Cash Flow

Cash flow is the movement of money into and out of a business, household, project or investment over a period of time. Money coming in, from sales, borrowing or the sale of assets, is an inflow; money going out, for wages, suppliers, interest or equipment, is an outflow. The difference between the two is net cash flow. The term is also written as one word, cashflow, particularly in British usage, and both spellings mean the same thing.

Cash flow is not the same as profit. Profit, reported on the income statement under accrual accounting, records revenue when it is earned and costs when they are incurred, even if no money has changed hands; deferred revenue is one example of the gap. A company can be profitable on paper and still run out of cash if customers pay late, which is why the cash flow statement sits beside the income statement and the balance sheet as one of the three core financial statements.

A household budget is the easiest way to see it. A salary lands in the account at the end of the month, while rent, groceries and bills leave it throughout the month. Over a year the family may earn more than it spends, but if rent is due on the first and pay arrives on the thirtieth, there are weeks when the account runs very low. Cash flow is about timing as much as totals.

A business works the same way. A firm that gives customers 60 days to pay still has to pay its staff and suppliers long before that money arrives. Growth can make this harder, because more orders mean more stock bought up front. Managers watch cash flow closely because an empty bank account, rather than a lack of profit, is what usually forces a company to stop trading.

Under the international standard IAS 7 and, in the United States, the FASB rules that have required a cash flow statement since 1987, companies report their cash movements in three groups:

• Operating activities. Cash from the core business: receipts from customers minus payments to suppliers, employees and, usually, tax.
• Investing activities. Cash spent on or received from long-term assets, such as buying equipment, acquiring other companies or selling investments.
• Financing activities. Cash raised from or returned to lenders and shareholders, including new debt, loan repayments, share issues, buybacks and dividends.

Operating cash flow can be shown directly, by listing receipts and payments, or indirectly, by starting from net income and adding back non-cash items such as depreciation and changes in working capital. Most companies use the indirect method. Interest and dividends may be classified differently under the international and US standards, which matters when comparing companies across borders.

Analysts often focus on free cash flow, the cash a business generates after the spending needed to maintain and expand its assets:

• $\text{FCF}$ is free cash flow for the period.
• Operating cash flow is taken from the cash flow statement.
• Capital expenditures are the cash spent on property, plant and equipment.

A company that reports operating cash flow of 12 million dollars and spends 4 million dollars on new machinery has free cash flow of $12 - 4 = 8$ million dollars. That money is available to repay debt, pay dividends, buy back shares or invest further. Free cash flow is not defined by accounting standards, so companies calculate it in slightly different ways, and readers should check the definition used.

Investors value a company by estimating its future cash flows and discounting them to today, the discounted cash flow method. Buyers of bonds and long-term investors such as pension funds prize assets with steady, predictable cash flows. Lenders ask whether operating cash flow comfortably covers interest and principal, since a business that cannot service its debt from cash is a credit risk. Firms with high leverage have little room when cash flow falls. EBITDA is often used as a rough stand-in for operating cash flow, but it ignores tax, interest, capital spending and swings in working capital.

Corporate treasury teams forecast cash daily, weekly and monthly and use tools such as credit lines, invoice financing and cash pooling to smooth out gaps; see treasury management and cash management. A shortfall begins as a liquidity risk rather than insolvency, but if it is not dealt with it can become both. When many firms and banks face shortfalls at once, the result can be a wider liquidity crisis. In banking and payments the same discipline is called liquidity management: making sure enough money sits in the right account before each settlement.

• IAS 7 Statement of Cash Flows (IFRS Foundation)
• Financial Accounting Standards Board