Cash Flow Definition
The term cash flow refers to cash receipts and cash payments during an accounting period, and analyzing the company’s cash provides critical information with respect to understanding business activities, reported earnings, and projecting the future cash flows at the same time.
Types of Cash Flow
Business activities are reported with the help of a statement of cash flows, which provides information about the company’s cash receipts and payments during an accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance. and also helps in validating the ending cash balance to the beginning balance being reported in the company’s balance sheet.
Let’s discuss some types for better understanding.
#1 – Operating Activities
Operating activities include a company’s day to day running activities like selling inventory and providing various services. Cash inflows are generated from operating activities such as cash sales, including a collection of sundry debtors and Cash outflows that are created from cash payments for purchasing inventories, salaries, taxes, and various other opexOpexOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.. Operating activities also include cash receiptsCash ReceiptsA cash receipt is a small document that works as evidence that the amount of cash received during a transaction involves transferring cash or cash equivalent. The original copy of this receipt is given to the customer, while the seller keeps the other copy for accounting purposes. and cash payments with respect to securities held for dealing and held for trading.
#2 – Investing Activities
Investing activities include investment in property, plant, and equipmentProperty, Plant, And EquipmentProperty plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. (PPE), purchasing and selling of investment excluding securities held for dealing and held for trading the cash flows from which are concerned with operating activities.
#3 – Financing Activities
Financing activities primarily include raising capital from equity or long term debtsLong Term DebtsLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.. There are two significant sources of finance, like shareholders and creditors. Cash inflows from financing activities may consist of cash receipts from issuing common stock, preferred stock, bonds, and borrowing. Cash outflows may include repayment of borrowing, the redemption of bonds, repurchase of treasury stockTreasury StockTreasury Stock is a stock repurchased by the issuance Company from its current shareholders that remains non-retired. Moreover, it is not considered while calculating the Company’s Earnings Per Share or dividends. , and payment and dividend. Consideration should be given to indirect borrowing from accounts payableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period., which is classified as operating activities.
Methods of Cash Flow Statement
Cash flow from operating activities can be reported in the direct and indirect format in this statement. The net cashNet CashNet Cash represent the company's liquidity position and is calculated by deducting the current liabilities from the cash balance reported on the company’s financial statements at the end of a particular period. Analysts and investors examine it to have a better understanding of the company's financial and liquidity position. used from operating activities will remain the same as indirect and indirect methods. The only difference is the format of the operating section.
#1 – Direct Method
- Specific cash inflows and outflows are used to provide the cash flow from operating activities.
- Remove the impact of accruals by adjusting the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. items by disclosure of cash receipts and cash payments.
- Provide information on specific sources of cash receipts and cash payments.
The major advantage of using the direct method is that it helps in providing critical information about the specific sources of cash receipts and cash payments as compared to an indirect method, which shows only the net cash received or paid. As the information on particular sources of cash receipts and payments is essential instead of net cash received or paid, users of financial statementsUsers Of Financial StatementsFinancial statements prepared by the Companies are used by different categories of individuals and corporates on the basis of their relevancy to the respective parties. The most common users to the financial statements are Management of the Company, Investors, Customers, Competitors, Government and Government Agencies, Employees, Investment Analysts, Lenders, Rating Agency and Suppliers. get additional information from the direct method. This additional information helps the creditors and investors in understanding the historical performance and predicting the future cash flow generating abilities of the concerned company.
#2 – Indirect Method
- Shows the operating cash flows from the reported net income statement with a series of adjustments;
- Adjustments are being made for non-cash items, non- operating items, and net changes in operating accruals.
- Shows the reasons for the variance of cash from operating activities and net income;
The primary advantage of using the indirect method is that it helps in explaining the differences between cash from operationsCash From OperationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital. and net income. The indirect approach also used to forecast future income by adjusting for changes in balance sheet items that occur due to accrual and cash accountingCash AccountingCash Accounting is an accounting methodology that registers revenues when they are received & expenditures when they are paid in the given period, thereby aiming at cash inflows & outflows. .
Following the example, exhibit information about XYZ operating, investing and financing cash flowsFinancing Cash FlowsCash flow from financing activities refers to inflow and the outflow of cash from the financing activities like change in capital from securities like equity or preference shares, issuing debt, debentures or repayment of a debt, payment of dividend or interest on securities. in this statement (Direct Method)
Analysis of Cash Flow
The analysis of these statements helps in providing vital information concerning the company’s business, earning, and predicting future cash flows. The following section provides various tools and techniques with the help of which users of financial statements can check major sources and uses of cash.
Free Cash Flow to the Firm (FCFF) and Free Cash to the Equity (FCFE)
The excess of operating cash flow over capital expenditureCapital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. is known as free cash flow. FCFFFCFFFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders. is available to the suppliers and owners after all required operating expenditures have been paid, and necessary investment in working capital and fixed capital have been made.
The calculation of FCFF can be illustrated with the following example.
FCFEFCFEFCFE (Free Cash Flow to Equity) determines the remaining cash with the company's investors or equity shareholders after extending funds for debt repayment, interest payment and reinvestment. It is an indicator of the company's equity capital management is the cash flow available to the stockholders. It comes after paying all the operating expenditures and borrowing costs and making the required investment in fixed and working capital.
Following is the illustration of the calculation of FCFE:
If the FCFE is positive, it indicates that the company has enough cash over and above the amount being required for future investments and debt repayments. The excess of cash is available to distribute among the owners.
In conclusion, we could say that this statement helps in determining the ability of a company with regard to:
- Funding a company’s requirement through internally generated cash in the absence of outside capital.
- Meeting debt obligations;
- Sustain dividend payoutDividend PayoutThe dividend payout ratio is the ratio between the total amount of dividends paid (preferred and normal dividend) to the company's net income. Formula = Dividends/Net Income.
- Working capital managementWorking Capital ManagementWorking Capital Management refers to the management of the capital that the company requires for financing its daily business operations. It is important for the company in order to maximize its operational efficiency, manage its short term liabilities and assets properly, avoiding the underutilization of the resources and avoiding the overtrading, etc..
- Liquidity management in terms of the ability of the company to payout debts obligation as they fall due. Stakeholder, including investors and creditors, monitors this statement to check if the concerned company can pay its existing commitments on time.
This article has been a guide to what cash flow is and its definition. Here we discuss the top 3 types of cash flows (operating, financing, and investing) along with examples. You can learn more about financing from the following articles –