What Is Cash Flow? Learn all About Its Importance In A Business
Businesses are bound by government regulation in most countries today. Taxes are paid on a monthly, and quarterly basis, and licensing practices are prevalent in many parts of the world. Standardized accounting techniques and procedures work wonders to manage business revenue and expenditure in figures on paper. This has seemingly made the job of investors extremely easy. The indicators within these income statements are acceptable to some novice investors who peer at net income as the main ingredient of the pie. They have no clue about the value of cash flow and are satiated by their estimations based on profitability alone
Are you one of these investors and so-called market specialists who will look at investing trends from influential financial advisors online and jump on the bandwagons? Or do you want to know how profits are manifested in businesses and the role that the cash flow of a company plays in profitability?
Do you wonder what a cash flow statement consists of and how a cash flow analysis is conducted? Furthermore, do you know what the term ‘cash flows’ means? The significance of changing business cash flows is felt by all prominent and skilled investors but for most amateurs who do not understand the real value of cash-in-hand, profit measurement commands their loyalty. Financial forecasting through the cash flow statement is a pivotal part of financial modeling practices in businesses. Without the aid of this statement, the financial model is considered incomplete or skewed towards the business’s goals i.e. it does not reflect real financial ability or current conditions accurately.
As a person running a business or a simple-minded investor looking to quickly cash in some dollars, you must have clarity about such financial concepts to cement the financial security of your business or portfolio. If you wish to learn the intricacies that swarm the concept of cash flow, this article is for you. Our discussions will display a stark lucidity in our understanding of the fundamental concepts. Before we start to pour our hearts out to fulfill your ultimate objective of gaining investment returns by availing the benefits of cash flow statements and learning how they influence investment choice, let’s first understand…
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The Concept Of Cash Flow:
As a soon-to-be businessperson, imagine a river flowing through its basin. What if you were given the task of measuring the volume of water flowing through it in a season to highlight flood-prone areas? A high-school student would take the volume of water by the distance of the surface from the riverbed, the width of the banks, and the length of a part of the river.
The flowing speed will be measured in kilometers per hour and shortly after the total volume of water will be taken and divided by the length. However, this estimate will not include natural changes in the river and the volume of water flowing through it at different locations while also not giving a proper answer to the question of flooding. It does not take into account that the river would interact differently under different circumstances and would be considered less prone or more for flooding in different locations i.e., more prone in areas likely to receive greater rainfall.
Similarly, net income only situates the overall accounting position of a company but conveys little about the real cash status of a company. It is a requirement that does overall profitability but is a half-measure for valuing the business stock. Despite the formulation for net income staving off external impingements on profit that is compelled by the debt management of an institution or by the taxation policy of a government, it remains a half measure because of the GAAP (Generally Accepted Accounting Principles) procedural guidelines permitting the addition of non-cash revenue in the net income. Furthermore, amortization i.e., the spreading of debt value over time, and the depreciation value of assets are also included.
This blurs the actual working capacity of the business and in many instances, businesses that have reported major profits in a quarter have shrunk massively by the time of the next quarterly release window. In rare cases, businesses have also defaulted on loans due to the unavailability of any liquid cash while proclaiming above-normal profits in their income statement.
Net income is compiled through a record of expected sales income. This record contains not only sales whose cash and service value have exchanged hands between consumer and producer but also the services that have been rendered by the cash payment for the same is due by a set future date. Until that date arrives the company has to manage its receivables and payables in such a manner so that the operating activities and immediate working expenses are cleared. Managing such complex cash cycles in big establishments is a difficult task. Any business would not like to spend its money or waste the precious time of its employed human resources in tasks of administration and micromanaging. Therefore, the stress businesses levy on cash flow is understandable.
Cash flow is the change in cash due to any business activities or transactions undertaken by a business board/ management or its employees. ‘Cash flow is King’ is a common idiom in business and financial circles because the operations of a business can only be managed through available cash and keeping it in check is a priority for any firm. The flow of cash is not only limited to use for clearing expenses to keep the business running but also plays a critical role in investor interest and shareholder loyalty.
The creation of FCF or free cash flows is an important long-term goal for any business. The availability of free cash flows implies that the business has accumulated surplus cash flows after discounting all essential expenses. These are critical for investor interest as surplus FCFs eliminate loan-bearing requirements for any firm. The capital for the investment can be arranged through consistent corporate savings. Moreover, dividends work wonders for keeping shareholders interested in the future of the company. Such handouts of cash are not concerning or thoughtless expenditure as it creates a better brand image and allures more investment into the business. It also raises the value of stocks in the market thus, paying for the dividend payout. Since free cash flows are a well-known indicator of good business health that induces investment in the long run, companies focus spreads towards achieving them and focusing on ways to manage cash flows better.
Cash flows are a critical indicator of economic growth as they set out to the total operating profits of a business. Therefore, they are assessed with ardor by businesses and their origins are laid bare to not only create an image of the company’s future performance but also plans for contingencies caused by supply chain issues and world events like the Covid-19 pandemic and the Ukraine-Russia War.
Events of this stature inhibit reach to targeted markets or audiences and result in the downfall of cash flows needed for the maintenance of business operations. Therefore, contingencies and emergencies must be secured for appropriate management of cash flows to avert the risk of a business closure. Liquidity preference is strong among businesses during emergencies and the appropriate amount of cash flows amounts to greater financial flexibility for an enterprise. Thus, reporting on cash flows is of utmost importance to ascertain the future well-being of a company. If you are a novice in the business world, you might be unaware of …
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The Types Of Financial Statements:
A venture does not operate without collecting information on its pricing, sales, and assets/liabilities. Managing these financial concepts is the core aspect of business management. Most businesses instead of fashioning self-created statements put to print based on arbitrary terms and muddled financial values report their financial details in three statements. The widely known financial statements are:
- The Income Statement –
The income statement of a company is the most sought-after document and details the revenue gained through sales and the overall expenditure of the company. It outlines the performance of the company through different periods. The statement is formatted in such a way as to showcase the total revenues of the business at the crest of the statement. It substantiates the figure of revenue with sales of several products & services and after the average cost of production by combining the cost of utilities used as well as the material consumed. This results in the calculation of gross profit. Net income is realized into figures when operating expenses like employee salary and money to suppliers are subtracted from the gross profit of the company. Net income forms the bottom line of a business entity and is equally important as the top line of a company. Both in combination supply the company with funds and time to improve product quality, administrative setup, and customer retention through improved customer support.
- The Balance Sheet –
This financial statement reports on the shareholder’s equity of the company, its assets & liabilities. It is an assessment of the total value of the assets of a company balanced by the addition of liabilities and the value of shareholder’s equity. In its format, the asset side of the sheet initiates by displaying the net cash flows of the company or the cash and cash equivalents in positive/negative terms. It also claims the net income or a business’s profitability into its fold after delivering the equity equivalent dividends to investors. Net income is transformed into retained earnings. The structure of the balance sheet is designed to give adequate space to important values and indicators over some time.
- Cash Flow Statement –
As per recent estimates and the outspoken Warren Buffet, Berkshire & Hathaway possessed 24 billion dollars worth of operating profit. Their earnings, however, amounted to a little more than 4 billion. Some of the huge gaps between these can be accounted for by taxation and other compulsory activities. Nonetheless, as per experts, the serious gap was a result of a market valuation decrease in their capital investments. This example demonstrates the limitations of the income statement of a company. Often companies inflate the bottom line of their business, and the financial modeling returns in the future further apple multiplicative effects, increasing the returns manifold. The cash flows of a company do not allow for such convenient mistakes to take place as a statement of the cash flows not only prompts a rechecking of inflated bottom lines but also tells the investor about the fundamentals profit accrued through the operation of the business at any point in time. Since cash flows removed the non-cash fluff from income statements, they are the best metrics for gauging the impact of decisions on business as they directly relate to changes in the business balance sheet.
A Statement of Business Cash Flows Abides by the Rules and Regulation of International Accounting Standard 7 and Are Divided Into Three Major Categories:
- Cash Flows In Operating Activities:
It is the most important indicator among the three business indicators for cash flows. It is formulated by using revenue generated through sales and subtracting money paid to suppliers, and employees. Furthermore, it subtracts interest remitted to banks as repayment of the loan and corporate taxes to governmental authorities. For businesses, operating profit has a direct correlation with a firm’s cash flow. With the rise in cash flows per quarter or over years denoting increasing company growth and a fall in cash flows relating to shrinking company production, CFOs are a reliable indicator for investors. In many cases, you will find negative cash flows for operation i.e. the cost of operation of a business is causing active losses.
- Cash Flows In Investing Activities:
It is the cash flow related to the cost pricing of maintaining or buying long-term fixed assets. These cash flows are mostly outflows used to gain funds through bank loans for expansion activities. It is also related to other important activities such as raising funds from issuing stocks through IPO and bonds or other securities, payback period repayments, dividend outflows, and share buybacks. Most CFI accounts of companies that are performing well are negative due to loans taken for business and production expansion. Write-offs and waivers of loan payments are not accounted for under this field since the inventory of cash flows is unaffected.
- Cash Flows In Financing Activities:
This is the financial side of the cash flow account where loans taken are depicted in the positive section. These are raised against stocks or equity of a company and aim to diversify business assets and improve financial management. These cash flows are mostly positive.
These are the 3 major cash flow categories found on a cash flow statement. It is a statement that is not only useful in separating the noise from the income statement but also renders insight into the quality of earnings of a firm and its sustainability. Furthermore, the ability to check net income and compare it to the economic position is useful for investors to part the chaff from the wheat i.e., reduce the inflated affectation on the bottom line of the firm.
There is also a fourth category of cash flows that are of significance to businesses, but it isn’t found on the statement provided by businesses. FCF or free cash flows are the manifestations of the surplus funds present in an enterprise. They are key for capital formation and the capital investment portfolio of a company. Regardless of whether you are researching whether to invest in a company or studying its books to buy major amounts of equity, free cash flow is the most reliable metric you can look for in a company. Furthermore, if the company also provides a steady supply of dividends to equity holders, you can rest assured that the company will pay back your initial investment. Now that you have been informed about the nature and types of financial statements in detail, let’s look toward the analysis of these cash flows…
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Cash Flow Analysis:
Ultimately it all boils down to the CCE or cash and cash equivalents of a company. These display the general liquidity and financial flexibility of the company. The nature of the inflows and outflows needs to be analyzed in detail and it must be done as soon as a statement of cash flows is ready. Analysis and interpretation are directed to probe for realistic changes in business health and the financial conditions surrounding it at the moment and in the future. Conducting an analysis is no easy task.
The calculation for the inflows and outflows needs to be understood. For instance, two companies with identical cash flows could be vastly different from the cash flows they are receiving. Cash flows received through loans, debt, or through the selling of securities and equity is not beneficial in the long run. For the case of operational cash flows, inflows from current and non-current assets need to be included and the outflows from current and non-current liabilities to be deducted. Loss incurred to the sale of fixed assets needs to be added back while gains from the sale need to be deducted.
Under cash flows through investing activities, the sale of long-term assets and securities is mingled with the net operating cash flows as the losses didn’t cost any material change in cash. Furthermore, profits from the sale of these assets and securities need to be deducted as well as their sale does not leave any impressions on the cash flows of a company.
The financing activities of cash flows account for the buying back or issuing of stocks. This relates to financial management activities and hence should fall under financing activities. Furthermore, loan repayment consisting of interest payments and the payments enclosing the initial amount, which is to be given to the bank inside of the agreed payback period falls under this category. Lastly, all dividends paid also come under this category. Once the inflows and outflows are generated, the analysis of the sources of cash flows is not a massive undertaking.
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Importance of Cash Flows In Investment:
Cash flows are of great significance to investors because they relay important information about the financial aspects of a business that can help investors judge whether there is profit or loss to be made from an investment. Furthermore, the situation of investing activities’ cash flows, operating cash flows, and free cash flows tell investors a great deal about the intentions of a business.
If a business’s cash flows in investing activities are going further negative while the free cash flows of the business start falling rapidly, the business might require immediate assistance in managing everyday expenses as the period of expansion often leads to greater cash outlays than inflows. Extension of loans during this period can reap many benefits in the short term.
On the other hand, if the free cash flows are increasing and the net income of the business is also booming, investors may be interested in buying equity in this booming enterprise, expecting dividend payables to increase their disposable incomes. Investing in businesses like Amazon despite negative net income is solely dependent upon the increasing cash flows boasted by their statement. Thus, their operating profits are soaring, but they are rapidly expanding their services to gain tax exemption, in the opinion of some financial experts.
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Q1. What are the steps to create a statement for cash flows?
The standardized steps to create a statement for business cash flows are:
- Understanding and gauging the starting balance of the CCE of the enterprise
- Calculations for business cash flows in operating activities
- Calculations for business cash flows in investing activities
- Calculations for business cash flows in financing activities
- Understanding and gauging the ending balance of the CCE of the enterprise
Q2. What are good cash flows?
Good cash flows refer to the situation wherein a company’s cash flows in operating, investing and financing activities are poised to indicate a healthy state of business affairs and plenty of free cash flows.
Q3. How are cash flows calculated?
Cash flows for a business are calculated by computing the loss in cash flows due to outflow and subtracting it from the gain in cash flows due to inflows.
We hope you learned something about cash flows through this article. Thank you for reading. Let us know what you think of the importance of cash flow in financial modeling in th comments section.