The Essence of Cash Flow


By cash flow, we simply mean the difference between the number of dollars that came in and the number that went out.

For example, if you were the owner of a business, you might be very interested in how much cash you actually took out of your business in a given year. No standard financial statement presents this information in the way that we wish. We will therefore, point out how
the result differs from that of standard financial statement calculations. There is a standard financial accounting statement called the statement of cash flows, but it is concerned with a somewhat different issue that should not be confused with what we’re discussing here.

From the balance sheet identity, we know that the value of a firm’s assets is equal to the value of its liabilities plus the value of its equity. Similarly, the cash flow from the firm’s assets must equal the sum of the cash flow to creditors and the cash flow to stockholders (or owners):

Cash flow from assets = Cash flow to creditors + Cash flow to stockholders


Cash Flow for Assets:

Cash flow from assets involves three components: operating cash flow, capital spending, and change in net working capital. Operating cash flow refers to the cash flow that results from the firm’s day-to-day activities of producing and selling. Expenses associated with the firm’s financing of its assets are not included because they are not operating expenses.

Some portion of the firm’s cash flow is reinvested in the firm. Capital spending refers to the net spending on fixed assets (purchases of fixed assets
less sales of fixed assets). Finally, change in net working capital is measured as the net change in current assets relative to current liabilities for the period being examined and represents the amount spent on net working capital.


Operating Cash Flow:

To calculate operating cash flow (OCF), we want to calculate revenues minus costs, but we don’t want to include depreciation because it’s not a cash
outflow, and we don’t want to include interest because it’s a financing expense. We do want to include taxes because taxes are (unfortunately) paid in cash.

Operating cash flow is an important number because it tells us, on a very basic level, whether a firm’s cash inflows from its business operations are sufficient to cover its everyday cash outflows. For this reason, a negative operating cash flow is often a sign of trouble.

There is an unpleasant possibility of confusion when we speak of operating cash flow. In accounting practice, operating cash flow is often defined as net income plus depreciation.

This definition of cash flow thus considers interest paid to be an operating expense. Our definition treats it properly as a financing expense. If there were no interest expense, the two definitions would be the same.


Capital Spending :

Net capital spending is just money spent on fixed assets less money
received from the sale of fixed assets.

Could net capital spending be negative? The answer is yes. This would happen if the firm sold off more assets than it purchased. The net here refers to purchases of fixed assets net of any sales of fixed assets. You will often see capital spending called CAPEX, which is an acronym for capital expenditures. It usually means the same thing.


Change in Net Working Capital :

In addition to investing in fixed assets, a firm will also invest in current assets.

As the firm changes its investment in current assets, its current liabilities will usually change as well. To determine the change in net working capital, the easiest approach is just to take the difference between the beginning and ending net working capital (NWC) figures. This change in NWC is often referred to as the “addition to” NWC.


Cash Flow to Creditors & Stockholders :

The cash flows to creditors and stockholders represent the net payments to creditors and owners during the year. Their calculation is similar to that of cash flow from assets. Cash flow to creditors is interest paid less net new borrowing; cash flow to stockholders is dividends paid less net new equity raised.


A Note about “Free” Cash Flow:

Cash flow from assets sometimes goes by a different name, free cash flow . Of course, there is no such thing as “free” cash (we wish!). Instead the name refers to cash that the firm is free to distribute to creditors and stockholders because it is not needed for working capital or fixed asset investments. We will stick with “cash flow from assets” as our label for this important concept because, in practice, there is some variation in exactly how free cash flow is computed; different users calculate it in different ways.

Nonetheless, whenever you hear the phrase “free cash flow,” you should understand that what is being discussed is cash flow from assets or something quite similar.


[Note: This was just a brief discussion of Cash Flow. I tried to explain the topic as easily as possible with the limited knowledge I have on the matter.

Hope this could be of help.]


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