. Companies analyze and track three different types of cash flows: the cash flow from operating activities, investing activities and financing activities.
Here are some definitions for these types of cash flows:
- Operating cash flow refers to the cash generated by a business’s everyday operations and activities. To maintain growth and expansion, companies must have a positive operating cash flow.
- Investment cash flow refers to the cash generated from investment activities that the business took part in. For example, purchasing physical assets like property and equipment. For businesses actively investing in their company and doing it correctly, their investment cash flow will be negative.
- Financing cash flow refers to the cash that is generated to finance the company and includes the costs of raising capital, dividend payments and debt.
The cash flow statement is a financial document designed to help provide a detailed analysis of what happens to a company’s cash during a specific period, making it useful for short-term planning. This statement can also:
- Show the source of the money coming in
- Monitor outgoing funds
- Inform about cash outflows, as well as fees paid for business activities and other investments at a specific point in time
- Help maintain an optimum level of cash on hand
- Help companies focus on generating cash
A cash flow statement is usually made up of three sections: the cash flow from operating activities; the cash flow from investing activities; and the cash flow from financing activities. As a result, when preparing a cash flow statement, be sure to follow the following steps.
- Step one: Determine the beginning balance of the cash and cash equivalents at the beginning of the reporting period. This value is found on the income statement. It should also be noted that this balance is necessary when trying to leverage the indirect method of calculating cash flow from operating activities, but it’s not required in the direct method.
- Step two: Figure out the cash flow from operating activities. This number will reveal how much cash the business produced from its operations. Cash flow from operating activities can be calculated by using either the direct or indirect method.
- The direct method takes all the cash collections from operations and subtracts the cash disbursements from the operational activities to get the net income.
- The indirect method starts with the net income from the income statement and adjust it to undo the impact of the accruals made during the reporting period. Essentially, this method requires the addition or subtraction of the non-cash revenue and expense items the company has from the net income to calculate the implied cash flow.
- Although both methods will have the same result, the process of calculating each will differ. Even though the direct method may seem easier to understand, it is often more time-consuming because it requires accounting for every type of transaction that took place during the reporting window.
- Step three: Determine the cash flow from investing activities. This section will detail cash flow related to the buying and selling of long-term assets, such as equipment or property.
- Step four: Calculate the cash flow from financing activity by examining the cash outflows and inflows related to the company’s financing activities. This includes cash flow from both debt and equity financing.
- Step five: Calculate the ending balance. To do this, add all the cash flows from all the activities. The value will show the total amount of cash the company lost or gained during the reporting period. A positive value means the company has more cash coming in than going out, while a negative value indicates that the company is spending more than it is earning.
When analyzing the cash flow statement, don’t forget to look at the free cash flow (FCF)…the funds that remain after a business pays to support its operations and maintain its capital assets. There are several different types of free cash flow. The ones that are most frequently used include:
- Free cash flow to the firm (FCFF) (also referred to as “un-levered”) represents the amount of cash flow from business operations available for distribution after accounting for taxes, depreciation costs, investments and working capital. In essence, it is the measure of a company’s profitability and represents the available cash flow to a business if it was debt-free.
- Free cash flow to equity (FCFE) (also known as “levered”) is the amount of money a business can make that is also available to be distributed to its shareholders. This amount is calculated by taking the cash from operations and subtracting it from capital expenditures plus the net debt issued.
FCF gives companies, managers and investors an important insight into the financial health of a business and its overall value. When there is a large amount of FCF, it can mean that the company will have enough funds to pay back their expenses with some money left over. This leftover can be used to reinvest in the business and pay investors or buy back stocks.
It is often observed that companies with high FCF figures are doing well and may want to expand. That is why investors are attracted to businesses with rising free cash flow because they are more able to produce a rate of return. In comparison a business with low FCF can mean that there is little money left for them after they pay out their expenses and costs. Consequently, investors are usually not attracted to these types of businesses as their future earnings prospects are often low.
If your company is looking for metrics to help it determine how well it is doing financially, analyzing the cash flow is a great way to keep track of key data that can help the business plan for the future while ensuring having enough cash to help get through some rainy days.
Be sure to view the free micro-videos entitled “The Financials – Managing Your Business Session 1 Understanding Key Concepts“.
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