Cash Flow Explained for Dummies

What is cash flow?

Cash flow (CF) refers to the amount of money flowing in and out of a business, institution, or organisation during a specific accounting period such as a month, quarter, or financial year. Cash flow can also be described as:

• The net amount of cash an entity, such as a company or organisation, receives and spends during a given period of time.
• ‘The difference between the available cash at the beginning of an accounting period and that at the end of the period.’ (ecom/encyclopedia/cash-flow)

The cash flow concept can also be applied to the finances of an individual.  

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What is the difference between cash flow and income and profit?

As mentioned, cash flow reflects the specific amount of a business’s cash inflows and outflows over a certain period of time. Put differently, revenues and expenses are recorded when they are received or paid. Income and profit are recorded according to the accrual basis of accounting, an accounting method where revenue and expenses are recorded when a transaction takes place rather than when income is received, or payments made. Income and profit, as indicated in the income statement of a business, also include non-cash items such as depreciation.  

Cash inflows and outflows

Cash flow includes the inflow of cash, also referred to as positive cash flow, and outflow of cash, also called negative cash flow. Typically, the cash flow of a business is categorised into three categories, namely:

• Cash flows from operations (CFO)
• Cash flows from investing (CFI)
• Cash flows from financing (CFF)

 

Cash flows from operations (CFO)

Cash flows from operations, also referred to as operating cash flow or cash from operating activities, refer to cash inflows and outflows with regard to the core or main activities of a business, such as goods or services provided to customers.  

• Cash inflows

These inflows include, inter alia, the sales of goods and services to customers and paid by the customers on the delivery of the goods and services. However, if customers do not pay when the goods or services are delivered or provided, the inflow of cash will occur when the accounts receivable of the particular customers are collected.  

• Cash outflows

Activities such as:

1. Buying of inventory and supplies.
2. Paying the salaries of employees.

Express differently, operating cash flow is the cash version of the net income of a business.  

Cash flows from investing (CFI)

Cash flows from investing (CFI), also known as cash flow from investments, is the net effect from profits gained from or losses incurred on investments. Cash flows from investing also consist of inflows and outflows:  

• Cash inflows

Some examples of cash flows from investing are:

• Sale of investment instruments, such as shares and bonds.
• Sale of fixed assets such as property, plant, and equipment (PP&E).
• Dividends received on share investments.
• Interest received on loans.
• Loans collected that were previously lent to borrowers.
• Proceeds of insurance settlements regarding damaged fixed assets.

 

• Cash outflows

Cash outflows include, among others, the following:

• Investments in investment instruments, such as shares or bonds.
• Purchase of assets like property, plant, and equipment (PP&E).
• Loans provided to borrowers.

 

Cash flows from financing (CFF)

Cash flows from financing (CFF) is an overview of cash used in business financing, indicating the cash inflows and outflows involving debt and equity.  

• Cash inflows

Cash inflows are, inter alia:

• Loans from banks and other financial institutions, or individuals.
• Equity, i. e. money from owners (shareholders).

 

• Cash outflows

Cash outflows comprise activities such as:

• Paying interest on principal debt (principal debt service).
• Repaying of principal debt to lenders.
• Distributing dividends to shareholders.
• Implementing share buybacks.

 

The importance of cash flow

Cash flow is of crucial importance for a business in order to carry on its business operations. It is a well-known fact that a lack of cash is one of the main reasons businesses fail, especially small businesses. Typically, the first six months of a business is a critical period for cash flow. Starting a business implies numerous expenses, which means cash is flowing out fast. Contrarily, sales are not at the same level, meaning cash is not flowing in at the same pace as the cash outflows. Hence, other temporary sources of cash, such as a loan from a financial institution or financial assistance from family or friends, will be required in order to get the business going with a positive cash flow situation. Keep in mind, even when a business starts to generate a profit, profit does not pay the accounts. A business needs cash to pay expenses that are needed to be paid on the spot. Further, a current asset such as accounts receivable has to be converted into cash before it can be part of the positive cash flow of a business. Furthermore, fundamentally, a company’s ability to generate value for its shareholders is determined by its capability to create positive cash flows.  

Analysing cash flow

Because of the crucial importance of cash flow for a business, it can be utilised in many ways to analyse the performance of a business. Many analysts view cash flow analysis as one of the most important standards of measurement in accounting. There are various methods to analyse the cash flow of businesses.  

Debt service coverage ratio (DSCR)

The debt service coverage ratio (DSCR) determines whether a company’s available cash flow is sufficient to pay current debt obligations. Put differently, a company’s DSCR allows creditors, lenders, and investors to determine whether the company has enough cash and cash equivalents to pay off short-term liabilities. Formula to calculate DSCR: Debt service coverage ratio = Net operating income/Total debt service Where:

• Net operating income = Revenue - COE (Net operating income is often viewed as the same as EBIT (earnings before interest and tax)).
• COE = Certain operating expenses.
• Total debt service = Current debt obligations (Including short-term debt and the current portion of long-term debt).

  A DSCR of less than 1 is an indication of a negative cash flow, meaning that a company will be unable to settle short-term debt obligations without obtaining other cash flow sources, such as loans. A DSCR greater than 1 implies that a company has a positive cash flow that enables it to cover short-term debt obligations. However, if the debt coverage ratio is just above 1, for example, 1.1, a business is still vulnerable to default on its short-term debt obligations because a minor decline in cash flow could change a positive cash flow into a negative one.  

Free cash flow (FCF)

The free cash flow formula (FCF) measures the amount of cash generated by a business, after reinvestment in non-current capital assets by a company has been taken into consideration. The formula for FCF is: Free cash flow = Operating cash flow - Capital expenditures Where:

• Operating cash flow is also known as cash from operations (Obtained from the statement of cash flows).
• Capital expenditures are also referred to as CapEx.

 

Price-to-cash-flow ratio (P/CF)

The price-to-cash-flow ratio (P/CF) indicates how much cash a company generates from operating activities relative to its share (stock) price. Put differently, P/CF is an assessment of the share price of a company relative to its operating cash flow. It is a ratio generally accepted as being more reliable than the price-to-earnings (P/E) ratio where a company’s share price is related to its earnings per share. The formula to calculate P/CF is: Price-to-cash-flow ratio = Share price/Operating cash flow per share Where:

• The share price is typically the closing price of the share on a particular trading day.
• Operating cash flow per share is calculated as follows: Operating cash flow (obtained from the statement of cash flows) divided by the number of outstanding shares.

Example of the price-to-cash flow ratio: The share price of company CEZ is R15.00 per share and the company has 100 000 shares outstanding. Its operating cash flow is R500 000. The operating cash flow per share is R500 000/100 000 shares = R5.00 The P/CF ratio = R15.00/R5.00 = R3.00 Thus, the investors of company CEZ are willing to pay R3.00 for every South African rand (ZAR) of operating cash flow. In other words, the company’s market value covers its operating cash flow 3 times.  

Current liability coverage ratio

The current liability coverage ratio, sometimes referred to as the current cash debt ratio or the current cash debt coverage ratio indicates the relationship between net cash generated by a company’s operating activities and the average current liabilities of the company. This ratio demonstrates a company’s ability to generate enough cash from its business operations that can be utilised to cover its current liabilities (debts to be paid within one year). A ratio of less than 1:1 implies that a company is not generating enough cash from operating activities to serve its immediate debt obligations, facing the risk to be declared bankrupt. Formula for calculating the current liability coverage ratio: Current liability coverage ratio = Net cash from operating activities/Average current liabilities Where:

• Net cash from operating activities is the net cash flow from cash inflows and outflows from a company’s operations, as indicated in the statement of cash flows.
• Average current liabilities = opening current liabilities plus closing current liabilities (for a certain accounting period)/divided by 2.

Example of the current liability coverage ratio: Let us say a company generated R550 000 cash from its operations during its last financial year. The opening balance of its current liabilities was R400 000 and the closing balance was R600 000. The average current liabilities = (R400 000 + R600 000)/2 =R500 000 Current liability coverage ratio = R550 000/R500 000 = 1.10 or 1.10:1 The ratio of 1.10 means that the company is able to cover its current liabilities 1.10 times with the cash generated from operating activities.  

Cash flow margin ratio

The cash flow margin ratio expresses the relationship between cash generated from a company’s operations and its net sales. Put differently, the ratio indicates the amount of cash generated per South African rand (ZAR) of net sales and is therefore an important ratio for managers and owners of companies and businesses. Formula for the cash flow margin ratio Cash flow margin ratio = Cash flow from operating cash flows/Net sales Where:

• Cash flow from operating cash comes from a company’s statement of cash flows.
• Net sales are indicated on the income statement and is the sum of gross sales minus returns, discounts, and allowances.

The calculation is often expressed as a percentage and the larger the percentage, the more cash is available from sales.  

Cash flow coverage ratio

The cash flow coverage ratio measures the ability of a company to pay interest and principal amounts on its debts when they become due. Put another way, this ratio indicates how many times a company can cover its debt obligations with its cash flow from operations. A ratio of one or more than one means that a company generates enough cash from its operating activities to meet its debt obligations. For example, a ratio of 2 means that a company could pay its debts (interest and principal amounts) 2 times with its operating cash flows. The higher the cash flow coverage ratio, the more cash a business has available from operations after coverings all its debt obligations. Contrarily, a ratio of less than one is a warning sign that a company is on the path to bankruptcy if it fails to improve its financial position. A too-low ratio can be a sign of too much debt or an inability to generate cash from operations. Formula to calculate the cash flow coverage ratio Cash flow coverage ratio = Cash flows from operations/Total debt Where:

• Cash flows from operations are obtained from the statement of cash flows.
• Total debt is long and short-term liabilities.

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