What is… Cash Flow?
Often, especially after there are a slew of company quarterly earnings announcements, I get asked about cash flow and what that actually means. Most people have a general idea of income, profit, even margin (to a degree). But cash flow is one that can be confusing or misunderstood. So let’s take a brief look at what cash flow is.
The term cash flow refers to the net amount of cash and cash equivalents being transferred in and out of a company. 1
The concept is simple: the money you have coming in from sales or investments needs to be enough to pay for your expenses related to your business at any given time. In our retail world, cash is mostly generated from the sales though registers and online transactions. That cash is then used to cover expenses like payroll, rent, the cost of the merchandise, supplies, and utilities. Business cash flow is no different from your personal cash flow. If you spend more money than you have, you find yourself in a negative cash flow situation.
At the company level, this can become a little more complicated, in the sense that businesses may have multiple streams of revenue or ways of creating cash flow. Long-term investments, issuing of stock, or use of credit lines can all be forms of cash flow to help cover the immediate needs of maintaining the business. Most of what I described above is cash from operations, and is a critical view into the viability of the day-to-day business. This can be seen on a company’s cash flow statement.
Operating cash flow is calculated by taking cash received from sales and subtracting operating expenses that were paid in cash for the period. 2
Investors tend to look at the long-term prospects of free cash flow to understand the health of a business. Is a company generating enough cash in each quarter to cover the expenses in that quarter, but also the prospects of upcoming business trends and known expenses? Using another retail example, where typically the holiday season can be a significant portion of a company’s income (or incoming cash flow), that amount of cash generated may need to cover several other month’s worth of expenses. Additionally, that cash must cover the cost of paying vendors for the merchandise that was sold. Timing of cash flow is sometimes as important as the amount of cash. If you know you have a big expense coming up, you need to save cash to be able to pay that bill when it's due. Looking at this over an extended period of time can provide good insight into the health of a business, as well as how the strategies are paying off in performance.
Cash is still king, and while we may see less of the physical dollars, it still represents what a company needs to pay for anything it has to buy. One final area that can create some confusion is how capital is connected to cash flow. Capital is usually a reference to large assets that are purchased for businesses. They have an extended life and are used for operating the business. Capital still requires cash flow. In some cases (especially for smaller businesses), those investments may use borrowed money (debt) to pay up front, but the cash is still required to pay down that debt over time. For larger businesses, cash is used to make the purchase. You can see a company’s collective assets on the balance sheet.
Reviewing the income and the balance sheet will give you an idea of the company’s cash flow picture. This is the cash flow statement. It can almost be considered the checkbook balance or, if you have all of your personal banking within a single account, your account register.
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1 https://www.investopedia.com/terms/c/cashflow.asp
2 https://www.investopedia.com/terms/c/cashflow.asp