Cash flow is the knowing the movement of cash in or out of the business, financial products or projects. It is always measured during a specified time period.
Measurement of cash flow can be used for various reasons like:
- To decide the return rate of the project’s value. The entire time for the cash flow in or out of the project is used for the financial inputs in models like net present value and internal rate or return.
- To understand the problems with the liquidity of business. If there is profit then it does not mean the company is liquid. A company can fail anytime if they are short on cash, even if they are making profit.
- It can be used as an alternate method for the profits in the business when you come to know that the accrual accounting concept doesn’t represent some of the economic realities.
- Cash flow at times can be used for evaluating the quality generated from the accrual accounting. When the net income is composed of large non-cash things then it is considered as low quality.
- To determine the risks in a financial product.
However, cash flow is a very generic term, which is used according to the preference of the user. It may be used to define the past flows, or the projected flows in the future. It can also refer to all the flows that have been involved or subset of those flows. The term subset means net cash flow, free cash flow and operating cash flow.
Financial statements are not that useful on their own, so it is really important to have a cash flow statement as it gives the critical overview of how much money is actually flowing out of or into a company. There are three sections in a cash flow and every section will reconcile information on the income statement of your company along with some information on the balance sheet. To start with the process of reconciliation, the cash flow statement starts with net income number from the income statement.
Here are some simple steps on how to read cash flow.
Steps:
- The cash flow starts from the cash flow of the operating activities. Now, at this time the non-cash expenses like depreciation and amortization are again added to the income. Some of the uncollected cash like the accounts receivable is deducted, since those sales were included in net income and revenue and the cash has to be collected yet.
- The second section for the cash flow statement will track the activities of investing. The most important and the largest component of this category includes money spent on the acquisition of certain capital assets like equipment, plants and property. Sometimes if applicable, investments and loans that are given to the customer or suppliers are included here as the cash outlays.
- The final section has all the financing activities. For instance, if a company has issued stocks, their offering is preceded with added cash in the category. The paid dividends are also included in this section since their principle of debt is completely owned by the company.
- The cash flow statement will have many several individual items but either of them will fall into any one of these categories. Once you have accounted these three categories for cash flow the net result will be an increase or decrease in the cash for the time being. This is the most important thing to understand.
- The cash flow statement is extremely revealing so you have to keep two things in mind while reading cash flow.
- As the shareholder, you must be concerned with not only the amount of cash growing but also the paid dividends by the company also. It is always the best idea to include the dividends paid while you are evaluating the net increase of cash, as this will be the clear benefit for all the shareholders.
- You will usually hear the analyst say ‘free cash flow’ or ‘free cash flow per share’ as a simple measure for financial performance but this is not equivalent to the net decrease or increase to cash at the bottom of the statement of cash flow. Free cash flow will exclude all the financial activities and it will never look like a complete picture of the abilities for generating cash for the company being analyzed.
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