Cash Flow

This article outlines what cash flow is, why investors care about it, and provides an example of it.

What is “cash flow”?

Cash flow is the net amount of cash generated (or consumed) by a business over a specified period of time.  If cash flow is positive it indicates the business generating money, and if it’s negative it indicates the business is burning money.  Cash flow can be very different than metrics net income or EBITDA because those contain all sorts of accounting principles, while cash flow has all of those accounting principles backed out.

Why do investors care about cash flow?

To most investors “cash is king” and cash flow trumps earnings or EBITDA.  The reason for this is that earnings can be materially difference than cash flow due to the accounting treatment of items on the income statement and balance sheet.  When calculating the internal rate of return (IRR) on an investment, investors use cash flow not earnings.  Cash flow forms the basis of financial modeling and DCF analysis.

What is the “Statement of Cash Flow”?

The cash flow statement reconciles the difference between accounting accruals and actual cash flow.  There are three sections: cash from operations, cash used in investing, and cash from financing.  Combined, the three sections total to the net change in cash over the period, which reconciles the starting and ending cash balances.  The cash flow from operations sections is what investors refer to as “cash flow” and the cash flow from operations less capital expenditures is what investors refer to as “free cash flow”.

Analyzing the cash flows allows managers to make informed changes as need. For example, the managers may decided to address increasing marginal costs to achieve a better free cash flow.

What is an example of cash flow?

Cash Flow Build UpValue
Net Income$1,000
Add back: Depreciation$200
Changes in working capital($500)
Cash From Operations (“Cash Flow”)$700
Less: Capital Expenditures($300)
Free Cash Flow (FCF)$400