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Cash Flow: What It Is, how it works, and how to analyze It?

ICICIdirect 7 Mins 06 Dec 2023

If you are an investor, you need to understand the nuances of cash flow, as it is paramount to make informed investment decisions. If we were to explain its importance in a line, it would be that cash flow is the lifeblood of any business. 

And for investors like you, it serves as a crucial indicator of a company's financial health. So, if you want to know any company's pulse, you must know its cash flow. For that, you have to learn everything about it. In this article, we will look into what cash flow is, how it works, and provide insights into how new investors can effectively analyze it.

What is Cash Flow?

Let us understand the cash flow of a company. It represents the movement of money into and out of a business over a specific period. It is a comprehensive measure that takes into account the cash generated by a company's operational activities, investments, and financing. Another way to look at it is by answering the question: "How much cash is flowing in and out of the business?" To answer this, you need to know what flows in and out. We will answer it as we discuss types of cash flow.

Types of Cash Flow

There are various types of cash flow, each serving a specific purpose in assessing the financial health and company's performance. In this section, we will look at them and also highlight the importance each holds for investors.

Operating Cash Flow (OCF): It is the cash generated or used by a company's core business operation. It provides insight into a company's ability to generate cash from its day-to-day activities. Since examples help, we will take one to make you understand it. Let us say there is a manufacturing company that produces and markets electronic devices. In a given period:

  • Net Income: Rs 50,00,000
  • Depreciation: Rs 5,00,000
  • Changes in Working Capital: (Rs 2,00,000)

OCF = 50,00,000 + 5,00,000 - 2,00,000 = 53,00,000

The positive OCF indicates that the company is generating cash from its core business operations.

Investing Cash Flow: Investing cash flow represents the cash transactions related to a company's investments in assets, such as property, equipment, or securities. It includes cash spent on acquiring or selling physical and financial investments.

Suppose the same manufacturing company decides to invest in new machinery for its production process:

  • Purchase of Machinery: (Rs 2,00,000)

The investing cash flow would be negative as the company is spending cash on acquiring an asset.

Financing Cash Flow: Financing cash flow encompasses transactions with a company's owners and creditors. It includes activities such as issuing stock, paying dividends, and taking on or repaying debt. This category provides insights into how a company is funding its operations and returning value to shareholders. If the manufacturing company issues new shares to raise capital:

  • Issuance of Common Stock: Rs 10,00,000

The financing cash flow would be positive as the company is receiving cash from issuing new shares. Investors can scrutinize financing cash flow to understand how a company manages its capital structure and its ability to meet financial obligations.

How to Analyze Cash Flows?

Here are the essential points you must know while analyzing a company's cash flow:

  • Positive Cash Flow: A consistently positive cash flow is generally a positive sign, indicating that the company can cover its expenses, invest in growth, and reward investors.
  • Negative Cash Flow: Negative cash flow for a short period might be acceptable if the company is making strategic investments for future growth. However, prolonged negative cash flow can be a cause for concern.
  • Free Cash Flow (FCF): FCF is a key metric that subtracts capital expenditures from operating cash flow. Positive FCF suggests the company has surplus cash that can be used for expansion, debt reduction, or shareholder returns.

Importance of Cash Flow

In the beginning, we said that cash flow is like a bloodline for a business. You would have gotten some idea through the examples and points we have discussed thus far. 

Positive cash flow is vital for a business as it ensures that a company can meet its immediate financial obligation. It also allows businesses to innovate, develop new products, and explore opportunities for growth without relying solely on external financing. It provides flexibility for strategic moves, such as acquisitions or mergers, enhancing a company's competitive position. On the other hand, insufficient cash flow can lead to insolvency, even if a company is profitable on paper.

For investors, understanding cash flow and its interplay is essential to assess a company's financial stability, growth prospects, and ability to reward investors through dividends or share buybacks. Analyzing cash flow alongside other financial metrics provides a comprehensive view of a company's financial health.

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