Cash flow

Cash flow is the movement of cash and cash equivalents into and out of an individual, business, organization, or other economic entity during a specified period. Cash inflows generally arise from operating, investing, or financing activities, while cash outflows represent payments associated with those activities.

Cash flow is an important measure of liquidity and financial health because an entity may report accounting profit while having insufficient cash to meet its obligations.

Types of cash flow

Cash flows are generally classified into three categories:

• operating activities;
• investing activities;
• financing activities.

These categories form the principal structure of a Statement of cash flows.

Operating cash flow

Operating cash flow represents cash generated or used by an entity's principal operating activities.

Cash inflows may include:

• cash received from customers;
• receipts from services;
• other operating receipts.

Cash outflows may include:

• payments to suppliers;
• employee compensation;
• operating expenses;
• taxes;
• other operating payments.

A simplified conceptual relationship is:

$\text{Operating Cash Flow}=\text{Operating Cash Inflows}-\text{Operating Cash Outflows}$

Investing cash flow

Investing cash flow represents cash flows associated with the acquisition and disposal of long-term assets and investments.

Examples include:

• purchase of property, plant, and equipment;
• sale of property, plant, and equipment;
• acquisition of investments;
• sale of investments;
• acquisition or disposal of businesses.

Capital expenditure generally represents a cash outflow under investing activities.

Financing cash flow

Financing cash flow represents cash flows associated with raising and returning capital.

Examples include:

• proceeds from issuing debt;
• repayment of debt;
• proceeds from issuing shares;
• share repurchases;
• dividend payments.

Financing cash flows therefore reflect changes in an entity's debt and equity financing.

Net change in cash

The net change in cash during a period can be expressed as:

$\text{Net Change in Cash}=\text{Operating Cash Flow}+\text{Investing Cash Flow}+\text{Financing Cash Flow}$

The resulting amount represents the change in cash and cash equivalents during the reporting period, subject to applicable accounting adjustments.

Cash flow and net income

Net income and cash flow measure different aspects of financial performance.

Net income is an accounting measure that may include non-cash items such as:

• depreciation;
• amortization;
• deferred taxes;
• unrealized gains or losses.

Cash flow focuses on movements in cash and cash equivalents.

A company can therefore report positive net income while experiencing negative cash flow.

Operating cash flow and net income

Operating cash flow may differ substantially from net income because of non-cash expenses and changes in working capital.

Under the indirect method, a simplified conceptual relationship is:

$\text{Operating Cash Flow}=\text{Net Income}+\text{Non-cash Adjustments}\pm \text{Changes in Working Capital}$

The precise calculation depends on the accounting framework and the specific transactions during the reporting period.

Free cash flow

Free cash flow is a financial measure that generally represents cash generated after specified investment requirements.

A commonly used simplified definition is:

$\text{Free Cash Flow}=\text{Operating Cash Flow}-\text{Capital Expenditure}$

Free cash flow can be used to assess the cash available for activities such as:

• debt repayment;
• dividends;
• share repurchases;
• acquisitions;
• investments;
• building cash reserves.

Definitions of free cash flow vary according to the analytical framework.

Cash flow and working capital

Working capital can have a significant effect on operating cash flow.

For example:

• an increase in accounts receivable can reduce cash flow;
• an increase in accounts payable can increase cash flow;
• an increase in inventory can reduce cash flow.

Changes in working capital therefore help explain differences between accounting profit and operating cash generation.

Cash flow and liquidity

Liquidity management involves ensuring that sufficient cash and readily available financial resources are available to meet obligations when they become due.

Cash flow forecasting can help identify potential:

• funding shortfalls;
• excess cash;
• debt-service requirements;
• investment requirements;
• liquidity risks.

Cash flow is therefore a central component of liquidity management.

Cash flow and corporate deleveraging

Corporate deleveraging can be supported by positive cash flow.

A company may use excess operating cash flow to repay debt, reducing:

• outstanding liabilities;
• interest expense;
• refinancing requirements;
• financial leverage.

Debt repayment using cash generally reduces both cash and liabilities, while future interest expenses may decline.

Cash flow and capital allocation

Capital allocation involves deciding how available financial resources should be deployed.

A company may allocate cash flow toward:

• capital expenditure;
• debt repayment;
• acquisitions;
• dividends;
• share repurchases;
• investments;
• cash reserves.

The appropriate allocation depends on expected returns, financial risk, liquidity requirements, and strategic objectives.

Cash flow from operations

Cash generated from operations is often used to assess whether a company's core business activities generate sufficient cash to support ongoing operations.

Persistent positive operating cash flow can provide resources for:

• capital expenditure;
• debt service;
• working capital;
• dividends;
• other investments.

However, operating cash flow should be evaluated over multiple periods because individual reporting periods can be affected by temporary changes in working capital.

Cash flow forecasting

Cash flow forecasting involves estimating future cash inflows and outflows.

A simplified forecast can be represented as:

$\text{Ending Cash Balance}=\text{Beginning Cash Balance}+\text{Expected Cash Inflows}-\text{Expected Cash Outflows}$

Forecasts may cover short-term, medium-term, or long-term periods.

Cash flow statement

The Statement of cash flows is a financial statement that reports cash inflows and outflows during an accounting period.

It generally presents cash flows from:

1. operating activities;
2. investing activities;
3. financing activities.

The statement helps users assess an entity's ability to generate and use cash.

Example

Suppose a company reports:

• Operating cash flow: US$20 million
• Capital expenditure: US$8 million
• Debt repayment: US$5 million
• Dividends: US$3 million

Its simplified free cash flow is:

$20-8=12$

The company therefore generates US$12 million of free cash flow under the stated definition.

If the company uses US$5 million of that cash to repay debt, its outstanding debt decreases while its cash balance also decreases by the repayment amount.

Importance

Cash flow is a fundamental measure of financial liquidity and operating capacity. Unlike accounting profit, which may include non-cash items and accruals, cash flow focuses on the movement of cash and cash equivalents. Analysis of operating, investing, and financing cash flows helps assess an entity's ability to fund operations, invest in assets, service debt, return capital to investors, and maintain financial stability.

See also

• Statement of cash flows
• Free cash flow
• Net income
• Operating income
• Operating expenditure
• Capital expenditure
• Working capital
• Liquidity management
• Corporate deleveraging
• Capital allocation
• Financial analysis
• Balance sheet