What Are External Cash Flows?
External cash flows refer to the movement of money into or out of a business from sources outside its core operational activities. These flows are primarily captured within the investing activities and financing activities sections of a company's cash flow statement, a key component of its financial statements. Understanding external cash flows is crucial in the field of financial accounting, as they provide insight into how a company raises capital and invests in its long-term future, distinct from the cash generated or consumed by its day-to-day operations.
History and Origin
The formal requirement for companies to report cash flows, including external cash flows, evolved over time. Early financial reports sometimes included summaries of cash receipts and disbursements, but a standardized cash flow statement was not always a core component of financial reporting. In the United States, the Financial Accounting Standards Board (FASB) issued Statement No. 95, "Statement of Cash Flows," in 1987, which formally mandated that businesses classify cash receipts and payments into operating, investing, and financing activities, making the statement of cash flows a required part of financial reporting starting in 1988.25, 26 Globally, the International Accounting Standards Board (IASB) adopted International Accounting Standard 7 (IAS 7), "Cash Flow Statements," in 1992, effective from 1994, which similarly required firms to provide cash flow statements.24 This standardization ensured greater transparency and comparability in how companies reported their external cash flows, providing a clearer picture of their capital structure and investment strategies.
Key Takeaways
- External cash flows represent money movements from non-operating activities, primarily related to a company's investments and financing.
- They are categorized into investing activities and financing activities on the statement of cash flows.
- Positive external cash flows from financing often indicate a company is raising capital (e.g., through debt or equity issuance).
- Negative external cash flows from investing typically mean a company is acquiring assets for growth (e.g., property, plant, equipment).
- Analyzing external cash flows helps stakeholders understand a company's long-term strategic decisions regarding growth and capital management.
Formula and Calculation
While there isn't a single "external cash flows" formula, these flows are integral components of the overall net change in cash on a company's cash flow statement. The statement generally follows this structure:
External cash flows are specifically represented by the sum of cash flow from investing activities and cash flow from financing activities.
- Cash Flow from Investing Activities (CFI): This reflects cash generated or used from the purchase or sale of long-term assets, such as property, plant, equipment, and investments in other businesses. For example, a cash outflow occurs when a company makes capital expenditures to buy new machinery.22, 23
- Cash Flow from Financing Activities (CFF): This section reports cash movements related to a company's debt and equity capital. Inflows include issuing new shares or borrowing money, while outflows include repaying loans, repurchasing stock, or paying dividends.19, 20, 21
Interpreting External Cash Flows
Interpreting external cash flows requires understanding the strategic implications behind the cash movements.
For investing activities, a negative cash flow often indicates that a company is investing heavily in its future growth by acquiring long-term assets or other businesses. While this reduces short-term cash, it can be a positive sign for long-term expansion and competitiveness. Conversely, a positive cash flow from investing, often due to significant asset sales, might suggest a company is divesting assets or struggling to generate cash from operations, potentially signaling financial distress.18
For financing activities, a positive cash flow typically means the company is raising capital, either by issuing new shares or taking on additional debt. This can fund expansion, acquisitions, or cover operational shortfalls. A negative cash flow from financing suggests the company is repaying debt, buying back its own shares, or distributing dividends, which can signal financial strength and a commitment to shareholder value. However, excessive reliance on external financing, particularly debt, can increase interest expenses and financial risk.17
Hypothetical Example
Consider "Tech Innovations Inc.," a growing software company.
In a given quarter, Tech Innovations Inc. reports the following:
- Cash Flow from Operating Activities: +$2,000,000 (from software sales and services)
- Cash Flow from Investing Activities: -$1,500,000 (spent on purchasing a new office building and upgrading servers)
- Cash Flow from Financing Activities: +$1,000,000 (received from issuing new common stock to fund expansion)
In this scenario, the external cash flows total -$500,000 ($-1,500,000 from investing + $1,000,000 from financing). This negative figure indicates that while the company generated cash from its operations, it invested significantly more in long-term assets than it raised from external capital markets during that period. This pattern is common for rapidly expanding companies, as they often require substantial capital expenditures to fuel growth. If these investments are strategic, they can lead to increased operational capacity and future revenue streams. The financing inflow suggests the company successfully attracted new investors to support its growth initiatives. This snapshot from the cash flow statement, alongside the balance sheet and income statement, helps paint a comprehensive picture of the company's financial movements.
Practical Applications
External cash flows are critically important for various stakeholders in assessing a company's financial health and strategic direction.
- Investment Decisions: Investors closely examine external cash flows, especially financing activities, to understand how a company funds its growth. A company that consistently generates strong operating cash flows and invests in strategic assets, even if it results in negative investing cash flow, may be seen as a sound long-term investment. Conversely, a company heavily reliant on external financing to cover operational shortfalls might signal concerns.16
- Credit Analysis: Lenders analyze financing cash flows to assess a company's ability to service and repay its debt obligations. A healthy history of managing debt and equity issuances responsibly can enhance creditworthiness.
- Strategic Planning: Management teams use external cash flow data to inform decisions about capital allocation, potential acquisitions, and fundraising strategies. For instance, a tech company might invest heavily in research and development or purchase expensive equipment, resulting in negative cash flow from investing activities, signaling an intent for significant future growth.15
- Mergers and Acquisitions (M&A): The financing section of the cash flow statement reveals how acquisitions are funded (e.g., through debt or equity), while the investing section shows the cash outflow for the acquisition itself. Analyzing these flows provides insight into the deal's financial impact. The overall importance of robust cash flow analysis for corporations is highlighted in academic discussions, underscoring its role in determining a company's liquidity, solvency, and overall financial health.14
Limitations and Criticisms
While external cash flows provide valuable insights, relying solely on them can offer an incomplete picture of a company's financial standing.
One limitation is that significant external cash outflows for investing activities, such as large capital expenditures or acquisitions, can make a company's overall net cash flow appear negative, even if its core operations are highly profitable. This negative net cash flow might be misinterpreted as a sign of weakness when, in fact, it reflects strategic growth initiatives. Conversely, a positive investing cash flow driven by the sale of core assets might artificially inflate overall cash flow while signaling a reduction in future productive capacity.
Furthermore, in financing activities, a company might generate positive external cash flows by taking on substantial new debt or issuing a large amount of new equity. While this boosts current cash, it could lead to increased financial leverage, higher interest expenses, or dilution for existing shareholders, posing long-term risks. Over-reliance on external financing without a clear path to generating sufficient operating cash flow can be a red flag for potential liquidity issues and sustainability.12, 13 Cash flow analysis, while powerful, does not always capture the true profitability and efficiency of a business as it may overstate or understate revenues and expenses in each period compared to accrual accounting.11
External Cash Flows vs. Internal Cash Flows
The distinction between external and internal cash flows lies in their origin and purpose.
External cash flows originate from outside the company's primary business operations. They primarily encompass activities from the investing and financing sections of the cash flow statement. Examples include cash received from issuing new shares or taking out loans (financing inflows) and cash paid for acquiring property, plant, and equipment or other businesses (investing outflows). These flows are about how a company raises capital and strategically deploys it for long-term growth or capital structure management.
Internal cash flows, on the other hand, are generated from within the company's existing operations. The most significant component is cash flow from operating activities, which includes cash generated from sales, collecting accounts receivable, and cash paid for expenses like salaries, rent, and inventory.10 Other forms of internal financing include retained earnings or the sale of existing, often non-core, assets.8, 9 Internal cash flows reflect a company's ability to self-sustain and fund its day-to-day operations without needing to seek outside capital. While internal sources are often more cost-effective and provide greater control, they may not be sufficient for large-scale expansion or significant investment needs.6, 7
FAQs
What are the main types of external cash flows?
The main types of external cash flows are those related to investing activities (e.g., buying or selling long-term assets, acquiring other companies) and financing activities (e.g., issuing stock, borrowing money, paying dividends, repaying debt).5
Why are external cash flows important for a business?
External cash flows are important because they show how a business funds its growth and manages its capital structure. They indicate whether a company is expanding through acquisitions, investing in new assets, or raising funds from investors or lenders. This information is crucial for assessing a company's long-term strategy and financial health.4
Can a company have negative external cash flows and still be healthy?
Yes, a company can have negative external cash flows and still be healthy, especially if the negative flow is from investing activities, indicating significant strategic investments in future growth, and the company has strong positive operating activities cash flow. However, persistently negative financing cash flow could indicate heavy debt repayment or significant share buybacks, which need to be evaluated in context.3
How do external cash flows relate to the cash flow statement?
External cash flows make up two of the three main sections of the cash flow statement: investing activities and financing activities. The third section, operating activities, represents internal cash flows. Together, these three sections reconcile the changes in a company's cash and cash equivalents over a period.
What's the difference between external cash flows and cash flow from operations?
External cash flows (investing and financing) are about how a company raises capital and invests in assets for future growth, or how it distributes funds to shareholders and creditors.2 Cash flow from operating activities is the cash generated or used by a company's core business functions—producing and selling goods or services. It represents the everyday money movements crucial for day-to-day survival and short-term liquidity.1