Let’s begin by defining the term. Cash Flow is the net amount of cash and cash equivalents going in and out of a company. The cash inflows are the revenues or income generated by the sales of goods and services, the cash inflows from treasury optimization, and short and long-term borrowing. In summary, it’s the cash from operations, investing, and financing. The cash outflows are the money expended, typically described as recurrent expenses, debt service, capital investments, asset protection, and payments for goods and services received. In other words, if a company brings in more cash than it spends, it has a positive cash flow. The inverse, or a negative cash flow, would occur if the organization spends more than it earns.
The “why” is the organization’s purpose. In short, it is the driver, the motivator, and the reason entrepreneurs assume the risk of monetizing their vision (whether altruistic or for-profit). The “how” is the organization’s process defined in the mission statement. It describes the actions and methods to execute the organization’s purpose and how to monetize the entrepreneur’s dream. The “what” are the outcomes, goods, or services the organization generates. “Cash Flow” analyzes the organization’s effectiveness in realizing the “why.” The organization’s values represent the common beliefs binding the people driving the organization’s purpose.
Cash Flow analysis, as previously described, assesses the amounts of cash, the timing, the certainty of the source, and where these resources are spent. This represents one of the most important objectives of financial reporting allowing organizations to manage their affairs. It is essential to the organization’s liquidity, flexibility, and overall financial performance. The “why, how, and what” is often described as the guardrails of the organization.
What Are the Types of Cash Flow?
There are three types, and all describe cash inflows and cash outflows.
- Investing Cash Flow for capital investment projects and other speculative assets. The revenues generated are based on reasonable price scenarios and the sales of goods and services forecasting. These inflows are used to assess the economic indicators (return on equity invested, payout time, etc.) generated from the efficient use of the outflows: Capital Expenditures (CAPEX), Operating Cost (OPEX), Cost of Money (financing), and the general burdens (taxes, licenses, royalties, etc.). Also, it is often described as the Cash Flow that has been generated or spent from various investment-related purchases or sales of speculative assets and securities in a specific period.
- Financing Cash Flow is the net Cash Flow used to fund the organization. Corporate or self-financing is the average cost of funding the organization using all its financial sources. This may include the owners’ own money, issuing debt, equity, and paying dividends. This Cash Flow projection is usually a measure of the organization’s financial strengths.
- Operations Cash Flow describes the money flow directly associated with the services provided and the production of goods sold now (associated with the organization’s “what”).
For all three types, the objective is the same. For long-term sustainability, the organization must generate more cash than it uses (i.e., positive cash flow). Therefore, Cash Flow planning is one of the tools required to analyze the organization’s “how” or processes. It also permits the company to evaluate its fidelity to the “why” or purpose.
How Can Cash Flow Analysis Assess Performance?
The principal indicator in cash forecasting for investors and owners is how much money or net income an organization generates. In my view, net profit is the leading indicator of performance. Cash Flow is different from Profit. Profit is a measure of organizational financial success or failure. It answers how much money it makes (net income) or loses (cash shortages) overall. Profit is best described as the money left after the organization has paid off all its obligations, calculated by subtracting the expenses from the revenues. Cash Flow, in conjunction with the organizations’ financials obtained from the: cash flow statement balance sheet or financial statement of profit and loss, is used by analysts to arrive at various metrics and ratios used by investors and owners to make informed budgeting decisions and recommendations.
The best-in-class organizations can only succeed if they generate enough cash inflow to stay liquid. We can use financial indicators to assess an organization’s liquidity level. The best way to think about liquidity is how quickly the organization can get cash. I prefer the Quick Ratio: the ability to pay short-term debt obligations with its most liquid assets. The use of ratios or Ratios Analysis is the method of quantifying an organization’s liquidity, operational efficiency, and profitability. At Cogent, we use three:
- Cash Conversion Cycle (CCC), defined as Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO).
- Days Cash on Hand, defined as Cash on Hand / (Operating expenses – Non-cash expresses) / 365.
- Liquidity Ratio (Quick Ratio) is a measurement that shows how much cash the organization has available to pay bills and debts. In addition to the Liquidity and Solvency Ratios previously described, other ratios are used (for example, Debt Service Coverage Ratio (DSCCR), Free Cash Flow (FCF), Lending Cover Ratio (CR), Unlevered Free Cash Flow (UFCF), etc.).
Let’s define some of the most frequently used terms:
- Debt Service Cover Ratio: DSCCR = Net Operating Income/Short-Term Debt Service. This ratio assesses the organization’s ability to meet its current liabilities with the cash it generates from operations. The pitfall is that the organization might have lots of money because it is mortgaging its future (ex., by selling off its long-term assets or taking on unsustainable debt levels). Another pitfall is when the profit is tied to standing account receivables and overstock inventory or is expending too much in capital investment ventures.
- Free Cash Flow. FCF = Operating Cash Flow – Capital Expenditures. This indicator shows the organization’s money left to expand the business after paying dividends or paying off debt.
- The banker’s preferred indicator is the Loan Cover Ratio: LCR = Free Cash Flow/Repayment Schedule. Banks are not in the business of repossessing assets. They are in the business of making money. It is recommended that the organization create reserve accounts to handle short-term liabilities and future fluctuations.
In short, we can use Cash Flow planning with the organizations’ financials to assess if we are meeting our purpose, the “why.” These tools are indispensable to making informed decisions and recommendations about the state of our process (the “what”) and the actions that are needed to reach the desired outcome of future cash flow management (the “how).