Project Management steps & tools
University of Malta
Institute for Tourism, Travel & Culture
Introduction to key concepts of the
What Is Cash Flow?
Cash flow is the net amount of cash and cash equivalents being transferred into and out of a business. Cash received represents
, while money spent represents
At basic level, a company’s ability to create value for shareholders is set by how able it is to generate positive cash flows. More specifically, its ability to maximise long-term free cash flow (FCF). FCF is the cash that a business generates from its normal business operations after subtracting any money spent on capital expenditures (known as CapEx).
Cash flow refers to the movement of money into and out of a business. It is generally classified as cash flowing from operations, investment 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.
As we saw, free cash flow (FCF), a measure commonly used by analysts to assess a company’s profitability, represents the cash a company generates after costs.
Understanding cash flow
A business absorbs money from sales as
and spends money on
. A company may also receive income from interest, investments, royalties, and licensing agreements. It may also sell products on credit, expecting to actually receive the cash owed at a later date.
One of the primary objectives of financial reporting is assessing the amounts, timing, and uncertainty of cash flows. Cash flows are also assessed for where they originate and where they go. This process 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. This allows it to cover obligations, reinvest in its own business, return money to shareholders, pay expenses, and provide a buffer against future financial challenges. A company with a significant financial flexibility can take advantage of profitable investments. This may translate to faring better in downturns, by avoiding the costs of financial distress.
Cash flows can be assessed using the cash flow statement. This is a standard financial statement that reports on a company’s sources and usage of cash over a specific time period.
Cash Flow Categories
Cash Flows from Operations (CFO)
CFO, also operating cash flow, is a way of describing money flows involved directly with the production and sale of goods from ordinary operations. CFO indicates whether a company has enough funds coming in to pay its bills or operating expenses or not. Clearly, there must be more operating cash inflows than cash outflows for a company to be financially viable over the long term.
Operating cash flow is calculated by taking cash received from sales and subtracting operating expenses that were paid in cash for a particular period. CFO is recorded on a company’s cash flow statement, generally reported both on a quarterly and annual basis. CFO should show whether a company can generate enough cash flow to maintain and expand operations. It can also show when a company may need external financing for capital expansion.
Note: CFO is useful in separating sales from cash received. For example, if a company generates a large sale, this boosts revenue and earnings. However, the additional revenue does not automatically boost cash flow if there it is hard to collect the payment from the customer.
Cash Flows from Investing (CFI)
CFI, or investing cash flow, shows how much cash has been generated or spent from various investment-related activities in a specific period of time. Investing activities include the following: purchases of speculative assets, investments in securities, and the sale of securities or assets.
Negative cash flow from investing activities might be due to important amounts of cash being invested in the long-term health of the company, such as research and development (R&D), and does not necessarily act as a warning sign.
Cash Flows from Financing (CFF)
CFF, or financing cash flow, illustrates the net flows of cash that are used to fund the company and its capital.
Financing activities include the following: transactions involving issuing debt, equity, and paying dividends.
Cash flow from financing activities gives investors the necessary insight into a company’s financial well-being, related to how well a company’s capital structure is managed.
Statement of Cash Flows
There are three critical parts of a company’s financial statements: the balance sheet, the income statement, and the cash flow statement. The
gives a moment-in-time snapshot of a company’s assets and liabilities. The
shows the business’s profitability in a particular period.
cash flow statement
is different from the other financial statements because it acts as a corporate checkbook that reconciles the other two statements. The cash flow statement records the company’s cash transactions (i.e. the inflows and outflows) during a given period. It shows whether all of the revenues booked on the income statement have been collected.
However, the cash flow does not necessarily show all of the company’s expenses. This is because not all expenses the company accrues are paid right away. Although the company may have incurred liabilities, any payments toward these liabilities are not recorded as a cash outflow until the transaction actually occurs.
Statement of Cash Flows
The first item to note on the cash flow statement is
the bottom line item
. This will probably be the net increase/decrease in cash and cash equivalents (CCE).
The bottom line shows the overall change in the company’s cash and its equivalents or, in other words, the assets that can directly be converted into cash over the last period.
Note: If you check under current assets on the balance sheet, you will 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.
Analysing Cash Flows
Using the cash flow statement in together with other financial statements may assist analysts and investors to get to various metrics and ratios that are used to make informed decisions and recommendations for any corrective or other actions.
Debt Service Coverage Ratio (DSCR)
Companies that may be making a profit may still fail. This may happend if their operating activities do not generate enough cash to stay
. This may happen if profits are tied up in outstanding accounts receivable and overstocked inventory, or if a company spends too much on capital expenditures (CapEx).
Therefore, investors and creditors need 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 will refert to the debt service coverage ratio (DSCR). DSCR is calculated this way:
Debt Service Coverage Ratio = Net Operating Income / Short-Term Debt Obligations (also referred to as “Debt Service”)
Neverthess, liquidity only gives us part of the picture. A company may have lots of cash if, for example, it is mortgaging its future growth potential by selling off its long-term assets or, for instance, taking on unsustainable levels of debt.
Free Cash Flow (FCF)
To understand the true profitability of a business, analysts will consider free cash flow (FCF). FCF is a very useful means of measuring financial performance. It tells a fuller story than net income. This is 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.
FCF is calculated this way:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
Unlevered Free Cash Flow (UFCF)
To measure the gross FCF generated by a firm, we use unlevered free cash flow (UFCF).
This is a company’s cash flow that does away with interest payments. It shows how much cash is available to the firm before taking financial obligations into account.
The difference between levered and unlevered FCF will show whether the business is overextended or operating with a healthy amount of debt.