Cash flow, liquidity and capital: What’s the difference?
Editorial staff, J.P. Morgan Wealth Management
For a solid object, cash is surprisingly liquid. No, we’re not talking about a dollar bill that just went through the washing machine, but the financial concept of liquidity, which is related to cash flow and capital.
Together, cash flow, liquidity and capital can give a holistic snapshot of a firm’s financial health. They can also shed light on a firm’s solvency, or its ability to quickly pay off long-term debts and other financial obligations. Solvency is critical during stress scenarios (e.g., the 2008 recession) and for supporting an organization’s growth and performance.
While the three terms are often used interchangeably, they are distinct and serve different purposes. To put this into context, firms have become insolvent because of inadequate capital, liquidity and/or cash flow, not only leading to loss of shareholder value but at times also shaking confidence in the overall stability of the financial system.
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What is cash flow?
Cash flow denotes the movement of cash in and out of a firm. While cash flow is typically associated with larger organizations, it can also apply to households and individuals (i.e., how much money you or your family bring[s] home every month versus how much you spend on bills and nonessentials). For firms, cash flow is what pays salaries, taxes, utilities, debt service payments and supplies, among other things.
Certain financial documents offer insight into an organization’s cash flow. The Statement of Cash Flow, which is an official document that is used to outline the specifics of an organization’s cash movement, provides a detailed picture of what happened to a firm’s cash during a particular accounting period. This document outlines the sources and uses of cash during this period, reconciling the beginning and ending cash balances.
The Statement of Cash Flow is organized into three main sections:
- Cash from operating activities (CFO): CFO is the cash a company makes from its core operating activities and is typically the first section listed on the Statement of Cash Flow. You can calculate the CFO using either the direct method or the indirect method. The former lists all cash-based transactions (both in and out of the firm) during a certain period and uses them to calculate the net difference. The latter method, on the other hand, works in reverse – using the accrual accounting method (i.e., reporting revenue when earned, not when received), you start with net income for the period, and then reconcile the numbers with increases and decreases in assets and liabilities as well as increases to Accounts Receivable (AR) on the balance sheet.
- Cash from investing activities (CFI): CFI shows how much money the firm spent or made in investment-related activities over the period. These activities can include the purchase and/or sale of assets or liabilities. Don’t panic if this number comes up negative, either – negative CFI could indicate that a firm is investing for the long term, which could translate to improved financial health down the line.
- Cash from financing activities (CFF): CFF will show you how a firm’s cash flow was used to keep it running during that period. These activities typically include equity, dividends and debt transactions, but it can also give investors a snapshot of a company’s financial health along with how well its capital structure is managed.
It may also be useful to think of cash flow in terms of its uses and sources, which are more or less inverse to each other:
Cash sources:
- Asset value decreases
- Liability increases
- Capital increases
Cash uses:
- Asset value increases
- Liability decreases
- Capital decreases
When evaluating a firm’s cash flow, investors need to consider the type of firm and the industry it’s in. For example, a high-growth bio-tech company will have a much different cash flow than that of a mature firm that sells consumer staples. Put another way, a high-growth company would probably have lower CFO and be more reliant on CFF.
What is liquidity?
Liquidity refers to a firm’s ability to meet its obligations, or in other words, pay off its debts. A firm can meet these obligations using cash on hand, converting assets to cash or by accessing lines of credit.
In practice, liquidity really means how quickly a firm can generate cash or other funding sources to pay off its debts. During normal times, liquidity functions smoothly. Conversely, a lack of liquidity can exacerbate the situation at hand during crises or other periods of extreme stress.
A firm’s ability to liquidate its assets for cash is highly dependent on market conditions, which can impact how quickly this can happen. Following this, a lack of liquidity can cause a firm to go belly up even when it’s technically solvent (i.e., has more assets than liabilities), simply because they cannot sell their assets quickly enough to meet its obligations. Liquidity is the lifeblood of financial services, meaning a lack thereof can cause a “run” on a firm, or a situation where the majority of clients scramble to get their cash back.
Liquidity risk has been a major factor in many crises, impacting both credit risk and market risk. It can be broken down into two subtypes: asset liquidity risk and funding liquidity risk. Below are their definitions, as defined by the Committee of European Banking Supervisors:
- Asset liquidity risk: Also called market or product liquidity risk, asset liquidity risk is the risk that an asset cannot be sold quickly without significantly influencing its market price. This phenomenon can happen because of inadequate market depth (i.e., the supply-demand ratio for a particular asset) or market disruption (i.e., a period of big, rapid market declines)
- Funding liquidity risk: Funding liquidity risk refers to the risk of a firm’s inability to pay off its current short-term debts when they are due (e.g. overhead costs)
In light of the 2008 recession, financial regulators established a liquidity coverage ratio (LCR) and a net stable funding ratio (NSFR), both of which are designed to mitigate organizational liquidity risk. The LCR addresses a firm’s ability to maintain a liquidity buffer during a short-term stress scenario, while the NSFR addresses how reliable or stable a firm’s funding sources are. Additionally, firms are now subject to periodic stress tests that assess their current liquidity in hypothetical crisis scenarios, determining the stability of their liquidity sources and any risks posed by possible illiquidity.
While there is no single measure of liquidity risk, firms typically use a handful of metrics to assess it. Liquidity risk management usually starts with establishing operational liquidity, which outlines a firm’s daily cash needs by projecting all cash inflows and outflows. Once a firm’s operational liquidity is established, the liquidity of its asset base and access to any outstanding unsecured funding sources are analyzed. Together, all this information is used to create a contingency funding plan, which is a plan of action only to be used in the face of an unexpected crisis. Management typically has to react quickly in these stressful times, thus making a pre-established plan both useful and necessary.
What is capital?
Last but not least, capital is the financial cushion needed to absorb unexpected losses and support business growth. Unexpected losses are losses that exceed the amount of expected loss, which is an estimate of losses a firm expects to incur and are considered a cost of doing business.
Capital is also used to support the growth of a business, and both capital and cash flow can be used to determine a company’s liquidity. On a firm’s balance sheet, capital is the net difference between assets and liabilities. Some typical forms of capital include economic capital and regulatory capital. Economic capital is a measure of risk, while regulatory capital is the amount of capital financial regulators require firms to have.
Economic capital is how much capital a company needs to stay solvent or weather risks and unexpected losses. From a management standpoint, economic capital can greatly impact organizational decision-making. However, both economic capital and regulatory capital play critical roles in a firm’s capital management. Stress tests are usually taken into consideration when estimating how much economic capital a firm needs to meet regulatory capital requirements, making it especially useful in capital planning.
The bottom line
In an effort to avoid crises like the 2008 recession, financial regulators have upped expectations for organizations in proactively assessing how their liquidity and capital will perform during stressful periods. Ultimately, these regulations are in place to ensure that firms stay solvent so that they can continue to participate in the global economy.
Connect with a J.P. Morgan advisor to see how cash flow, liquidity and capital may impact your prospective investment opportunities.
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Editorial staff, J.P. Morgan Wealth Management
