What is Cash Flow?
Cash flow is the net amount of cash and cash-equivalents being transferred into and out of a business. At the most fundamental level, a company’s ability to create value for shareholders is determined by its ability to generate positive cash flows, or more specifically, maximize long-term free cash flow (FCF).
- Positive cash flow indicates that a company is adding to its cash reserves, allowing it to reinvest in the company, pay out money to shareholders, or settle future debt payments.
- Cash flow comes in three forms: operating, investing, and financing.
- Operating cash flow includes all cash generated by a company's main business activities.
- Investing cash flow includes all purchases of capital assets and investments in other business ventures.
- Financing cash flow includes all proceeds gained from issuing debt and equity as well as payments made by the company.
- Free cash flow, a measure commonly used by analysts to assess a company's profitability, represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
Understanding Cash Flow
How Cash Flow is Used
Assessing the amounts, timing, and uncertainty of cash flows is one of the most basic objectives of financial reporting. Understanding the cash flow statement – which reports operating cash flow, investing cash flow, and financing cash flow — is essential for assessing a company’s liquidity, flexibility, and overall financial performance.
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. Companies with strong financial flexibility can take advantage of profitable investments. They also fare better in downturns, by avoiding the costs of financial distress.
Analyzing Cash Flow
Debt Service Coverage Ratio
Even profitable companies can fail if their operating activities do not generate enough cash to stay liquid. This can happen if profits are tied up in outstanding accounts receivable and overstocked inventory, or if a company spends too much on capital expenditures.
Investors and creditors, therefore, want to know if the company has enough cash and cash-equivalents to settle short-term liabilities. To see if a company can meet its current liabilities with the cash it generates from operations, analysts look at the debt service coverage ratio.
Debt Service Coverage Ratio = Net Operating Income / Short-Term Debt Obligations (also referred to as "Debt Service")
But liquidity only tells us so much. A company might have lots of cash because it is mortgaging its future growth potential by selling off its long-term assets or taking on unsustainable levels of debt.
Free Cash Flow
To understand the true profitability of the business, analysts look at free cash flow. It is a really useful measure of financial performance – that tells a better story than net income — because it shows what money the company has left over to expand the business or return to shareholders, after paying dividends, buying back stock, or paying off debt.
Free Cash Flow = Operating Cash Flow - Capital Expenditures
Unlevered Free Cash Flow
For a measure of the gross free cash flow generated by a firm, use unlevered free cash flow. This is a company's cash flow excluding interest payments, and it shows how much cash is available to the firm before taking financial obligations into account. The difference between levered and unlevered free cash flow shows if the business is overextended or operating with a healthy amount of debt.
Real World Example of Cash Flow
|Cash flows from operating activities:|
|Consolidated net income||7,179|
|(Income) loss from discontinued operations, net of income taxes||—|
|Income from continuing operations||7,179|
|Adjustments to reconcile consolidated net income to net cash provided by operating activities:|
|Unrealized (Gains) and Losses||3,516|
|(Gains) and Losses for Disposal of Business Operations||4,850|
|Depreciation and amortization||10,678|
|Deferred income taxes||(499)|
|Other operating activities||1,734|
|Changes in certain assets and liabilities:|
|Accrued income taxes||(40)|
|Net cash provided by operating activities||27,753|
|Cash flows from investing activities:|
|Payments for property and equipment||(10,344)|
|Proceeds from the disposal of property and equipment||519|
|Proceeds from the disposal of certain operations||876|
|Payments for business acquisitions, net of cash acquired||(14,656)|
|Other investing activities||(431)|
|Net cash used in investing activities||(24,036)|
|Cash flows from financing activities:|
|Net change in short-term borrowings||(53)|
|Proceeds from issuance of long-term debt||15,872|
|Payments of long-term debt||(3,784)|
|Purchase of Company stock||(7,410)|
|Dividends paid to noncontrolling interest||(431)|
|Other financing activities||(629)|
|Net cash used in financing activities||(2,537)|
|Effect of exchange rates on cash and cash equivalents||(438)|
|Net increase (decrease) in cash and cash equivalents||742|
|Cash and cash equivalents at beginning of year||7,014|
|Cash and cash equivalents at end of year||7,756|
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 year," 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 the bottom line, "income from continuing operations" on the income statement.
Because the cash flow statement only counts liquid assets in the form of cash and cash equivalents, it makes adjustments to operating income in order to arrive at the net change in cash. Depreciation and amortization expense appear on the income statement in order to give a realistic picture of the decreasing value of assets over their useful life. Operating cash flows, however, only consider transactions that impact cash, so these adjustments are reversed.
Meanwhile, the net change in assets that are not in cash form, such as accounts receivable and inventories, are also eliminated from operating income. For example, in Walmart's cash flow statement, $368 million in net receivables are deducted from operating income. From that, we can infer that there was a $368 million increase in receivables over the prior year.
This increase would have shown up in operating income as additional revenue, but the cash had not yet been received by year end. Thus, the increase in receivables needed to be reversed out to show the net cash impact of sales during the year. The same elimination occurs for current liabilities in order to arrive at the cash flow from operating activities figure.
Investments in property, plant, and equipment and acquisitions of other businesses are accounted for in the cash flow from investing activities section. Proceeds from issuing long-term debt, debt repayments, and dividends paid out are accounted for in the cash flow from financing activities section.
The main takeaway is that Walmart's cash flow was positive (an increase of $742 million) for this year. That indicates that it has retained cash in the business and added to its reserves in order to handle short-term liabilities and fluctuations in the future.