Cash flow (also called net cash flow) is the balance of the amounts of cash being received and paid by a business during a defined period of time, sometimes tied to a specific project. Measurement of cash flow can be used
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Cash flow (also called net cash flow) is the balance of the amounts of cash being received and paid by a business during a defined period of time, sometimes tied to a specific project. Measurement of cash flow can be used
- to evaluate the state or performance of a business or project.
- to determine problems with liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable.
- to generate project rate of returns. The time of cash flows into and out of projects are used as inputs to financial models such as internal rate of return, and net present value.
- to examine income or growth of a business when it is believed that accrual accounting concepts do not represent economic realities. Alternately, cash flow can be used to 'validate' the net income generated by accrual accounting.
Cash flow as a generic term may be used differently depending on context, and certain cash flow definitions may be adapted by analysts and users for their own uses. Common terms (with relatively standardized definitions) include operating cash flow and free cash flow.
Classification
Cash flows can be classified into:
- Operational cash flows: Cash received or expended as a result of the company's core business activities.
- Investment cash flows: Cash received or expended through capital expenditure, investments or acquisitions.
- Financing cash flows: Cash received or expended as a result of financial activities, such as interests and dividends.
All three together - the net cash flow - are necessary to reconcile the beginning cash balance to the ending cash balance. Loan draw downs or equity injections, that is just shifting of capital but no expenditure as such, are not considered in the net cash flow.
Benefits from using cash flow
The cash flow statement is one of the four main financial statements of a company. The cash flow statement can be examined to determine the short-term sustainability of a company. If cash is increasing (and operational cash flow is positive), then a company will often be deemed to be healthy in the short-term. Increasing or stable cash balances suggest that a company is able to meet its cash needs, and remain solvent. This information cannot always be seen in the income statement or the balance sheet of a company. For instance, a company may be generating profit, but still have difficulty in remaining solvent.
The cash flow statement breaks the sources of cash generation into three sections: operational cash flows, investing, and financing. This breakdown allows the user of financial statements to determine where the company is deriving its cash for operations. For example, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a case, the company may be deriving additional operating cash by issuing shares, or raising additional debt finance.
