Cash Flows

The key concept in finance...

Cash flows are generated by the company and paid to either shareholders or creditors.

Sources of positive cash Flows

In order to make cash flows available to owners or lenders, the firm must generate cash from one of these three sources:

1.  cash flows from operations

2.  cash flows from selling fixed assets

3.  cash flows from changes in working capital

Operating Cash flows

This is the cash flows that are directly generated from operations.  They are the most relevant when valuing a business (or project). 

Operating cash flows do include tax payments, but should exclude all financing, capital spending, and changes in net working capital.   This means that operating cash flows will look at how well a company generates earnings, but will not consider cash flows from financing, or those needed for net working capital. 

Operating cash flow = earnings before interest and taxes, but after taxes (so, its not the same as EBIT)

If operating costs are negative, then the firm is in trouble because they will not be generating enough cash to pay for operating costs.  

Total Cash Flows

May be negative (and typically are for growing firms). 

The total cash flows include investments in increased working capital, as well as investments in new capital projects.  So, if a firm is investing, or growing, their total cash flow might be negative, and this does not necessarily indicate trouble.   They might just be spending more on inventory and on fixed assets than what they are generating today, but future cash flows are expected to be higher.  This company may require outside financing to get past this growth stage. 

Note:  because of the timing of cash flows, it is important not to mistake net income with cash flows.  they are different.  The net income is an accounting number on the income statement that might be positive even when the firm is negative in total cash flows.  This is because accountants measure earnings when a sale happens, and not when cash actually gets into a company.  For a growing company, this difference might be significant!

Timing of Cash Flows

One of the key concepts of finance is that cash today is worth more than cash tomorrow.  This is because cash today could be invested and grown to more cash tomorrow.   Also, its because there is no risk in having cash today, but a "guaranteed" cash flow tomorrow has some risk (perhaps the person wont pay, or maybe the money wont be worth anything tomorrow?).

When valuing a project (or a company), it is important to look at the value of their expected cash flows.

Net Present Value analysis

Timing of cash flows is important when looking at net present value analysis (looking at the net present value of future cash flows)....ie...how much is that stream of expected cash flows worth today.  NPV analysis is how you compare to different streams of cash flows (two different projects).

Statement of Cash Flows

The cash flow statement is one of the three major statements released by most public companies (along with the balance sheet and income statement).   While the statement of cash flows is often considered the 3rd statement by accountants, the financial analyst often considers it the most important, since the value of the firm is ultimately determined by its ability to generate cash flows (see business valuation discussion)