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Cash flow

Cash flow (also called net cash flow) is the balance of the amounts of cash being received and paid by a business during a defined period of time, sometimes tied to a specific project. Measurement of cash flow can be used

  • to evaluate the state or performance of a business or project.
  • to determine problems with liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable.
  • to generate project rate of returns. The time of cash flows into and out of projects are used as inputs to financial models such as internal rate of return, and net present value.
  • to examine income or growth of a business when it is believed that accrual accounting concepts do not represent economic realities. Alternately, cash flow can be used to 'validate' the net income generated by accrual accounting.

Cash flow as a generic term may be used differently depending on context, and certain cash flow definitions may be adapted by analysts and users for their own uses. Common terms (with relatively standardized definitions) include operating cash flow and free cash flow.


Cash flows can be classified into:

  1. Operational cash flows: Cash received or expended as a result of the company's core business activities.
  2. Investment cash flows: Cash received or expended through capital expenditure, investments or acquisitions.
  3. Financing cash flows: Cash received or expended as a result of financial activities, such as interests and dividends.

All three together - the net cash flow - are necessary to reconcile the beginning cash balance to the ending cash balance. Loan draw downs or equity injections, that is just shifting of capital but no expenditure as such, are not considered in the net cash flow.

Benefits from using cash flow

The cash flow statement is one of the four main financial statements of a company. The cash flow statement can be examined to determine the short-term sustainability of a company. If cash is increasing (and operational cash flow is positive), then a company will often be deemed to be healthy in the short-term. Increasing or stable cash balances suggest that a company is able to meet its cash needs, and remain solvent. This information cannot always be seen in the income statement or the balance sheet of a company. For instance, a company may be generating profit, but still have difficulty in remaining solvent.

The cash flow statement breaks the sources of cash generation into three sections: operational cash flows, investing, and financing. This breakdown allows the user of financial statements to determine where the company is deriving its cash for operations. For example, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a case, the company may be deriving additional operating cash by issuing shares, or raising additional debt finance.

Companies that have announced significant writedowns of assets, particularly goodwill, may have substantially higher cash flows than the announced earnings would indicate. For example, telecoms firms that paid substantial sums for 3G licenses or for acquisitions have subsequently had to write-off goodwill, that is, indicate that these investments were now worth much less. These write-downs have frequently resulted in large announced annual losses, such as Vodafone's announcement in May 2006 that it had lost £21.9 billion due to a writedown of its German acquisition, Mannesmann, one of the largest annual losses in European history. Despite this large "loss", which represented a sunk cost, Vodafone's operating cash flows were solid: "Strong cash flow is one of the most attractive aspects of the cellphone business, allowing operators like Vodafone to return money to shareholders even as they rack up huge paper losses.

In certain cases, cash flow statements may allow careful analysts to detect problems that would not be evident from the other financial statements alone. For example, WorldCom committed an accounting fraud that was discovered in 2002; the fraud consisted primarily of treating ongoing expenses as capital investments, thereby fraudulently boosting net income. Use of one measure of cash flow (free cash flow) would potentially have detected that there was no change in overall cash flow (including capital investments).

Ways Companies Can Augment Reported Cash Flow

Common methods include:

  • Sales - Sell the receivables to a factor for instant cash. (leading)
  • Inventory - Don't pay your suppliers for an additional few weeks at period end. (lagging)
  • Sales Commissions - Management can form a separate (but unrelated) company act as its agent. The book of business can then be purchased quarterly as an investment.
  • Wages - Remunerate with stock options.
  • Maintenance - Contract with the predecessor company that you prepay five years worth for them to continue doing the work
  • Equipment Leases - Buy it
  • Rent - Buy the property (sale and lease back, for example).
  • Oil Exploration costs - Replace reserves by buying another company's.
  • Research & Development - Wait for the product to be proven by a start-up lab; then buy the lab.
  • Consulting Fees - Pay in shares from treasury since usually to related parties
  • Interest - Issue convertible debt where the conversion rate changes with the unpaid interest.
  • Taxes - Buy shelf companies with TaxLossCarryForward's. Or gussy up the purchase by buying a lab or O&G explore co. with the same TLCF.

Example of a positive $40 cash flow

Transaction In (Debit) Out (Credit)
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 +16M
Year 3: cash flow of +17M

Company B has a higher yearly 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, total = +10M
Year 2: OC: +21M FC: +5M IC: -15M, total = +11M
Year 3: OC: +22M FC: +5M IC: -15M, total = +12M

Company B:

Year 1: OC: +10M FC: +5M IC: 0, total = +15M
Year 2: OC: +11M FC: +5M IC: 0, total = +16M
Year 3: OC: +12M FC: +5M IC: 0, total = +17M

  • OC = Operational Cash, FC = Financial Cash, IC = Investment Cash

Now it shows 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.

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