Cash flow

 

Introduction to cash flow

What is “cash flow”? It is the term used in business and personal finance to describe the cash coming into or going out of a business or a personal account during a given period.

What does cash flow show? In the case of a business, the cash flow — inflow and outflow — shows the following:

  • It indicates the cash income of the company concerned—for example, from sale of products—during a specified period.
  • It indicates the cash expenditure of the company—for example, on payment of salaries and purchase of raw materials for the manufacture of products.

Similarly, in personal finance, cash inflow indicates income from salary, for example, and cash outflow indicates expenditure on household necessities and personal investments.
 

Positive and negative cash flow

If the cash inflow of a business is higher than its cash outflow, it is said to have a positive cash flow. This means that the business generates adequate cash to meet its expenditures.

For example, if a retail store earned a revenue of Rs. 10,00,000 in March 2015 and incurred an expenditure of Rs. 5,00,000 in the same period, its cash statement would show a positive cash balance of Rs. 5,00,000. This would be taken as one of the indicators of the viability of the store’s business.

On the other hand, a negative cash flow would indicate that the business is not bringing in enough cash to pay its dues, a sign that it is becoming unviable or insolvent.
 

Cash flow and profit

However, a negative cash flow does not mean that a business is not profitable. For example, imagine that a biscuit company is showing a negative cash flow, meaning that its cash outflow is higher than its cash inflow.

This may be because the company is repaying a loan borrowed for purchase of land or machinery, for example. It may be making a profit but using the cash from the profit for the repayment of the loan.
 

Three types of cash flow

In general, the cash flows of a business can be classified into three types: operating activities, investing activities, and financing activities.

  • Operating activities are cash transactions related to net income—for example, cash generated from sale of goods or services (which is revenue, and is therefore related to net income) and cash spent on purchase of raw materials (which is an expenditure, and is therefore, again, related to net income).
  • Investing activities are cash transactions related to noncurrent assets such as property and machinery. Cash earned from sale of land and cash spent on purchase of machinery fall in this category.
  • Financing activities are cash transactions related to noncurrent liabilities and owners’ equities, which include payment of the principal amount of long-term debts, proceeds from sale of stocks, and dividend payments.

Of these three activities related to the cash flow of a business, operating activities are the ones that investors and company managers are most interested in, because these activities show how well the core business operations of the company are doing.

The cash transactions related to operating activities tell the investors whether the business is viable.

They are more interested in the income generated by the company through its core business than in how much the company earned from a one-time transaction—for example, sale of property or sale of company stock.
 

Cash flow statement

Next, we move on to cash flow statement. The cash flow statement of a business organization shows the balance between the amount of cash earned (from sale of products, for example) and the cash expenditure incurred under various heads (payment of salaries and purchase of raw materials, for example).

The income statement of a company shows its revenue and expenditure. However, under what is known as the accrual method of accounting, which is the most common method of accounting used by companies, revenue is reported in the income statement when it is earned, not when cash actually comes in.

Similarly, expenditure is recorded in the income statement when the outgo is recognized, not when cash is actually paid.
 

Structure of a cash flow statement

The cash flow statement, or the statement of cash flow, gives the details of cash flows under the three types of cash flows already described above—operating activities, investing activities, and financing activities.

The heading of the statement gives the time period during which the cash flows mentioned took place. The period is as decided by the company concerned: that is, it can be monthly, quarterly, or annual.

We looked at the three types of cash flow and found that the income statement of a company, under the accrual method system of accounting, does not provide the details on the basis of cash.

It is the cash flow statement that managers and investors turn to understand the income statement on the basis of cash.

The cash flow statement interprets the three types of cash flows in the following ways:

  • Operating activities: The cash flow statement converts the entries in the income statement into cash actually received and paid.
  • Investing activities: It gives details of funds invested in land and machinery in cash terms.
  • Financing activities: The cash flow statement provides information about issuance of the company’s own stocks and bonds as cash transactions.
  • Additional information: It makes available information on taxes and interest paid in cash as well as cash payments under various other major heads.

 

How is the cash flow statement used?

Although the cash flow statement of a company is considered a less important document than its balance sheet or income statement, it provides vital information to the company managers and investors about how the business is really doing.

The cash flow statement helps investors and company managers in the following ways:

  • It tells the investors how their company is doing in its core business areas. This indicates the viability of the business and the future of their investment. A positive cash balance may lead to an increase in dividend, debt reduction, or acquisition of another company. (However, it should be kept in mind that a negative cash flow might sometimes be the result of the company’s projects—for example, an expansion programme—and may not always be a sign of insolvency.)
  • The cash flow statement gives the managers a basis for budgeting: for example, availability of cash can help them firm up plans for investing in new machinery or land.
  • The statement shows the managers which revenue entries have yielded cash and which of the expenditures entries have already been paid in cash. If some entries related to net income are not turning into cash, they can find out why this is happening and step up their efforts to convert these entries into cash.

 

Example of a cash flow statement

Cash flow statement exampleLook at the sample cash flow statement for Company XYZ on the left. What does it tell us?

It tells us

  • that the company’s cash flow for the (US) financial year 2003 was $1,522,000
  • that the bulk of the earnings came from the core business of the company, which means that the company is doing well
  • that the company has cash to invest in inventory for expansion (shown by the purchase of equipment for $500,000—figures in parentheses show cash payments)
  • that cash is available should the company need to go in for a loan (indicated by the entry against “notes payable”)

 

Summary of Cash flow Statements

To wind up, here are some of the merits of the cash flow statement.

  • As the cash flow statement focuses on the inflow and outflow of cash, it can be used to analyse the actual performance of a business.
  • Although the cash flow statement is seen as less important that other financial statements of a company, such as the balance sheet and the income statement, it shines light on aspects of performance not readily visible in other documents.
  • Financial experts see the cash flow statement as a true reflection of the financial health of a business in a given period and its viability, as it is more difficult to doctor, compared with other financial documents of a company, such as the income statement.

Therefore, the cash flow statement, often described as the most transparent index of performance of a company, is an important tool of financial analysis.
 

Important Finance Topics

Introduction to Finance
Balance Sheets
Profit and Loss
Ratio Analysis

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