Cash Flow

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 period 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.

Types of Cash Flow

#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 opex. Operating activities also include cash receipts 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 equipment (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 debts. 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 stock, and payment and dividend. Consideration should be given to indirect borrowing from accounts payable, 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 cash 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 statement 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 statements 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 operations 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 accounting.

Following the example, exhibit information about XYZ operating, investing and financing cash flows in this statement (Direct Method)

Cash Flow (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)

FCFF

The excess of operating cash flow over capital expenditure is known as free cash flow. FCFF 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.

Formula:

FCFF = Net Income + Non-cash items + Interest (1-Tax rate) – Fixed capital investment – Working capital Investment.

The calculation of FCFF can be illustrated with the following example.

FCFF

FCFE

FCFE 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.

FCFE = CFO – Fixed capital investment + Net borrowing – Net debt payments

Following is the illustration of the calculation of FCFE:

 

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.

Conclusion

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 payout.
  • Working capital management.
  • 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.

Recommended Articles

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 –

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