Cash Flow

What Is Cash Flow?

The term cash flow refers to the net amount of cash and cash equivalents being transferred in and out of a company. Cash received represents inflows, while money spent represents outflows. A company’s ability to create value for shareholders is fundamentally determined by its ability to generate positive cash flows or, more specifically, to maximize long-term free cash flow (FCF). FCF is the cash generated by a company from its normal business operations after subtracting any money spent on capital expenditures (CapEx).

Key Takeaways

  • Cash flow is the movement of money in and out of a company.
  • Cash received signifies inflows, and cash spent signifies outflows.
  • The cash flow statement is a financial statement that reports on a company's sources and usage of cash over some time.
  • A company's cash flow is typically categorized as cash flows from operations, investing, and financing.
  • There are several methods used to analyze a company's cash flow, including the debt service coverage ratio, free cash flow, and unlevered cash flow.
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Understanding Cash Flow

Understanding Cash Flow

Cash flow is the amount of cash that comes in and goes out of a company. Businesses take in money from sales as revenues and spend money on expenses. They may also receive income from interest, investments, royalties, and licensing agreements and sell products on credit, expecting to actually receive the cash owed at a late date.

Assessing the amounts, timing, and uncertainty of cash flows, along with where they originate and where they go, is one of the most important objectives of financial reporting. It 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 cover obligations, 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.

Cash flows can be analyzed using the cash flow statement, a standard financial statement that reports on a company's sources and usage of cash over a specified time period. Corporate management, analysts, and investors are able to use it to determine how well a company can earn cash to pay its debts and manage its operating expenses. The cash flow statement is one of the most important financial statements issued by a company, along with the balance sheet and income statement.

Cash flow can be negative when outflows are higher than a company's inflows.

Special Considerations

As noted above, there are three critical parts of a company's financial statements:

  • The balance sheet, which gives a one-time snapshot of a company's assets and liabilities
  • The income statement, which indicates the business's profitability during a certain period
  • The cash flow statement, which acts as a corporate checkbook that reconciles the other two statements. It records the company's cash transactions (the inflows and outflows) during the given period. It shows whether all of the revenues booked on the income statement have been collected.

But the cash flow does not necessarily show all the company's expenses. That's because not all expenses the company accrues are paid right away. Although the company may incur liabilities, any payments toward these liabilities are not recorded as a cash outflow until the transaction occurs.

The first item to note on the cash flow statement is the bottom line item. This is likely to be recorded as the net increase/decrease in cash and cash equivalents (CCE). The bottom line reports the overall change in the company's cash and its equivalents (the assets that can be immediately converted into cash) over the last period.

If you check under current assets on the balance sheet, that's where you'll find CCE. If you take the difference between the current CCE and that of the previous year or the previous quarter, you should have the same number as the number at the bottom of the statement of cash flows.

Types of Cash Flow

Cash Flows From Operations (CFO)

Cash flow from operations (CFO), or operating cash flow, describes money flows involved directly with the production and sale of goods from ordinary operations. CFO indicates whether or not a company has enough funds coming in to pay its bills or operating expenses. In other words, there must be more operating cash inflows than cash outflows for a company to be financially viable in the long term.

Operating cash flow is calculated by taking cash received from sales and subtracting operating expenses that were paid in cash for the period. Operating cash flow is recorded on a company's cash flow statement, which is reported both on a quarterly and annual basis. Operating cash flow indicates whether a company can generate enough cash flow to maintain and expand operations, but it can also indicate when a company may need external financing for capital expansion. 

Note that CFO is useful in segregating sales from cash received. If, for example, a company generated a large sale from a client, it would boost revenue and earnings. However, the additional revenue doesn't necessarily improve cash flow if there is difficulty collecting the payment from the customer.

Cash Flows From Investing (CFI)

Cash flow from investing (CFI) or investing cash flow reports how much cash has been generated or spent from various investment-related activities in a specific period. Investing activities include purchases of speculative assets, investments in securities, or the sale of securities or assets.

Negative cash flow from investing activities might be due to significant amounts of cash being invested in the long-term health of the company, such as research and development (R&D), and is not always a warning sign.

Cash Flows From Financing (CFF)

Cash flows from financing (CFF), or financing cash flow, shows the net flows of cash that are used to fund the company and its capital. Financing activities include transactions involving issuing debt, equity, and paying dividends. Cash flow from financing activities provide investors with insight into a company’s financial strength and how well a company's capital structure is managed.

Cash Flow vs. Profit

Contrary to what you may think, cash flow isn't the same as profit. It isn't uncommon to have these two terms confused because they seem very similar. Remember that cash flow is the money that goes in and out of a business.

Profit, on the other hand, is specifically used to measure a company's financial success or how much money it makes overall. This is the amount of money that is left after a company pays off all its obligations. Profit is whatever is left after subtracting a company's expenses from its revenues.

How to Analyze Cash Flows

Using the cash flow statement in conjunction with other financial statements can help analysts and investors arrive at various metrics and ratios used to make informed decisions and recommendations.

Debt Service Coverage Ratio (DSCR)

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 (AR) and overstocked inventory, or if a company spends too much on capital expenditures (CapEx).

Investors and creditors, therefore, want to know if the company has enough CCE 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 (DSCR).

Debt Service Coverage Ratio = Net Operating Income / Short-Term Debt Obligations (or 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 (FCF)

Analysts look at free cash flow (FCF) to understand the true profitability of a business. FCF is a really useful measure of financial performance and 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 - CapitalEx

Unlevered Free Cash Flow (UFCF)

Use unlevered free cash flow (UFCF) for a measure of the gross FCF generated by a firm. 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 FCF shows if the business is overextended or operating with a healthy amount of debt.

Example of Cash Flow

Below is a reproduction of Walmart's cash flow statement for the fiscal year ending on Jan. 31, 2019. All amounts are in millions of U.S. dollars.

Walmart Statement of Cash Flows (2019)
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:  
Receivables, net (368)
Inventories (1,311)
Accounts payable 1,831
Accrued liabilities 183
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)
Dividends paid (6,102)
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

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 CCE, 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.

The net change in assets not in cash, such as AR and inventories, are also eliminated from operating income. For example, $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 wasn't received yet 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 (PP&E) and acquisitions of other businesses are accounted for in the cash flow from the 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). 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.

How Are Cash Flows Different Than Revenues?

Revenues refer to the income earned from selling goods and services. If an item is sold on credit or via a subscription payment plan, money may not yet be received from those sales and are booked as accounts receivable. But these do not represent actual cash flows into the company at the time. Cash flows also track outflows as well as inflows and categorize them with regard to the source or use.

What Are the Three Categories of Cash Flows?

The three types of cash flows are operating cash flows, cash flows from investments, and cash flows from financing.

Operating cash flows are generated from the normal operations of a business, including money taken in from sales and money spent on cost of goods sold (COGS), along with other operational expenses such as overhead and salaries.

Cash flows from investments include money spent on purchasing securities to be held as investments such as stocks or bonds in other companies or in Treasuries. Inflows are generated by interest and dividends paid on these holdings.

Cash flows from financing are the costs of raising capital, such as shares or bonds that a company issues or any loans it takes out.

What Is Free Cash Flow and Why Is It Important?

Free cash flow is the cash left over after a company pays for its operating expenses and CapEx. It is the money that remains after paying for items like payroll, rent, and taxes. Companies are free to use FCF as they please.

Knowing how to calculate FCF and analyze it helps a company with its cash management and will provide investors with insight into a company's financials, helping them make better investment decisions.

FCF is an important measurement since it shows how efficient a company is at generating cash.

Do Companies Need to Report a Cash Flow Statement?

The cash flow statement complements the balance sheet and income statement and is a mandatory part of a public company's financial reporting requirements since 1987.

Why Is the Price-to-Cash Flows Ratio Used?

The price-to-cash flow (P/CF) ratio is a stock multiple that measures the value of a stock’s price relative to its operating cash flow per share. This ratio uses operating cash flow, which adds back non-cash expenses such as depreciation and amortization to net income.

P/CF is especially useful for valuing stocks that have positive cash flow but are not profitable because of large non-cash charges.

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  1. U.S. Securities and Exchange Commission. "Form 10-K, Walmart: Consolidated Statements of Cash Flows." Accessed Dec. 1, 2021.

  2. Financial Accounting Standards Board. “Statement of Financial Accounting Standards No. 95,” Page 4. Accessed Dec. 1, 2021.