What is Cash Flow?

Cash flow is like water going into and out of a swimming pool…

You’re filling the swimming pool with a hose, which represents the incoming cash flow for a business. But the swimming pool has a hole in it. The water escaping through the hole represents the outgoing cash flow for the company. If more water comes in than goes out, the level of the water in the pool rises; if more goes out than comes in, the level of the water falls.

Cash flow is essential because it provides the money that companies must spend in order to stay afloat. A company brings in cash flow by selling its goods and services. It can also bring in cash by taking on additional debt, or by selling additional shares in the company.

The company then uses its cash flow to pay its operating expenses like employee salaries, raw materials, and rent. It also uses cash flow to fund investment in the company in the form of capital expenditures, like purchasing or building new buildings or buying equipment. Companies might also use some of their cash flow to fund dividend payments to shareholders, or to buy back shares of their own stock.

Cash flow is particularly essential for new companies that often spend more money than they’re bringing in, since they aren’t yet generating much cash from the sale of goods and services. They have to find alternative means of getting cash, like taking on additional debt or issuing new equity (meaning selling some ownership in the company to outside investors).

A cash flow statement details the amount of cash or cash equivalents that flow in and out of the company during a fiscal period. It is one of three primary financial statements, along with the balance sheet (which lists a company’s assets and liabilities)and income statement (which lays out the calculation of its profit or loss). Every publicly-traded company has to file these financial statements.

A cash flow statement consists of three main components: cash from operating activities, cash from investing activities, and cash from financing activities. Together they make up a company’s net cash flow.

Cash from operating activities is the cash a company takes in by selling its goods and services and spends to fund its operations. Cash from investing activities is the cash a company spends to invest in its business, such as capital expenditures on property or equipment, or makes from its investments. Cash from financing activities is the money a company raises from creditors or investors (generally from issuing debt and equity) or pays out to shareowners (in the form of dividends or share repurchases).

The cash flow statement can be helpful for potential investors in deciding whether or not they want to invest in a particular company, by showing them how the company is managing its money. They can see how the company is making money and where it is spending it. They can also see how much free cash flow a company has, meaning how much cash the company’s operations are generating that isn’t taken up by capital expenditures. Free cash flow is often used as a gauge of a company’s liquidity and financial flexibility.

Operating, investing, and financing cash flow are calculated on separate sections of the cash flow statement, with each section recording the inflows and outflows of cash for each type of activity.

Operating cash flow can be calculated using either a direct or indirect method, although the indirect method is generally easier and is the most common. The indirect method takes the net profit or loss from the company’s income statement, adds back any non-cash expenses (such as depreciation and amortization), takes out any non-cash gains or losses that are counted as part of net income, and adjusts for changes in certain balance-sheet items such as accounts receivable (money due to the company that it hasn’t received yet) and accounts payable (bills incurred by the company that it hasn’t paid yet).

Investing cash flow is the net amount of all the cash a company spends or receives for investing activities. This includes capital expenditures, the purchase of businesses, securities, or other investments, and the gains from selling or receiving interest on those investments.

Financing cash flow is the inflow of money from selling stock or issuing bonds or other corporate debt minus the outflow of money for repaying debt, buying back stock, or paying dividends.

If a company has positive cash flow, it is taking in more cash than it is spending. If a company has negative cash flow, it is spending more cash than it is taking in.

A company with positive cash flow has more flexibility to pay its bills, settle its debts, pay dividends to shareholders, and invest in the growth of its business.

Since companies have three different types of cash flow, they could have positive cash flow in one area and negative cash flow in another. Of the three types, it is most important for a company for its operating cash flow to be positive. While a company can make up an operating-cash shortfall through financing, its primary business should be producing cash on its own.

Positive cash flow might seem to be the same thing as profit, but it isn’t.

Profit is revenue minus expenses--a big-picture calculation of how the business is doing. But at publicly traded companies, revenue and expenditures are recorded when they occur, and that could be before or after money is actually exchanged. Cash flow, on the other hand, measures only the cash that comes in and out of a company during a given period--it doesn’t include things like sales or purchases on credit until the money actually changes hands.

One key area where the two calculations differ is accounts receivable, meaning money that a customer owes to the company for purchasing a good or service. Sales on credit count as revenue, so they go into determining a company’s profit and result in an increase of accounts receivable. But it doesn’t count as cash flow--the company hasn’t received the cash yet and can’t use it to pay bills or spend on investments.

Let’s say a company has $1,000 in sales, all on credit. Its income statement would show that amount as revenue, which would boost its profit. But it would lead to $0 in incoming cash flow.

As a result, some investors think operating cash flow is a better indication of how a company is performing than profit. Cash flow leads to liquid, spendable cash, while profit may not necessarily do so.

Cash flow is also harder for a company to “game” than profit--if a company wanted to appear healthier, it could tinker with non-cash items or shift its revenue around so as to inflate its profit for a particular period. Doing this, however, violates accounting rules, and could lead to an investigation from the Securities and Exchange Commission.

Cash flow is dictated by how much cash a company is actually receiving and spending. If a company’s profit is much higher or consistently higher than its operating cash flow, that might be a red flag to investors to look more closely at whether the company’s profit is high-quality - i.e., backed by actual cash coming into the company.

To be sure, there are also times when cash flow can be misleading in terms of how a company is doing. For example, a company could have positive cash flow because it’s borrowed money, but the company has now increased its debt. Cash flow could also be boosted if a company delays paying its vendors.