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.

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Understanding Cash Flow

BREAKING DOWN Cash Flow

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.

Even profitable companies can fail if operating activities do not generate enough cash to stay liquid. This can happen if profits are tied up in accounts receivable and inventory, or if a company spends too much on capital expenditure. 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 debt service coverage ratios.

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 (FCF). 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 leftover 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 - dividends (though some companies don’t because dividends are viewed as discretionary).

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 before taking interest payments into account and 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

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 millions 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