Cashflow`

What Is Cashflow?

Cashflow, often seen as the lifeblood of a business, represents the total amount of money being transferred into and out of a business. It is a critical component of financial accounting and helps assess a company's ability to generate cash, meet its obligations, and fund its operations. Unlike net income, which is calculated using accrual accounting and can include non-cash items like depreciation and amortization, cashflow focuses purely on the actual movement of cash. Positive cashflow indicates that more money is coming into the business than leaving it, while negative cashflow suggests the opposite. Analyzing cashflow is essential for understanding a company's liquidity and overall financial health.

History and Origin

While the concepts of cash receipts and disbursements have always been fundamental to business, the formal "Statement of Cash Flows" as a distinct financial statement is relatively modern. Early forms of financial reporting, such as summaries of financial transactions, can be traced back to the mid-19th century, with an example being the Northern Central Railroad's summary of cash transactions in 1863.¹¹ For many years, companies primarily reported changes in "funds," often broadly defined as working capital. This changed with the issuance of Accounting Principles Board (APB) Opinion No. 19 in 1971, which required a "statement of changes in financial position" but allowed flexibility in the definition of funds.¹⁰

The pivotal moment for cashflow reporting in the United States came in 1987 when the Financial Accounting Standards Board (FASB) issued Statement No. 95 (SFAS 95), titled "Statement of Cash Flows."⁸, ⁹ This statement mandated that all business enterprises include a statement of cash flows in their financial reports, classifying cash receipts and payments into three distinct activities: operating, investing, and financing. This standardized approach aimed to provide clearer, more consistent information about a company's cash movements, replacing the less defined "statement of changes in financial position."⁷ Internationally, the International Accounting Standards Board (IASB) also introduced International Accounting Standard (IAS) 7, which similarly requires the presentation of a statement of cash flows.⁶

Key Takeaways

• Cashflow represents the actual movement of cash into and out of a business, distinguishing it from profitability which includes non-cash items.
• It is categorized into three main activities: operating activities, investing activities, and financing activities.
• Positive cashflow is crucial for a company's short-term solvency and ability to meet its financial obligations.
• Analyzing cashflow helps stakeholders understand how a company generates and uses its cash resources, indicating its financial strength and sustainability.
• A company can be profitable on paper but still experience negative cashflow if it is not collecting its revenue quickly or is making significant capital expenditures.

Formula and Calculation

The Statement of Cash Flows typically starts with net income and adjusts for non-cash items and changes in working capital accounts (indirect method), or directly lists cash receipts and payments (direct method). While there isn't a single universal "cashflow formula" that applies to all aspects, the net cash flow from operating activities can be derived using the indirect method:

Where:

• Net Income: The company's profit after all expenses, taxes, and interest have been deducted, as reported on the income statement.
• Non-Cash Expenses: Items like depreciation and amortization that reduce net income but do not involve an actual cash outlay.
• Non-Cash Revenues: Items that increase net income but have not yet been received in cash.
• Changes in Current Assets/Liabilities: Adjustments for changes in current accounts on the balance sheet that impact cash, such as accounts receivable, inventory, and accounts payable.

The sum of cash flows from operating, investing, and financing activities gives the total change in cash for the period:

Interpreting the Cashflow

Interpreting cashflow involves more than just looking at the final number; it requires understanding the components from each of the three main activities. A healthy company typically generates strong positive cashflow from its operating activities, indicating that its core business is producing sufficient cash. Negative cashflow from operations, on the other hand, can signal fundamental problems with a company's business model or operational efficiency, potentially leading to a reliance on external financing or asset sales.

Cashflow from investing activities reflects a company's purchases and sales of long-term assets, such as property, plant, and equipment, as well as investments in other companies. A negative number here is often a positive sign, indicating that the company is investing in its future growth through capital expenditures. Conversely, significant positive cashflow from investing could mean the company is selling off assets, which might raise concerns about its long-term prospects.

Financing activities show how a company raises and repays capital. This includes issuing or repurchasing stock, issuing or repaying debt, and paying dividends. Positive cashflow from financing might indicate a company is borrowing money or issuing new shares, while negative cashflow often means it's repaying debt, buying back shares, or paying dividends to shareholders. The interpretation depends heavily on the company's stage of growth and strategic objectives.

Hypothetical Example

Consider "Alpha Tech Inc.," a software development company. For the fiscal year, Alpha Tech reports a net income of $500,000. However, to understand its true cash position, we look at its cashflow statement.

• Cash Flow from Operating Activities:

  • Net Income: $500,000
  • Add back Depreciation (non-cash expense): $50,000
  • Decrease in Accounts Receivable (customers paid up): $70,000
  • Increase in Inventory (bought more stock): -$30,000
  • Increase in Accounts Payable (delayed payments to suppliers): $40,000
  • Net Cash from Operating Activities: $500,000 + $50,000 + $70,000 - $30,000 + $40,000 = $630,000

• Cash Flow from Investing Activities:

  • Purchase of new equipment (fixed assets): -$150,000
  • Sale of old vehicle: $10,000
  • Net Cash from Investing Activities: -$150,000 + $10,000 = -$140,000

• Cash Flow from Financing Activities:

  • Issued new debt: $100,000
  • Paid dividends: -$50,000
  • Net Cash from Financing Activities: $100,000 - $50,000 = $50,000

• Total Change in Cash for the Year: $630,000 (Operating) - $140,000 (Investing) + $50,000 (Financing) = $540,000

This example shows Alpha Tech generated $630,000 in cash from its core operations, used $140,000 to invest in its future, and received a net of $50,000 from financing activities. Overall, the company's cash position increased by $540,000 during the year, indicating robust cash generation.

Practical Applications

Cashflow analysis is a cornerstone of financial assessment, finding broad applications across various aspects of business and investing.

• Investment Analysis: Investors meticulously review a company's cashflow to gauge its financial health beyond reported earnings. Strong operating cashflow is often preferred as it suggests the company can sustain itself without relying on debt or equity issuance. It is vital for calculating metrics like free cash flow, which indicates the cash available to distribute to investors or reinvest in the business after all operating expenses and capital expenditures are covered.
• Credit Analysis: Lenders scrutinize cashflow statements to assess a borrower's capacity to repay debt. Consistent, positive operating cashflow reassures banks that the company can service its obligations. It provides insight into a company's ability to cover its debt service requirements.
• Corporate Management: Businesses use cashflow projections for budgeting, planning, and day-to-day operations. Effective cashflow management ensures sufficient funds are available to pay suppliers, employees, and other immediate expenses. It helps in making decisions about expansion, research and development, and dividend policies.
• Regulatory Oversight: Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), emphasize the importance of high-quality cash flow information for investors. The SEC states that cash flow statements are integral to a complete set of financial statements and should be prepared with the same rigor as other financial reports.⁵ This focus helps ensure transparency and reliability in financial reporting.
• Valuation: Cashflow forms the basis for discounted cash flow (DCF) models, a widely used valuation method that projects future cashflows and discounts them back to the present value to estimate a company's intrinsic worth.

Limitations and Criticisms

While invaluable, cashflow analysis is not without its limitations. It provides a historical snapshot and does not inherently predict future cash movements, which can be affected by unforeseen economic shifts or market changes.⁴ A company might, for instance, delay payments to suppliers or aggressively collect receivables to temporarily boost its reported cash balance at the end of a reporting period, a practice sometimes referred to as "window dressing."³

Furthermore, the cashflow statement alone does not present a complete financial picture. It needs to be analyzed in conjunction with the balance sheet and income statement to gain comprehensive insights. For example, a high level of cash from financing activities might seem positive, but it could indicate an over-reliance on debt or new equity issuance, which may not be sustainable. Similarly, a company might show strong operating cashflow but have significant off-balance-sheet liabilities that aren't immediately apparent in the cashflow statement. Critics also point out that while standard-setters like FASB encourage the direct method of reporting operating cash flows (showing gross cash receipts and payments), most companies opt for the indirect method, which starts with net income and reconciles to cash flow, potentially obscuring detailed cash movements.² This reliance on the indirect method can make it harder for users to assess the actual cash sources and uses directly.¹

Cashflow vs. Profit

Cashflow and profit (or net income) are two distinct but interconnected measures of a company's financial performance, often confused by non-experts.

A common point of confusion is that a profitable company can still run out of cash. This can happen if customers delay payments (increasing accounts receivable), if the company invests heavily in new assets (capital expenditures), or if it holds a large amount of inventory that is not selling quickly. Conversely, a company might show negative profit but have positive cashflow if, for example, it is selling off assets or receiving large amounts of cash from new loans or equity infusions. Both metrics are essential for a complete understanding of a company's financial standing.

FAQs

What are the three types of cashflow?

The three primary types of cashflow, as reported on the statement of cash flows, are cashflow from operating activities, investing activities, and financing activities. Each category represents cash movements related to different aspects of a company's business.

Why is positive cashflow important?

Positive cashflow is crucial because it indicates that a company is generating enough cash from its operations to cover its expenses, repay debts, fund investments, and distribute funds to shareholders. It is a direct measure of a company's financial liquidity and its ability to remain solvent and grow.

How is cashflow different from profit?

Cashflow measures the actual money coming into and going out of a business, while profit (or net income) is a measure of a company's profitability calculated by subtracting expenses from revenue over a period, often including non-cash items like depreciation. A company can be profitable but still experience negative cashflow if it's not effectively managing its cash movements.

What is free cashflow?

Free cashflow is a measure of the cash a company generates after accounting for cash outlays to support or expand its asset base. It is typically calculated as cash flow from operating activities minus capital expenditures. It represents the cash available to debt holders and equity holders after all necessary investments in operating assets have been made.

Can a company have negative cashflow but still be healthy?

Yes, a company can have negative cashflow and still be healthy, especially if the negative cashflow is primarily from investing activities (e.g., significant investments in new equipment, technology, or acquisitions for future growth). However, consistently negative cashflow from operating activities usually signals underlying financial problems and may not be sustainable long-term.