Cash flow
In finance, cash flow refers to the amounts of cash being received and spent by a business during a defined period of time, sometimes tied to a specific project.
Most of the time cash flows are being used to determine gaps in the liquid position of a company. For this reason only the total amount of cash flowing in and out of a company matters. However when using cash flows as a benchmark tool (for example when calculating the internal rate of return) it is better to separate the total cash flow into separate cash flows streams. Another reason for separating the different types of flows is that it makes it much easier to read cash flows statements and to determine when earnings are being manipulated.
There are multiple types of flows of incoming and outgoing cash that are included in the total cash flow amount:
- Operational cash flows: Cash received or spent during the company’s core business.
- Investment cash flows: Cash received or spent by buying or selling capital expenditures, investment or acquisitions.
- Financing cash flows: Cash received or spent during the moving of cash between the company and the debtors and creditors.
The following example shows a positive cash flow of $40:
Example
| Transaction | In | Out |
|---|---|---|
| Incoming Loan | +$50.00 | |
| Sales (which were paid for in cash) | +$30.00 | |
| Materials | -$10.00 | |
| Labor | -$10.00 | |
| Purchased Capital | -$10.00 | |
| Loan Repayment | -$5.00 | |
| Taxes | -$5.00 |
| Total.......................................... | .......+$40.00....... |
|---|
In this example the following types of flows are included:
- Incoming loan: financial flow
- Sales: operational flow
- Materials: operational flow
- Labor: operational flow
- Purchased Capital: Investment flow
- Loan Repayment: financial flow
- Taxes: financial flow
Let us, for example, compare two companies using only total cash flow and then separate cash flow streams. The last three years show the following total cash flows:
Company A:
Year 1: cash flow of +10M
Year 2: cash flow of +11M
Year 3: cash flow of +12M
Company B:
Year 1: cash flow of +15M
Year 2: cash flow of +15M
Year 3: cash flow of +17M
Company B has a higher monthly cash flow and looks like a better one in which to invest. Now let us see how their cash flows are made up:
Company A:
Year 1: OC: +20M FC: +5M IC: -15M = +10M
Year 2: OC: +21M FC: +5M IC: -15M = +11M
Year 3: OC: +22M FC: +5M IC: -15M = +12M
Company B:
Year 1: OC: +10M FC: +5M IC: 0 = +15M
Year 2: OC: +11M FC: +5M IC: 0 = +16M
Year 3: OC: +12M FC: +5M IC: 0 = +17M
- OC = Operational Cash, FC = Financial Cash, IC = Investment Cash
Now it seems that Company A is actually earning more cash by its core activities and has already spent 45M in long term investments, of which the revenues will only show up after three years. When comparing investments using cash flows always make sure to use the same cash flow layout.
See also
- Cash flow statement
- Free cash flow
- Cash is king
- Discounted cash flow
- Internal rate of return
- Net present value
- Income statement
- Balance sheet
- Cash on cash return