Cash Flow

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DEFINITION of 'Cash Flow'

Cash flow is the net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses and provide a buffer against future financial challenges. Negative cash flow indicates that a company's liquid assets are decreasing. Net cash flow is distinguished from net income, which includes accounts receivable and other items for which payment has not actually been received. Cash flow is used to assess the quality of a company's income, that is, how liquid it is, which can indicate whether the company is positioned to remain solvent.

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BREAKING DOWN 'Cash Flow'

The accrual accounting method allows companies to count their chickens before they hatch, so to speak, by considering credit as part of a company's income. "Accounts receivable" and "settlement due from customers" can appear as line items in the assets portion of a company's balance sheet, but these items do not represent completed transactions, for which payment has been received. They do not, therefore, count as cash. (Note that the credit vs. cash distinction is not the same as it is in everyday terminology; proceeds from credit card transactions are considered cash once they are transferred.)

The opposite can also be true. A company may be receiving massive inflows of cash, but only because it is selling off its long-term assets. A company that is selling itself for parts may be building up liquidity, but it is limiting its potential for growth in the long term, and perhaps setting itself up to fail. In the same vein, a company may be taking in cash by issuing bonds and taking on unsustainable levels of debt. For these reasons it is necessary to view a company's cash flow statement, balance sheet and income statement together.

Cash Flow Statement

Often called the "statement of cash flows," the cash flow statement indicates whether a company's income is languishing in the form of IOUs – not a sustainable situation in the long term – or is translating into cash flow. Even very profitable companies, as measured by their net incomes, can become insolvent if they do not have the cash and cash-equivalents to settle short-term liabilities. If a company's profit is tied up in accounts receivable, prepaid expenses and inventory, it may not have the liquidity to survive a downturn in its business or a lawsuit. Cash flow determines the quality of a company's income; if net cash flow is less than net income, that could be a cause for concern.

Cash flow statements are divided into three categories: operating cash flow, investing cash flow and financing cash flow. Operating cash flows are those related to a company's operations, that is, its day-to-day business. Investing cash flows relate to its investments in businesses through acquisition; in long-term assets, such as towers for a telecom provider; and in securities. Financing cash flows relate to a company's investors and creditors: dividends paid to stockholders would be recorded here, as would cash proceeds from issuing bonds.

Free cash flow is defined as a company's operating cash flow minus capital expenditures. This is the money that can be used to pay dividends, buy back stock, pay off debt and expand the business.

Real World Example

Below is a reproduction of Wal-Mart Stores Inc.'s (WMT) cash flow statement for the quarter ended April 30, 2015. All amounts are in million of U.S. dollars.

Cash flows from operating activities:
     Consolidated net income 3,283
     (Income) loss from discontinued operations, net of income taxes
     Income from continuing operations 3,283
     Adjustments to reconcile consolidated net income to net cash provided by operating activities:
          Depreciation and amortization 2,319
          Deferred income taxes (159)
          Other operating activities 239
          Changes in certain assets and liabilities:
               Receivables, net 782
               Inventories (1,475)
               Accounts payable (319)
               Accrued liabilities (919)
               Accrued income taxes 695
Net cash provided by operating activities 4,446
 
Cash flows from investing activities:
     Payments for property and equipment (2,203)
     Proceeds from the disposal of property and equipment 68
     Other investing activities 22
Net cash used in investing activities (2,113)
 
Cash flows from financing activities:
     Net change in short-term borrowings (741)
     Proceeds from issuance of long-term debt 43
     Payments of long-term debt (915)
     Dividends paid (1,579)
     Purchase of Company stock (280)
     Dividends paid to noncontrolling interest (69)
     Purchase of noncontrolling interest (70)
     Other financing activities (84)
Net cash used in financing activities (3,695)
 
Effect of exchange rates on cash and cash equivalents (14)
 
Net increase (decrease) in cash and cash equivalents (1,376)
Cash and cash equivalents at beginning of year 9,135
Cash and cash equivalents at end of period 7,759

Let's begin by seeing how the cash flow statement fits in with other components of Walmart's financials. The final line in the cash flow statement, "cash and cash equivalents at end of period," is the same as "cash and cash equivalents," the first line under current assets in the balance sheet. The first number in the cash flow statement, "consolidated net income," is the same as "income from continuing operations" on the income statement. 

Because the cash flow statement only counts liquid assets, it makes adjustments to operating income in order to arrive at the operating income that flows in as cash and cash equivalents. Depreciation and amortization appear on the balance sheet in order to give a realistic picture of the lifetime value of assets. Operating cash flows, however, are considered at face value, so these adjustments are reversed. Meanwhile assets that are not in cash form are deducted: inventories, for example. Investments that appear as assets on the balance sheet are deducted, because these were presumably paid for in cash. The statement also takes debt repayments, dividends and foreign exchange impacts into account.

The main takeaway is that Walmart's cash flow was negative (a decrease of $1.38 billion) for this quarter, but that is not necessarily a bad thing as long as it retains sufficient reserves to handle short-term liabilities and fluctuations in its business.

Learn to analyze a corporation's cash flows by reading Analyze Cash Flow The Easy Way and The Essentials of Corporate Cash Flow

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