Cash flow: Definition, how to calculate it, how it’s used

Cash flow is a term that is mentioned quite a bit in financial markets, especially when it comes to analyzing a company’s performance. The most basic definition of cash flow is the movement of money into or out of a business.

Understanding cash flow can help investors make informed decisions about a company’s potential as an investment and highlight potential risks.

Let’s take a closer look at how investors may look at cash flow when assessing a company’s fundamentals.

What is cash flow?

Cash flow is the amount of funds coming into and going out of a company’s (or an individual’s) accounts during a specified period. A point to note is that cash flow is primarily a measure of liquidity. Positive cash flow generally implies that more money is coming in than going out, while negative cash flow is the opposite, with more money going out than coming in. Because of that it doesn’t necessarily signify the full financial picture of a company and its value, although it’s still a valuable measure.

The Securities and Exchange Commission (SEC) requires publicly-traded companies to report their cash flow. By delving into the details of cash flow, an investor can get a lot of information about a company’s financial health, such as where the money is coming from and whether the company can pay its current expenses, like real estate costs and salaries.

What’s the difference between positive and negative cash flow?

Positive cash flow generally shows that a company is bringing in more cash than its spending in a given period. This may be considered attractive to investors as it shows the company’s core operations are generating cash and that the company can fund its day-to-day operations without needing external financing.

Negative cash flow means that a company does not have cash on hand to cover expenses and must find other means of satisfying these obligations. Negative cash flow isn’t always bad and usually requires context to determine how significant it is.

For instance, fast-growing companies may show negative cash flow as they spend to quickly drive growth, while heavily seasonal businesses may cycle through positive and negative periods and project-based businesses may see temporary negative cash flow between contracts.

That said, there are certainly instances where negative cash flow indicates trouble for a company. For instance, it could indicate that a company has declining cash reserves without a clear path to positive cash flow or a heavy reliance on external financing to fund company operations.

Calculating cash flow 

The calculation for cash flow can be relatively straightforward in that it is the sum of the net change in the different types of cash flow.

It is calculated by adding operating cash flow, investing cash flow and financing cash flow.

Net Change in Cash = Operating Cash Flow + Investing Cash Flow + Financing Cash Flow

If the result is a positive number, it shows a net increase in cash for the period. If it’s a negative number, it shows a net decrease in cash for the period.

How to analyze a cash flow statement

Cash flow is reported on a company’s cash flow statement. It provides a summary of how a company generates and spends cash, offering valuable insights into its financial health. Simply put, anyone looking to evaluate a company’s cash flow may rely on this document.

Cash flow statements are often divided into three main parts that align with the three types of cash flow.

Types of cash flow

Typically, a company’s cash flow is divided into three areas:

Cash flow from operating activities: This refers to net cash generated from core business operations. For example, cash sales would bring money into the company, while employee salaries would result in money leaving the company.

Cash flow from investing activities: This refers to net cash generated from long-term investments made to improve  a company’s profitability. For example, the purchase of property, plant and equipment (PP&E) would be a cash outflow, while the sale of such assets would result in a cash inflow. A healthy company seeking to maintain its market share may be actively investing in its core business. Therefore, cash flow from investing activities may be negative.

Cash flow from financing activities: This refers to the cash relationship between a company and the entities financing it. Normally, these entities are shareholders and creditors. For example, issuing common stock would bring cash into the company, while paying dividends would result in cash leaving the company.

How cash flow statements are used by companies and investors 

Cash flow statements are used by a company’s internal stakeholders like its C-suite and board members along with external stakeholders such as investors and potential investors.

Understanding a company’s cash flow statements may provide investors with insights into a company’s  operational decision-making and strategic planning process.

This in turn can help investors assess a company’s strengths and weaknesses so they can make informed investment decisions.

How to analyze a company’s cash flow versus its profit 

Cash flow and profit are sometimes used interchangeably, but they are not the same thing. Cash flow focuses on the actual cash coming into and going out of a company during a specified period. Profit, on the other hand, refers to the amount of money that is left after all liabilities have been accounted for.

A lot of the confusion around these two concepts is due to the accrual accounting method that is commonly used in a company’s financial statements. Accrual accounting records revenue when it’s earned and an expense when it’s billed. However, these payments may or may not have been made yet, so the pending inflow and outflow do not result in the net change in cash that is measured by cash flow.

Because cash flow and profit signify something different when it comes to a company’s financial health, it’s important to differentiate between them when assessing a company’s fundamentals.

The bottom line

Cash flow may provide critical insights into a company’s health, but it’s only part of the picture. Investors also rely on additional financial statements, like income statements and balance sheets, among other items.

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