Understanding cash flow
In business, cash is king. Companies can put whatever sheen they want on their accounting results — but at the end of the day, if they don't have the actual cash on hand to pay their expenses, then they're in trouble.
This is why a company's cash flow is so important. Accounting rules mean companies can book revenues on their income statement before they've actually received the cash.
They must also recognise non-cash expenses, like depreciation and amortisation, on their income statement. A cash flow statement excludes all this accounting noise and examines the company's actual cash received and paid.
At its core, cash flow refers to a company's money flowing in and out. If it has positive cash flow, this indicates the company has money left over after receiving revenue and paying expenses.
In contrast, negative cash flow indicates the company is losing money, as it isn't generating enough cash receipts to cover its expenses. It's obvious which is the better financial situation for a business!
Management tools
In essence, positive cash flow enables a small business to grow as it can use excess capital from its ordinary operations to invest in the pursuit of higher revenue and a profit down the road. To achieve this, a company needs good cash flow management.
This can include a cash flow analysis, a cash flow budget, and a cash flow projection.
Cash flow analysis examines the sources of a company's cash, like the sales revenue earned on its various products. It also considers where that money goes — whether it's paying the company's employees and vendors, servicing debt, or any other operating costs. The goal of cash flow analysis is to understand how the company is making (and spending) its money so that it can develop strategies to maximise its positive cash flow.
A cash flow budget looks at a company's cash flows over a particular period — be it a week, month, half year or full year. This can help a company determine whether it is bringing in enough cash to cover its expenses. It can also help identify seasonality in cash flows and help the company budget for low periods.
Finally, a cash flow projection estimates a company's future cash inflows and outflows. This can be a detailed model that considers assumptions about a company's sales growth runway and future cost savings.
It even includes factors from the broader economy, like interest rate and inflation forecasts, as well as trends in population growth.
What is a cash flow statement?
A cash flow statement is a document that every listed ASX company must provide to its investors.
It gives us a snapshot of the company's cash position and how it manages its cash flow. This crucial financial statement includes the company's cash receipts, accounts receivable, working capital, expenses, cash balance, and reserve.
A cash flow statement differs from other financial statements listed companies provide (such as the balance sheet or income statement) because it only measures cash and cash equivalents.
However, the cash flow statement complements the other financial statements because it shows how items on the income statement (like operating expenses) and the balance sheet (like the sale or purchase of machinery and equipment) impacts the company's cash position.
A cash flow statement typically comprises three parts:
- Cash flow from operations: Also called operating cash flow, this is similar to free cash flow but doesn't account for capital maintenance or operational expenses. It measures how much cash is left over after the company's ordinary operations without considering other forms of income or cash outflow.
- Cash flow from investments: This reflects a company's income and expenses from investing activities and capital expenditures. It is less helpful than operating cash flow or free cash flow from an investment perspective, but it is still a handy cash flow analysis metric to be familiar with.
- Cash flow from financing: Cash flow from financing is where we can see money flowing in from creditors and out to debtors or shareholders. We can usually see 'post cash flow' expenses like dividends or share buybacks here, as well as finance from creditors and the servicing of debt obligations. While not a measure of pure cash flow, looking at cash flow from financing offers a more well-rounded view of the finances of a business.
What is discounted cash flow?
As an investor, you may have heard of the term discounted cash flow (DCF). No, this doesn't indicate cash flows from the company's products at discount prices.
Instead, a discounted cash flow model is a method many investors and analysts use to value a business as a potential (or current) investment. It is so named because it uses a company's cash flows to forecast how valuable it may be in the future and, therefore, how much we should pay to buy the company today.
It can consider effects like inflation or the 'risk-free rate' in determining the value of the company's cash flows.
The term 'discounted' is used because a DCF calculation will typically work out a company's potential future value in terms of cash flows and then 'discount' it back to what it would be worth in today's dollars.
It works off the principle that a dollar today is worth more than a dollar tomorrow (referred to as the 'time value of money') and adjusts an investor's potential future returns accordingly.
A discounted cash flow valuation can work better with some companies than others. It works best when a company's future cash flow is relatively easy to predict. Examples include toll road operator Transurban Group (ASX: TCL) and utility provider AGL Energy Limited (ASX: AGL).
In contrast, DCFs are less effective when analysing small, high-growth companies that may not be profitable yet (and therefore have no positive cash flow).
How to think about cash flow when investing
Cash flow is an essential consideration for any ASX investor. Cash flow is how companies afford growth, pay dividends, and manage their debt.
A company with consistently positive cash flow and even a cash reserve has ready means to reward its shareholders at the end of the day. Conversely, alarm bells should be ringing if a company has poor cash flow. A business can borrow or raise capital to fill the gap for a while, but not forever.
So, if you're considering investing in an ASX share, be sure to understand the company's cash inflow and outflow and where the money is going.
- With additional reporting by Motley Fool contributor Rhys Brock
Frequently Asked Questions
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In business, cash is king. A company's accounting profit includes non-cash revenue and expenses like accrued income and depreciation. A company's cash flow, on the other hand, doesn't include any of this accounting noise. Instead, it is the actual cash a company has received and paid during the reporting period. It shows you how well a company manages its revenue and expenses – in other words, whether it is earning enough cash to keep the lights on.
Positive cash flow means a company is earning more money than it is spending, while negative cash flow means it isn't making enough to cover its costs. If a company consistently has negative cash flow, it should start ringing alarm bells for investors.
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A cash flow statement is how shareholders, potential investors, and other interested parties can see how a company manages its cash flows. It is one of the financial statements every ASX-listed company must regularly provide to the market.
The cash flow statement is divided into three sections: operating cash flow, investing cash flow, and financing cash flow. Operating cash flow shows how the company manages the cash flows related to its core business operations. This includes cash inflows from sales revenue and outflows for operating expenses, like salaries and wages, advertising and marketing, property costs, and all other overheads.
Investing cash flow includes cash flows from the purchase or sale of assets, including machinery and equipment, as well as any financial securities the company owns. Finally, financing cash flows relate to the company's sources of financing, including debt repayments and any dividends paid to the company's shareholders.
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A company's investing activities are the cash flows it records from buying and selling the long-lived assets (also called non-current assets or long-term assets) it holds on its balance sheet. It also includes capital expenditures the business has made maintaining or improving its existing assets. You can think of investing cash flows as the cash the company invests to grow its business.
For example, if a company purchased a new piece of machinery or equipment, this cash outflow would be recorded in the investing section of its cash flow statement. If the company buys or sells financial securities like stocks or bonds, these would also be recorded as investing cash flows.
For a company to have positive cash flows from investing activities, the proceeds it has earned from the sale of its long-term assets must exceed the cash it has spent on long-term assets during the reporting period. This could happen if it has disposed of expensive assets (like property or shares) but hasn't spent as much money on buying new assets.
