Cash Flow

Cash flow is an accounting term that refers to the amounts of cash being received and spent 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.

Cash flow measurement can be used 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. Cash measurement can be used 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.

Cash flow is used 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 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 receiving or paying loans, issuing or repurchasing stock, and paying dividends.

All three together are necessary to reconcile the beginning cash balance to the ending cash balance.

Benefits from using Cash flow:

The cash flow statement is one of the three 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.

Operating cash flow as proxy for income:

Many investors have lost faith in the value of published income statements. One way to by-pass them is to use cash flows instead. The feeling is that

  • cash flows cannot be fudged. This presumption is shown to be wrong by the following section.
  • cash liquidity is necessary for survival. This is true, and even more true for businesses with limited access to financing.
  • cash is tangible proof of income. The problem with this concept is that cash can be received as profit on a sale ... but also as proceeds from the sale of an asset with no profit. One asset is simply exchanged for another. This reality is expressed by non-cash expenses like depreciation, amortization and depletion. Capital assets wear out in the process of being used to generate sales. Part of the proceeds from the sale is a return of capital not income. The cash replaces the reduction in the asset’s value.

Considering the problems with GAAP, the growth of a business is better measured by Net Income than by Cash from Operations.

                              Example of a positive $40 cash flow:

Transaction In (Debit) Out (Credit)
Incoming Loan +$50.00  
Sales (which were paid for in cash) +$50.00  
Materials   -$10.00
Labor   -$10.00
Purchased Capital   -$10.00
Loan Repayment   -$5.00
Taxes   -$5.00
Total.......................................... .......+$40.00.......

  In this example the following types of flows are included:

  • Incoming loan: financial flow
  • Sales: operational flow
  • Materials: operational flow
  • Labor: operational flow
  • Purchased Capital: Investment flow
  • Loan Repayment: financial flow
  • Taxes: financial flow

Let us, for example, compare two companies using only total cash flow and then separate cash flow streams. The last three years show the following total cash flows:

Company A:

Year 1: cash flow of +10M
Year 2: cash flow of +11M
Year 3: cash flow of +12M

Company B:

Year 1: cash flow of +15M
Year 2: cash flow of +16M
Year 3: cash flow of +17M

Company B has a higher yearly cash flow and looks like a better one in which to invest. Now let us see how their cash flows are made up:

Company A:

Year 1: OC: +20M FC: +5M IC: -15M = +10M
Year 2: OC: +21M FC: +5M IC: -15M = +11M
Year 3: OC: +22M FC: +5M IC: -15M = +12M

Company B:

Year 1: OC: +10M FC: +5M IC: 0 = +15M
Year 2: OC: +11M FC: +5M IC: 0 = +16M
Year 3: OC: +12M FC: +5M IC: 0 = +17M

  • OC = Operational Cash, FC = Financial Cash, IC = Investment Cash

Now it seems that Company A is actually earning more cash by its core activities and has already spent 45M in long term investments, of which the revenues will only show up after three years. When comparing investments using cash flows always make sure to use the same cash flow layout.