EFA (14): Cash Flow

Cash flow is a key factor for companies. But what exactly is cash flow? This is the subject of the 14th item in our Economics for Amateurs (EFA) series. You can find this series here every Monday.

It is often said in business that “the customer is king”. When we look at the financial situation of companies, however, there is a different monarch: “King Cash”.

In this context, cash is not simply banknotes and coins, but also other liquid assets, such as money in bank accounts, which can be used to pay bills, wages, etc. “Cash flow” refers to the movement of such liquid assets in and out of a company within a specific time period. When a company has a positive cash flow this means that more money came into the company during this time period than went out of it.

Cash flow is important, because firms that don’t have the liquid assets to pay their bills are insolvent and may have to stop trading. So a “cash flow statement” (also called “funds flow statement”) is usually a key part of a company’s financial statements, along with the profit and loss account and the balance sheet.

Unlike the profit and loss account, which measures the theoretical profit that a company has made on its trading and other activities, the cash flow statement looks at the actual money flows that took place. That’s why it is often said that “cash is king”.

A simple example can illustrate the difference between profit and cash flow. Imagine a company that pays out $2 million for raw materials, staff and other costs in a year. The company then makes goods from these raw materials and sells them all for $3 million. However, it receives only $1 million in sales revenue during the year; the rest has accrued but won’t come until the following year.

This firm has made a trading profit of $1 million in the year, which will be shown on the profit and loss account: $3 million in sales revenue minus $2 million in costs. But the company also has a negative cash flow of $1 million: the $2 million in costs has all left the company, but only $1 million of revenue has so far come in.

This shows how even profitable companies can get into difficulties through cash flow problems. Cash flow can be improved by getting debtors to pay more quickly and by paying creditors more slowly. A company can also cover its negative cash flow by borrowing from banks or asking for more money from shareholders.

Real cash flow statements are more complicated, but the principle is the same: certain revenue items on the profit and loss account do not involve a cash flow into the company, and certain cost items — such as allowances for depreciation of fixed assets or provisions for pensions — involve no outward cash flow.

In practice, there are many measures of cash flow. These include operating cash flow (relating to trading activities); investment cash flow (relating to things such as capital expenditure) and financial cash flow (including loans received or paid, new money from shareholders, and dividends paid to shareholders). Another useful financial concept is “free cash flow”: this is the difference between a company’s operating cash flow and its capital expenditure.