A Ready Reckoner on Cash Flow

What is Cash Flow?

Cash flow is the total amount of cash (in hand and demand deposits) or cash equivalents that either go in or out of a business. According to International Accounting Standard 7, the following items constitute cash equivalents:

  • Investments: Only investments with a significantly low risk rate and maturity duration of 3 months or less from the acquisition date.
  • Assets: Highly liquid assets that can be readily converted into cash without the risk of losing value.
  • Equity Investments: Those investments with short-term redemption dates.

At the end of accounting cycles (yearly or quarterly), businesses issue a document known as the cash flow statement. This document reports a detailed account of income and expenditure of a business during that period. Based on the cash flow statement, companies can determine whether the cash flow over a period has been positive or negative. If the net inflow (all the cash or cash equivalents) surpasses the net outflow (all the cash or equivalents going out of the business), the company has generated a positive cash flow. If the net outflow surpasses the net inflow, the company faces a negative cash flow.

It is important to note that positive cash flow does not necessarily translate into profit; neither does negative cash flow necessarily mean loss. A company can take a loan or sell assets (both of which are cash injections but not profit); in other cases, if a company decides to use the available cash to pay debts, the cash flow statement might show negative cash flow while it could be the case that the debt was paid by the money earned through profits.


Why Calculate Cash Flow?

Cash flow is the source from which internal funding for a business comes from. While positive cash flow can be a signal for expansion and more income revenues, a negative cash flow could mean the loss of potential investors, depreciation of assets, and business shrinkage. The following are some of the most important roles that cash flow plays in a business:


Investment Financing

Businesses have three major sources of financing projects: internal financing, debt and raising equity by selling company shares. According to a popular theory  , these sources are internal financing, debt financing, and equity, which is often seen as a last resort. The motivation to avoid selling shares even at the cost of raising debt is that owners wish to avoid the attention of the capital markets. The market’s awareness of the financial strength of the business may lead to the reevaluation of credit ratings. In order for a company to raise equity, it is important that it have a positive cash flow.


Assessing liquidity

Liquidity is the degree to which a company’s assets can be sold in the market without the loss of value. For example, if a company has a low liquidity rate, its assets will have a lower market value (the value for which the asset will be priced in a competitive market) compared to their book value (value of assets minus liabilities such as depreciation or impairment).

By definition, cash flow not only takes the amount of cash that is available into consideration, but also cash equivalents which include liquid assets or investments that have a high rate of liquidity.

Liquidity and cash flow are also connected in a different way. If the cash flow statement at the end of a period shows negative cash flow for the business, one way to compensate is to liquidate assets. Liquidation allows companies to gain cash which tips the balance for cash inflow.


Business expansion

Businesses that show highly positive cash flow by the end of a financial period can have free cash flow. Free cash flow is what remains after subtracting capital expenditures and dividends from operating cash flow. Operating cash flow is the gains and losses from internal activities of the business such as sales or salary payments. Capital expenditure is the sum of money invested in improving, fixing or acquiring tangible assets like property or machinery. Dividend is the amount that a company pays to its shareholders out of profits in a monthly or quarterly period. Free cash flow can be used for expanding the business by investing in more infrastructure.


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Cash flow statement

A cash flow statement is a financial report of cash flow during a given period. A cash flow statement provides vital information for various stakeholders. Accountants use cash flow statements to determine whether the business is capable of handling its expenses such as paying salaries or providing internal funds for future investments. It gives external lenders or creditors the assurance for repayment. Shareholders will be informed of the state of their assets and whether they are turning a profit.

Every cash flow statement has three main constituents:


Operating cash flow 

Cash flow that is a result of operating activities such as sales. Operating cash flow mainly includes gains or losses due to internal activities of the company. The following is a more extensive list of what needs to be included in a cash flow statement according to IAS 7:

  1. Cash receipts for sale of goods or services performed.
  2. Cash receipts from royalties, fees, commissions and other revenue.
  3. Expenses made to suppliers for goods and services.
  4. Cash payment to, and on behalf of employees.
  5. Cash receipts or payments from, or to insurance services.
  6. Cash payment or refund of income taxes unless they relate to financing or investing activities (which will be explained in what follows).
  7. Cash receipts and payments from contracts held for dealing or trading purposes.

Disclosure of operating cash flow shows the capability of the business to sustain its activities, repay its loans, invest in future projects without appealing to external funding sources, and paying dividends.

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Financing cash flow

Cash flow activities that are categorized under financing cash flow are the following:

  1. Cash income through issuing shares or equity.
  2. Cash payments in order to redeem or acquire shares.
  3. Cash earnings from issuing debentures, loans, bonds, mortgages or long-term borrowings.
  4. Debt repayments.
  5. Payments for reduction of liability.

Disclosure of financing cash flow helps capital providers have a sound prediction of future cash flow. 


Investing cash flow

Investing cash flow is the cash flow that is generated through a specific set of investing activities. Not all investments contribute to investing cash flow.

A statement of investing cash flow must include the following:

  1. Cash spent on acquiring, or earned from selling property, equipment, intangible properties and long term assets.
  2. Cash spent on selling or spent on acquiring equity or debt instruments (unless they are considered cash equivalents).
  3. Loans or cash advances made to other institutes or received as repayment (unless it is done by a financial institute).
  4. Forward cash payments and receipts for future contracts. 

Disclosure of investing cash flow helps the party of interest remain informed about activities that will lead to future cash flow and income.

Disclosing the cash flow statement is not only required by U.S. Securities and Exchange Commission (SEC), it provides potential investors with valuable information about the cash flow rate and liquidity of the company’s assets.

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