What are cash flow and cash flow management?
The term cash flow (CF) refers literally to the "flow," or movement of cash funds into or out of a business. This article defines and explains this and related terms such as cash flow stream, net cash flow, and cumulative cash flow, and illustrates their role in financial statement analysis, investment analysis, and business case decision support.
Cash flow is distinguished from accounting terms such as income, revenue, expense, and cost, all of which may result in CF, but which are not that themselves.
- Consider a person paying a restaurant bill with a credit card (a charge card, not a bank debit card). Dinner is an expense event, or cost event, but not cash flow. Cash flow occurs later when the credit card bill is paid.
- A company may purchase goods or services on credit and register a charge (liability) in its own accounts as an account payable. The liability is removed with a different event, later, when cash actually flows from buyer to seller.
- A company may sell goods or services, send the customer an invoice requesting payment, and recognize revenue earned with a transaction in its own accouns as an account receivable. Cash flow associated with the sale may come later when the customer actually sends payment.
Individuals and companies in business need to manage revenues, costs and expenses, on the one hand, and cash inflows and outflows on the other. The majority of businesses worldwide use accrual accounting, by which they report revenues in the period they are earned along with the expenses incurred in earning the same revenues. The resulting cash inflows and outflows may or may not actually occur in the same period.
For companies using accrual accounting …
The timing and management of revenues, costs, and expenses is critical for reporting earnings, determining taxes, and declaring dividends.
The timing and management of cash flow is critical for meeting obligations and needs: Paying employees, paying interest on loans or bonds, or investing in new product development or an infrastructure upgrade, for instance.
Tax authorities also allow businesses to report some non cash expenses on the income statement. These are charges against earnings used solely for the purpose of lowering reported income (thereby lowering taxes). They do not represent actual CF. The best known non cash expense for the income statement is depreciation expense, but others include amortization and writing off bad debts.
Actual CF gains and losses for the period are reported directly on another reporting instrument, the statement of changes in financial position (SCFP, or cash flow statement, or funds flow statement). There are no "non cash" expenses on the cash flow statement.
Note, incidentally, that for the few companies that do use cash basis accounting (instead of accrual accounting), the distinction between cash flow on the one hand and accounting terms (income, revenue, expense, and cost) on the other hand, largely disappears. Accounting on a cash basis is "all about" CF and little else.
Cash flow and net CF are center stage in two kinds of business analyses:
- Financial statement analysis: Cash holdings and flows contribute to metrics for evaluating a company's financial position—especially its ability to meet current obligations and take action on short notice.
- Business case and investment analysis: Cash flows are viewed as the basic input and output of a proposed investment or action. CF Estimates enable further analysis with metrics such as net present value (NPV), internal rate of return (IRR), return on investment (ROI), and payback period.
- What are cash flow and cash flow management?
- What is the role of cash flow in financial statement analysis?
- What is the role of cash flow in business case and investment analysis?
- How should net cash flow be shown graphically?
- How should cumulative cash flow and present value be shown graphically.
- Which financial metrics are frequently used for for comparing investment cash flow streams?
What is the role of cash flow in financial statement analysis?
A company's cash flows over a reporting period are summarized on a cash flow statement (statement of changes in financial position, SCFP). This statement is one of four primary reporting instruments that publicly traded companies publish quarterly and annually. The other three are the income statement, statement of retained earnings, and the balance sheet or statement of financial position. The cash flow statement reports actual cash inflows during the period under "Sources of Cash" and actual cash outflows under "Uses of Cash." Net CF for the period is the difference between total Sources of Cash and total Uses of Cash.
The financial accounting cash flow statement shows management and stockholders the cash holdings available to work with, as well as cash gains and losses during the period just ended. By contrast, the income statement (or profit & loss statement, P&L) tells stockholders and taxing authorities what the company reports for earnings during a period.
cash flow statement also helps explain the differences between the
current balance sheet and the previous period's balance sheet. Note that
some companies (e.g., IBM) call their balance sheet a "Statement of
Financial Position." This helps explain why the financial accounting
CF statement is also known as the "Statement of Changes in Financial Position."
The company's end-of-period cash holdings are also shown as an asset account on the balance sheet called Cash on hand or something similar. Cash on hand appears under Current assets, along with other relatively liquid assets such as inventories and accounts payable. "Cash" is by definition a "liquid" asset, and the balance sheet "Cash on hand" account is a major contributor to financial statement liquidity metrics such as working capital, current ratio, and the quick ratio.
Working capital is simply the company's Current Assets less Current Liabilities, both taken from the balance sheet. Working capital is expressed in currency units (for example, dollars, euro, pounds, or yen).
The current ratio uses the same balance sheet input figures as working capital, except that it makes a ratio of them. Current ratio is the ratio of Current Assets to Current Liabilities.
As mentioned, the Current Assets figure used for both metrics includes cash, as well as other assets that could—in principle—be turned quickly into cash (primarily Inventories and Accounts receivable).
A more severe variation on the current ratio is the quick ratio metric:
Quick ratio (or acid-test ratio) is calculated just like the current ratio, except that quick ratio essentially uses only Cash and Accounts Receivable (but not Inventories) in it's numerator:
For example, consider a company whose end-of-year balance sheet reports:
Current Assets: $9,609,000
Current Liabilities: $3,464,000
These data are sufficient for measuring the company's liquidity as follows:
= Current assets – Current liabilities
= $9,609,000 – $5,986,000 = $3,623,000
= Current assets / Current liabilities
= $9,609,000 / $5,986,000
= (Current assets–Inventories) / Current Liabilities
= ($9,609,000 – $3,464,000) / $5,986,000
Management will have a keen interest in knowing the working capital figure when budgeting and when planning projects, programs, products, and expensive initiatives for infrastructure improvement or research and development. Working capital must be sufficient for these plans, as well as covering financial expenses (e.g., paying interest on bonds) and operational expenses (such as paying employee salaries).
very poor cash position is signaled by any or all of the following:
negative working capital, a current ratio less than 1.0, or a quick
ratio less than 1.0. In such cases, the company is clearly not well
prepared to meet payroll or other short term obligations. By contrast,
an abundance of working capital or high current ratio (or high
quick ratio) indicates the company can pursue investments—such as
entering new markets, product research and development, or upgrading
corporate infrastructure—without borrowing, and without putting other
critical operating needs at risk.
What is the role of cash flow in business case and investment analysis?
In the simplest kind of investment analysis there may be only two cash flow events: The original investment (cash outflow) and collection of the returns (cash inflow). That scenario describes an investor who buys a certain kind of bond (a non-coupon paying bond, such as a US Government savings bond) and then holds it and redeems it at maturity. The two-event CF scenario also describes an investor who makes a winning bet on a racehorse. Investment metrics such as simple return on investment, yield, and present value are still possible with two-event transactions like these .
In business, however, investments (or actions examined with business case analysis) typically bring a series of cash inflows and outflows over time. The resulting cash flow stream for a large business may look something like this:
A cash flow stream for analysis such as the one above typically results from many kinds of business investment actions.
This kind of cash flow stream may result, for instance, from actions such as ...
- Business investments of many kinds (e.g., buying bonds or investing in real estate properties).
- A capital acquisition (e.g. acquiring production machinery, vehicles, or computer systems).
- A decision to fund and launch a project or program (e.g., a marketing program or an employee training program).
- A decision to add a line of business (e.g., after-sales customer service business).
- A large set of activities and investments that are the focus of a single business case analysis
forecasting a stream of this kind, management takes the
analysis further with financial metrics designed to answer specific
kinds of questions:
- Does this investment represent a good business decision?
- How do returns compare to investment costs?
- How does this investment (or action) compare to other potential uses of the same investment funds?
- Which possible course of action is the better business decision?
In this way, projected CF and its analysis lie at the heart of the financial business case.
Consider an action called "Investment Alpha." The estimated cash inflow and cash outflow consequences from taking the action are as follows:
The action or acquisition under consideration is expected to bring a net inflow of $100 over five years. Note that each column and row tells a story: Inflows continue to rise throughout the 5-year period, but so do total outflows. Management will want to use this understanding and the data behind it, for instance, to apply financial tactics: reduce costs, increase gains, accelerate gains. In a nutshell, a business case summary should always include a projected net cash flow stream for each business case scenario. The scenario cash flow summary …
- Shows actual inflow and outflow figures, which are important for budgeting and business planning.
- Provides the basis for calculating other financial metrics, such as NPV/DCF, IRR, and payback.
- Is the beginning point for management actions to manage and optimize overall results.
How should net cash flow be shown graphically?
For reports and presentations it is usually helpful to show cash flow results as graphical images, in addition to the tabled figures, even when the graph only contains information that could also be read from the table. The graph communicates a "feel" for the overall flow pattern and period to period trends that is not so easily grasped from reading numbers.
A net cash flow stream, such as the right column of the table above, is normally graphed as a series of simple vertical bars, like the examples above and below.
When it is important to see the inflows and outflows that contribute to net figures, the analyst can show inflows, outflows, and their net all In one graph using a combination chart, such as the one below.
How should cumulative net CF and present
value be shown graphically?
It is often helpful to present net cash flow figures and graphs along with other metrics derived from these figures, including cumulative CF and present values for the stream. In this case, the net cash flow figures are used first to create additional data for graphing, as shown in the summary below: This list starts with the five year Net CF figures from the list in the section above. Each year's cumulative CF and Present value (discounted value) is derived from the Net figures.
Cumulative figures show the total net cash flow through the end of
each period. The cumulative value for Year 3, for instance, is the sum of the the year's net cash flow plus the net figures for Years 2, 1, and the initial outflow:
$40 + $20 + 20 – $100 = –$20.
For more on the computation and
uses of payback period as a financial metric, see the
Encyclopedia entry Payback period. (Note, incidentally, the line chart shown here is a Microsoft Excel X-Y Scatter Plot Chart, not
an Excel Line chart. Only the scatter plot places data points
appropriately at each year end on the horizontal axis, thus locating the
payback event correctly.)
When the cash flow figures are used for discounted analysis, the analyst can graph each net figure alongside its discounted result, that is, alongside its present value, as shown in the bottom graph.
Each present value is the future net figure (here, called future value), divided by (1+ i )n, where i is an interest rate (discount rate) and n is the number of interest periods (here, years). Using an 8% discount rate, the Year 3 present value is $31.75 when the future net figure, $40, is divided by (1 + 0.08)3 (That is, $40 divided by 1.26). See the next section of this article. (For more complete coverage of discounting calculations, see the Encyclopedia entry for Discounted cash flow).
Which financial metrics are frequently used for comparing investment cash flow streams?
- Cash flow projections often serve as the starting point for comparing different investment possibilities or different business case scenarios. A recommended choice of investment or course of action may
depend on the analyst's evaluation of the projected CF streams
from each alternative. Such analyses typically center on several
- Net CF
- Net present value (NPV)
- Simple return on investment (ROI)
- Payback period
- Internal rate of return (IRR)
It is rarely advisable to base important business decisions on a single financial metric. When comparing different cash flow streams, different metrics can in fact "disagree" as to which stream represents the better business decision. Decision makers will usually want to see how each action alternative scores on several or all of the above metrics before making a recommendation.
Consider, for example, two competing investment proposals, Investment Alpha and Investment Beta. The expected cash flow streams for each investment appear in table 1 and the graph below:
Table 1. Expected cash flow streams for Investment Alpha and Investment Beta (Investment Alpha figures are the same as those in Table 1 and the graphical images above). Financial metrics for these figures include net CF, NPV, IRR, ROI, and payback period, all of which address the question "Which investment is the better business decision?
Which investment, Alpha or Beta, is the better business decision?
Which investment should the analyst recommend?
Part of the information needed FOR an informed judgement comes from the financial metrics listed above calculated for each cash flow stream. The results appear in table 2, below:
Table 2. Cash flow financial metrics for two investment cash flow streams. The results for all metrics except ROI are based entirely on net cash flow figures from Table 3. ROI alone is sensitive to the magnitudes of individual cash inflows and outflows each year.
Regarding Investment Alpha and Investment Beta cash flow streams, Table 2 include financial metrics in favor of both potential investments.
Investment Alpha has a higher net CF ($100) than Investment Beta ( $95). However, the difference is only 5% of Investment Alpha's five-year net. The decision maker will have decide if this advantage is large enough to matter. Nevertheless, the net CF results are one point in favor of investment Beta.
There is another story, however, lying beneath the net cash flow figures. While Investment Alpha has the higher five-year net CF, Investment Beta has larger total inflows and outflows. Total outflows (costs, or expenditures) for Investment Alpha are $225, whereas total outflows for Investment Beta are $350, for example. Setting aside investment returns and focusing only on investment costs, Investment Beta is 56% more costly that investment Alpha. Before committing to Investment Beta, management will consider whether the extra funds that would be tied up for Investment Beta might instead be put to better use elsewhere.
Net present value (NPV)
It is easy to see in Table 3 and in the image above that investment Beta has the "early returns," while investment Alpha shows the larger returns later in the five-year period. This difference is highlighted when both investments are evaluated as Net present value (NPV), a direct measure of the "time value of money." When the cash flow streams are viewed as discounted cash flow (using an 8% discount rate), it is no surprise that investment Beta has a higher NPV ($59.51) than investment Alpha ($52.36). The Net present value results are a strong point in favor of investment Beta.
Net present value (NPV) for investment Alpha is calculated as follows:
NPV = ∑ FVj / (1+ i )n for j = 0 to n
FVj for each yearly period j = Net cash flow for the period.
Discount rate i = 8.0% ( 0.08) for example period.
j = 0 (now) through 5 (Year 5)
NPV1 = –100/(1+.08)0 + 20/(1+.08)1
+ 20/(1+.08)2 + 40/(1+.08)3
+ 60/(1+.08)4 + 60/(1+.08)5
= –100 + 18.52 + 17.15 + 31.75
+ 44.10 + 40.83
Using the same approach with investment Beta's net cash flow figures (for FVs), NPV2 = $59.51. NPV results are a point in favor of investment Beta.
Simple return on investment (ROI)
Investment 1 shows a simple Return on Investment (ROI) of 39.2%, whereas investment Beta shows a 27.1% ROI for the five year period. This is not surprising because both investments have similar net CF, but investment Beta has larger net costs. Of the cash flow metrics shown here, only ROI is sensitive to the magnitude of individual costs (cash outflows) as well as the net of cash inflows and outflows. ROI is sometimes said to measure the "efficiency" of an investment, and in this case investment Alpha wins the efficiency contest. Whether or not investment Alpha should be recommended depends on whether or not investment Beta is the only other possible use of funds and, if not, how still other possible measures compare on this metric. Regarding simple return on investment, however, ROI results are a point in favor of investment Alpha.
Simple return on investment for this analysis is calculated as follows:
ROI = (Net gains – Net Costs) / (Net Costs)
For investment Alpha . . .
ROI = ((0+40+50+75+90+100)
Using the same approach, simple ROI for investment Beta is 27.1%.
Financial officers usually prefer shorter payback periods over longer payback for two reasons. With a shorter payback period, returns are considered less risky. Also, the shorter payback period means that invested funds are recovered sooner and available for further productive use. On the payback period metric, investment Alpha "pays for itself" in 3.33 years, while investment Beta requires only 2.00 years to cover investment costs. Payback period is a strong point in favor of investment Beta.
Payback period for investment Alpha may be determined from the Net CF and Cumulative CF data in Table 2 (see the previous section, above).
note that Cumulative flow goes from negative to positive between
the end of Year 3 and the end of Year 4. That means that payback occurs
at some time during Year 4.
- Note also that at the end of Year 3, Cumulative flow is -$20 and that Net CF during Year 4 is $60. This information is sufficient to locate the payback point in Year 4 by interpolation. At the start of Year 4, $20 more must be "paid back" in order for returns to exactly cover costs. The analyst assumes this occurs at 20/60 of Year 4, i.e., after 0.33 years. Payback period for investment Alpha is thus 3 + 033 = 3.33 Years.
- By the same approach, Payback period for investment Beta is 2.0 years.
that this approach can be used only when cumulative cash flow is
monotonically increasing across time (i.e., cumulative CF always
increases from period to period). For more on the mathematics and
meaning of cash flow payback, see the encyclopedia entry Payback period.
Internal rate of return (IRR)
Also no surprise, the heavier "early returns" with investment Beta compared to investment Alpha lead to a higher IRR with investment Beta (30.9%) than with investment Alpha (22.4%). Both IRR's are no doubt much higher than the investor's cost of capital, and financial officers will no doubt agree that both investments are for that reason a "net gain." However, the higher IRR with investment Beta is a strong point in favor of investment Beta.
For more on finding the IRR for a cash flow stream and the meaning of IRR, see the encyclopedia entry internal rate of return.
Cash flow metrics: Conclusion
Which investment, Alpha or Beta, is the better business decision? The five financial metrics above can be viewed as providing a mixed "scorecard" on the potential investments. However, by this scorecard—and absent any other information about the two investments—an experienced financial specialist or investment analyst would probably vote in favor of investment Beta, the alternative with the higher NPV, higher IRR, and shorter payback period.
Looking beyond the cash flow .
Nevertheless, the prudent investor will also consider two other factors before committing to a choice:
The financial metrics above say nothing about the likelihood these
cash flow projections actually appear. The decision maker will also
try to measure the probabilities that predicted results arrive, as
shown, as well as the probabilities that other, different results
The wise investor, in other words, considers potential rewards (measured by financial metrics) and then weighs them against risks.
Other business benefits:
For investments or actions where all benefits and costs are directly
measurable in cash flow terms, the metrics above (and a risk analysis)
may be sufficient for the decision maker. However, cash flow metrics
are "blind" to business benefits from outcomes that contribute to non
financial business objectives.
Many actions and investments are undertaken for the purpose of contributing to business objectives that may be defined first in non financial terms. Such benefits may be made tangible and measured in terms of changes in key performance indicators, but not initially in terms of cash flow.