Cash flow is the movement of cash inflows, money into the business, and cash outflows, money out of a business. It is the primary measure of the financial health of a business, its capacity to expand and its solvency and liquidity.
The four core financial statements are the balance sheet, income statement, statement of stockholder’s equity and cash flow statement.
The balance sheet is a snapshot of what the company owns and what is owes at a fixed point in time. The income statement details sales and other income, expenses and how much profit or loss a company made in a period.
In order to match revenues and expenses, these two financial statements are prepared on the accrual basis of accounting, transactions being recognised when they are incurred rather than when monies are received or paid.
The cash flow statement reports cash generated and used during the period, and excludes transactions that do not directly affect cash.
If a business has a positive cash flow, it has higher cash inflows than cash outflows during the period. If negative, it paid out more cash than it received.
The roots of analysing financials on a cash basis started in 1863 with the Dowlais Iron Company.
Although the company was profitable, it lacked cash for expansion. The company prepared a comparison balance sheet on a cash basis and soon discovered it was holding too much inventory.
This was the beginnings of the cash flow statement , which has become a mandatory report by the Financial Accounting Standards Board and International Accounting Standard Board.
The cash flow statement is classified into three categories: operational, investment and financial cash flows.
The operating section begins with net income and converts it from an accrual to cash basis by adjusting net income for items that affected reported net income but didn’t affect cash.
Adjustments are made for non-cash items such as depreciation or write-offs and for changes in the balances of current asset and liability accounts.
For example, an increase in working capital – current assets less current liabilities – implies more cash was invested in the business, thus reducing cash flow. Earnings are considered high quality if cash from operating activities is generally higher than net income. If less, then managers should be concerned, as reported income is not being converted to cash.
The investment section reports capital expenditures and changes in the balances of long-term assets such as property, plant and equipment. If fixed assets such as vehicles were purchased, this would reduce cash flow. If sold, it would increase cash flow. The financing section reports changes in long-term liabilities and stockholder’s equity. If a bond was issued, the cash flow would increase, or decreased if redeemed.
Cash flow statements are used by lenders, investors and shareholders and are generally viewed as the best gauge of the financial health of a business.
It is essentially the capacity of a business to meet its obligations such as payment to suppliers, employees and creditors. It is also an excellent indicator of the ability of the business to expand and return cash to shareholders.
A business may be very profitable, but it will not survive if it lacks the cash flow.
As the well-known saying goes, cash is king.
Anthony Galliano is chief executive of Cambodian Investment Management. firstname.lastname@example.org