What is cash flow?

Cash flow is the movement of money in and out of a business, organization, or an account. Cash flow is important as it helps evaluate the current value and situation of a business, which are essential to solvency.

Not to be confused with ‘cash’, which simply means the most liquid assets there are, i.e. coins, notes, traveler’s checks and some short-term bank deposits and other negotiable instruments.

When the amount of money flowing in is greater than how much is flowing out, this is a sign of good financial health, both for businesses and private individuals.

With good cash flow, a company has plenty of cash on hand to pay wages and suppliers. The same goes for private individuals – we all need enough money flowing in to pay for where we live, our cars, and other personal expenses.

Cash flow problems can cause businesses to die. For example, if there are too many outstanding or uncollected invoices, but you have to pay your bills on time, you will probably have a cash flow problem unless you have an emergency fund. It is crucial that businesses and individuals manage their cash flow carefully and set aside emergency reserves.

Cash FlowCash flow refers to the incomings and outgoings of cash, representing the operating activities of an organization.

Normally cash flows are measured during specific periods – typically quarters, half years, or full years. The opening balance refers to how much cash was available at the beginning of a period, while the closing balance was how much was available at the end of that period.

The net cash flow of a business over a period is found by calculating the change in cash balance over this period.

If the amount of cash (cash balance) goes up, then it’s positive and there is more available cash, whereas it is negative if the cash balance drops.



 

Cash flow in other languages: French, cash flow; Spanish, flujo de caja; Portuguese, (Brazil) fluxo de caixa (Portugal) fluxo de tesouraria; German, cashflow; Chinese, 现金流通现現金流通; Japanese, 資金繰り; Russian, денежный поток.

Net cash flow

Net cash flow is the sum of the following:

  • Operational cash flows: cash that comes in through internal business activities, such as cash earnings and working capital changes. For a business to be solvent this must be positive.
  • Investment cash flows: cash coming in from the sale of long-life assets or capital expenditure.
  • Financing cash flows: cash acquired from the issue of debt or paid out as dividends.

Liquidity vs. Cash Flow

Liquidity refers to an organization’s ability to meet its current liabilities using available current assets. Cash flow refers just to cash that flows in and out.

How well a firm performs in these two areas can affect its ability to operate, and ultimately, also its profitability.

Liquidity also refers to a business’ assets that can easily be converted into cash with either no loss of value or extremely little. An example of a liquid asset is a savings account.

Liquidity can impact cash flow. If a business does not have enough cash flow to cover an obligation, it has the option of liquidating an asset to raise the amount of cash on hand. The moment it turns an asset into cash, it has increased the amount of incoming, i.e. part of its cash flow.

Warren Buffet“I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.” (Warren Buffett, American business magnate and investor)

Below is an example of how net cash flow is calculated:

Description Amount ($) totals ($)
Cash flow from operations +30
  Sales (paid in cash) +50
  Materials -10
  Labor -10
Cash flow from financing +30
  Incoming loan +40
  Loan repayment -5
  Taxes -5
Cash flow from investments -8
  Purchased capital -8
Total +52

Why is cash flow important?

  • It allows you to determine the rate of return or value of a project.
  • To assess any liquidity problems. Being profitable does not always mean a business is liquid.
  • When accrual accounting concepts may not accurately portray economic realities, cash flow statements can be used as a means of determining profits. 
  • To assess what percentage of net income is made up of non-cash items (which would make it low quality).
  • For risk evaluation

Video – Cash flow explained