Cash is King — Everything you need to know about cash flow

What is Cash Flow? A Definition

Cash flow is a term often quoted in the business world as a measure of financial health. But what exactly lies behind it? Cash flow, also referred to as cash flow, capital flow, or payment stream, provides insight into the net inflow or outflow of cash within a specific accounting period—whether monthly, quarterly, or annually.

This key figure reflects the financial strength and liquidity of a company and is particularly meaningful as it disregards non-cash transactions such as depreciation and provisions.

Why is Cash Flow so Important for Companies?

“Cash is king” is a common saying in the financial world, and for good reason: Cash flow is a standardised and meaningful financial metric that serves as the basis for effective and precise financial planning and offers the crucial advantage of significantly reducing the possibility of financial manipulation.

This transparency allows investors and stakeholders to gain a clear picture of a company's liquidity position. How much money does a company have available for investments, debt repayments, or dividend distributions? A solid understanding of cash flow helps to identify and mitigate financial risks early on, before they lead to insolvency, over-indebtedness, or ultimately bankruptcy.

Positive vs. Negative Cash Flow

Cash flow can be both positive and negative. Below, we look at both possibilities and explain why even positive cash flow can come with challenges.

Positive Cash Flow – Opportunities and Benefits

A positive cash flow means that a company has generated a net inflow of cash during a specific period, meaning the inflows exceed the outflows in the period under consideration. This state is an indicator of financial health and stability, as it shows that the company has generated enough funds to cover its operating costs, make investments, pay off debts, and build up reserves for future challenges.

As a result, a strong cash flow also makes a company attractive to both investors and lenders. On the other hand, it gives the company financial flexibility and independence, which is especially advantageous in economically uncertain times.

Positive Cash Flow Despite Losses

Despite positive cash flow, a company can still make losses. The key to understanding this phenomenon lies in the distinction between the cash flow statement and the income statement (P&L). The latter considers income and expenses regardless of whether cash has actually been paid out. It includes non-cash items like depreciation and provisions, which can reduce profit without cash actually being spent.

This can be illustrated with the following example: When a company purchases a machine and depreciates it, this reduces profit even though no cash was spent. If the company simultaneously receives high customer payments, the cash flow can be positive even if the P&L shows a loss. This means the company has enough cash to pay its bills but is accounting for a loss due to depreciation.

Negative Cash Flow – Risks and Disadvantages

A negative cash flow indicates that a company has a net outflow of cash during a specific period, which suggests a liquidity shortage. This can be normal in certain phases of a company's development, such as during major investment projects or market expansion. A negative cash flow is also known as a cash loss or cash drain. During this period, expenses exceed income.

However, sustained negative cash flow signals potential financial problems in the long term:

1. Dependence on External Financing: The company may need to raise additional capital through loans or issuing new shares, leading to higher debt or equity dilution.
2. Restrictions on Business Activity: Lack of financial resources may cause investments and growth plans to be postponed or scaled back.
3. Business Risk: Sustained negative cash flow increases the risk of insolvency or even bankruptcy.

Cash Flow and Liquidity – What’s the Difference?

In contrast to liquidity, which indicates a company’s solvency at a specific point in time, cash flow is the flow of cash that shows how much money flows in and out of a company over a certain period.

Both indicators are crucial for assessing a company's financial stability. Good cash flow ensures that a company can operate effectively and meet its long-term obligations. Good liquidity is critical to ensuring that a company does not run into cash flow problems when unexpected expenses arise, or income falls short in the short term.

Types of Cash Flow and Their Importance

Cash flow is often divided into different categories, each reflecting different aspects of a company's financial activities. The careful analysis of these cash flows provides valuable insights into the actual financial situation and the efficiency of a company’s operations. They are best analysed together with the company’s liquidity situation.

1. Operating Cash Flow

Operating cash flow shows the result of regular cash inflows and outflows in the context of the operational performance of a company for a specific period. This includes income from the sale of products or services and is recorded net of operating expenses such as wages, rent, and taxes.

A positive operating cash flow indicates that the core business of the company is healthy and generates sufficient money to cover ongoing costs. It also allows conclusions to be drawn about whether the company can finance itself or if it might need financial support.

Alternatively, operating cash flow can also be referred to as gross cash flow. If you subtract the taxes actually paid, you get the net cash flow.

2. Cash Flow from Investment Activities

This type of cash flow represents the inflows and outflows resulting from investment activities or the purchase of assets. The difference indicates whether these activities have led to positive or negative cash flows for the company.

Negative cash flow from investment activities is often observed during growth phases when companies invest in their future. A positive cash flow typically arises from the sale of assets, which could indicate a consolidation or contraction phase.

3. Cash Flow from Financing Activities

Cash flow from financing activities reflects transactions related to the equity and debt structure of the company. This includes proceeds from the issuance of shares or bonds and outflows for dividend payments or debt repayments.

A positive cash flow from financing activities indicates that the company is raising new capital, while a negative value suggests that the company is repaying capital to shareholders or settling debts.

4. Free Cash Flow

Free cash flow is the cash flow that remains after deducting operating expenses and investments. It is an important indicator of a company's financial flexibility, showing how much money is available for distribution as dividends, reducing debt, or making further investments. A stable or growing free cash flow is often seen as a sign of sound business management.

Calculating Cash Flow – Here's How

Cash flow can be calculated either directly or indirectly. The chosen method depends on the company’s financial reporting and the goal of the calculation.

Indirect Cash Flow Calculation

The indirect method is derived from the annual financial statement and is adjusted for non-cash expenses and non-cash revenues. It is used when a statement about the liquidity situation of a company can only be made based on publicly accessible financial statements.

This method is often employed by external tax and business consultants. However, this calculation does not allow for up-to-date figures to be included.

Calculation: Cash flow from operating activities = Net profit + Depreciation + Changes in current assets and short-term liabilities

Example: A company has a net profit of 150,000 euros, depreciation of 50,000 euros, and an increase in receivables of 20,000 euros. The latter means that the company has lent more money to customers, which represents a cash outflow.

The calculation of operating cash flow is therefore as follows: 150,000 euros + 50,000 euros - 20,000 euros = 180,000 euros.

Direct Cash Flow Calculation

The direct cash flow calculation provides a statement about the timely cash flow of a company because it is not based on retrospective figures from the annual financial statements, but on current cash receipts and disbursements. Additionally, the direct calculation allows for a more precise breakdown of cash flows. However, when calculating, special attention should be paid to the accuracy of internal information, as this is used without additional prior verification for the calculation.

Incomings include:

• Receipts from product sales
• Receipts from the settlement of receivables
• Borrowings

Outgoings include:

• Payments for wages/salaries
• Settlement of open supplier invoices
• Debt repayments

Calculation: Cash flow from operating activities = Receipts from sales - Payments to suppliers and employees

Example: Suppose a company receives 500,000 euros from product sales over the course of a year and pays 300,000 euros for raw materials, wages, and other operating costs. The operating cash flow would then be: 500,000 euros - 300,000 euros = 200,000 euros.

Optimising Cash Flow through Cash Flow Planning

A cash flow plan helps companies react early to their financial situation. Specifically, a plan helps with strategic financial planning and assessing financial risks such as liquidity bottlenecks.

Tidely transforms the way companies approach their liquidity management by offering automated, professional, and up-to-date cash flow reporting. With Tidely, you can regularly create cash flow forecasts that not only play a crucial role in short-term cash management but also contribute significantly to medium- and long-term strategic planning. Investors often place great value on such 5-year forecasts to see a clearly defined roadmap for the company's future growth.

Cash Flow Planning with Scenario Analysis

A central part of the forecasting process with Tidely is the creation of scenarios. This function allows you to effectively monitor, manage, and optimise cash flow. The simulation of scenarios provides your company with an overview of possible financial developments. These should cover both best-case and worst-case scenarios to keep an eye on the risk of unforeseeable factors.

Tidely also helps you by setting up scenarios to make the best possible business decisions. By simulating internal decisions (e.g., purchasing new machinery) and external factors (e.g., the corona pandemic), the potential impact on the financial situation of the company can be assessed. A sensitivity analysis allows for a quick evaluation of the impact of individual measures.

Don’t leave the financial situation of your company to chance—manage your cash flow with Tidely.

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