Cash Flow

What It Means

Cash flow is the movement of ready money, or cash, into and out of a company over a specified time. Cash flow can be calculated for a company as a whole or for a particular project within the company. A statement of cash flow is a document that is issued periodically by a company and that identifies the important business activities that generate inflows and outflows of cash for the company. The document helps to reveal how the company is using the financial resources it has available and how well it is able to pay its bills. In other words, the cash flow statement can provide a short-term picture of the company’s overall financial health.

When a company receives more money than it spends during a specified time period, the company is said to be cash flow positive. When the company spends more than it receives, it is said to be cash flow negative. A company that keeps its cash flow positive over time shows that its employees and lenders can be reliably paid. A company that has negative cash flow is in danger of losing the ability to keep up its day-to-day operations; if the negative cash flow is sustained, the company risks going bankrupt (being declared legally unable to pay its debts).

The cash flow statement is the standard financial accounting document for reporting a company’s cash flow. It reveals the sources and uses of the company’s cash by putting each cash receipt or cash payment under one of three main sections: operating activities, investing activities, and financing activities. Operations refer to the company’s core business activities such as the marketing, sales, and production of its goods or services. Investments refer to such activities as the purchase or sale of an asset such as a building or manufacturing equipment. Financing refers to such activities as the receipt or payment of loans or the issuing of company stock.

The cash flow statement is one of three major documents that a company prepares to reveal the state of its financial situation. The other two are the balance sheet and the income statement. The balance sheet describes the company’s assets (for example, cash, inventory, land and buildings, and long-term investments) and liabilities (for example, bills, wages, and taxes to be paid) on a specified date and indicates where they have come from. The income statement, calculated for a particular time period, shows the sources of a company’s net income (the difference between the income derived from its goods and services and the expenses it had while that income was being generated).

When Did It Begin

Contemporary cash flow statements trace their origin to statements prepared by American companies in the 1950s and 1960s. These documents, which listed the sources of any uses of the company’s funds, were basically records of the different increases and reductions of the company’s balance sheet items. In 1961 an accounting research study conducted by the Accounting Principals Board (APB), then the authoritative body for accounting principles in the United States, recommended that accountants develop a funds statement for recording cash flow that would be required from every company as part of its annual financial reporting. The name of this cash flow statement became the Statement of Source and Application of Funds, and most businesses adopted the standard form of it. In 1984 the Financial Accounting Standards Board (FASB), the successor to the APB, recommended that a statement of cash flow become a part of the primary financial statements for every company and that the statement show cash receipts categorized by their sources and cash payments categorized by their major uses.

More Detailed Information

As mentioned, the cash flow statement is an indicator of the performance of a company or of one of its projects over a certain time period. In addition, the statement shows if a company is liquid; that is, whether it can quickly and easily convert (liquidate) assets to cash. Although a company may be generating a profit through strong sales of its products, it still may have trouble liquidating assets when a demand for cash arises, such as when its bills are due. A factory, for example, is an asset that is hard to convert into cash because it is usually time-consuming to sell. On the other hand, stock certificates are more easily and quickly convertible to cash because they can be sold within hours if necessary.

The cash flow statement presents each major source and use of cash, listing the transactions that directly affect the cash account over a certain time period. It answers the questions “Where did cash come from?” and “Where did cash go?” Therefore, it explains the business activities that resulted in an increase or decrease in cash. In a company’s first year of operation, the beginning cash balance is $0. At the end of its first year, its net increase or decrease in cash is its net cash flow (cash receipts minus cash payments) from operating, investing, and financing activities.

The operating section the cash flow statement includes those transactions that relate to wages, purchases of merchandise, and other operating activities including the company’s sale of goods and services. This section also identifies cash paid for the resources that are used to make goods and services. For instance, if a dairy farmer purchases 10 dairy cows one year, the expense for the cows falls under the operating section. Having a positive cash flow in the operations section of the statement is important, because a negative cash flow is an indication that the company has not made a profit for the time period of the statement. Generally, if a company remains unprofitable for an extended time, it goes out of business.

The investing section of the cash flow statement includes cash transactions associated with the purchase of long-term assets and financial investments. This section shows the cash flow involved when fixed assets (which are tangible pieces of property, such as buildings or equipment, that a business keeps for a fairly long time) are purchased or sold. Investing cash flow is simply the difference between the amount the company paid for long-term assets and the amount it received from selling such assets.

The finance section of the cash flow statement includes cash transactions between a company and its shareholders (individuals or firms that have invested money in the business) or its creditors (individuals or firms to which the company owes money). These transactions relate to the borrowing or repaying of debt and investments, such as stock. If the company pays dividends (shares of the company’s profits) or makes other cash distributions to shareholders, these activities fall into the finance section. Cash flow in this section is affected positively when, for instance, the company either borrows cash by taking on more debt or sells stock to shareholders. It is affected negatively when the company pays off some of its debt or pays dividends to shareholders.

Recent Trends

In the past several decades one strategy available to a company to improve the public’s perception of its cash flow has been to purchase some of its own stock shares from the marketplace. This is sometimes called a share buyback or a stock repurchase. By using its own cash to buy shares, the company is, in a sense, investing in itself. Because there now are fewer shares (claims on the company’s profits) in the marketplace, the value of the remaining shares (known as the “earnings per share”) increases because the profits are distributed over a smaller number of shares.

When a company buys its shares on the open market in the same way as an individual investor, it generally is viewed by the investing public as a confident move by the company. It is interpreted as a sign that the company has an excess of cash to spend and that an investment in its own stock is the best investment possible, even better than other major investments such as purchases of facilities. This signal of confidence, in turn, can enhance the price of the shares remaining on the market. However, after a company buys back its own stock, its financial performance needs to live up to the confidence that it has signaled.