Financial Literacy

What Is Cash Flow?

When evaluating the financial health of a business, cash flow is one of the most important metrics to consider. Cash flow represents the amount of money transferred in and out of an entity, representing the organization’s activities. The key to a healthy, profitable business is to have more inflow than outflow. 

Cash flow is a seemingly simple concept that can get very complex very quickly. It’s not as simple as tracking revenue vs. expenses. Understanding cash flow takes comprehension of accrual basis accounting – specifically accounts payable and receivable. When and where cash comes from and goes to matters as much as the amounts. Here’s what every business (and investor) should know about cash flow. 

Cash flow can stack up or fall

The Basics of Cash Flow

At its core, cash flow accounts for every dollar that comes into a business and every dollar that goes out. This fundamental concept is what determines profitability. If a business brings in more cash than it pays out, it’s profitable – regardless of the origin or destination of inflows and outflows. 

That said, it’s important to understand where cash comes from and where it goes. There are several types of cash flow that comprise overall business:

  • Operational. This is cash spent or received as the result of normal business operations. Examples include revenue from sales or payment for materials. 
  • Investment. This is cash that’s spent or received via investment activities. Examples include buying inventory or the purchase of marketable securities.
  • Financing. This is cash that’s received as the result of debt payments to the company or paid out as repayment against debt.

Ultimately, businesses need to be mindful of revenue sources (inflows) and expenses (outflows) as part of operations. There are many levers available to businesses when it comes to dictating cash flow, and staying cognizant of it can help them avoid a cash crunch. 

A cash crunch occurs when cash outflows exceed inflows. Essentially, this means the business is spending more than it’s bringing in. Over time, this can lead to insolvency and, ultimately, bankruptcy. 

Importance of Financial Health

Cash flow is important for the obvious reason that it paints a picture of the business’ financial health. Looking at a statement makes it easy to see how frequently a business has money coming in and what its regular financial obligations look like. Moreover, it represents financial health over time, which can help investors contextualize operations from a financial standpoint. 

For businesses, cash flow can set the tone for a number of other important operational aspects. For example, if cash leaves a business faster than it comes in, the business may struggle to cover its short-term financial obligations. Moreover, pinpointing where cash comes from and where it’s owed can help a business better manage its books. 

Above all, healthy cash flow brings financial freedom to a company. Positive cash flow gives businesses a buffer between inflow and outflow. This makes paying expenses easier and brings some predictability to operations. For example, companies can afford to hire more employees or stock more inventory if they have strong free cash flows. On the flip side, a cash crunch may send companies seeking a bridge loan or line of credit as a buffer to protect against insolvency. 

What Is Free Cash Flow?

Free cash flow specifically looks at the cash a company generates from normal business operations, after accounting for capital expenses. It’s a measure of profitability that excludes noncash expenses and includes spending on equipment and assets, and changes in working capital. At its core, free cash flow represents the real cash available to a company to repay debt or, for larger companies, to pay a dividend to shareholders.  

There are some drawbacks to free cash flow when viewed in a vacuum, such as accounting for depreciation of assets over time. Moreover, free cash flow is only as accurate as a company is transparent. Without a full accounting of the company’s free cash flow, investors may not truly understand the practices that contribute to it. Nevertheless, free cash flow is an important and useful metric for evaluating the financial health of a business. 

What Is a Cash Flow Statement?

It’s important for businesses to track cash flows and for that information to be readily available to executives and investors alike. This is where a company’s cash flow statement comes in. 

This statement is effectively a checkbook for the business: a representation of inflows and outflows. Moreover, the statement summarizes the cash entering and leaving a company and shows where it’s coming from and going to. It shows each of the three types of cash flow (see above) and may include a disclosure of noncash activities affecting cash on-hand. It’s important to note that a cash flow statement differs from a business income statement. It doesn’t account for future incoming and outgoing cash recorded as credit in the ledger. 

From a business standpoint, a cash flow statement is useful for budgeting and predicting future cash flows. Looking back at the statement shows a regular pattern of inflow and outflow and can clue a company in to where it needs to create stability.

Essential for Business Success

Cash flow seems like such a simple concept: Bring in more money than you spend. But it can be extremely complex. Understanding where money comes from, when it comes in and what’s generating it is essential in orchestrating the operations that lead a business to profitability. For businesses, cash flow management is a cornerstone of sound operations. For investors, understanding a company’s cash flow statement and what it means for the business’ financial health is imperative for smart investment decision making. Sign up for the Trade of the Day e-letter below for instant access to daily stock picks, tips and analysis. The experts at Trade of the Day do the research for you on trends and price movement!


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