In the field of finance, a fundamental concept reigns supreme: cash flow. Mastery of this concept is indispensable for comprehending value creation, investment strategies, and effective financial management. Cash flow, the measurement of money inflows and outflows within a business over a specific period, holds significant sway in decision-making processes and evaluating a company’s financial robustness. Establishing an understanding of cash flow serves as a springboard for navigating more complex financial principles with ease.

1. CLASSIFYING COMPANY CASH FLOWS

First, let’s consider a common scenario: the monthly bank account statement received by individual customers. This document meticulously outlines various transactions, delineating the inflows and outflows of money on specific dates, along with transaction types such as cheque deposits.
Our initial task involves analyzing the purpose and the rationale behind each entry on the statement, which may include everyday expenditures, payment of a salary, automated transfers, loan repayments, or bond coupon receipts, among others.

Similarly, financial managers shoulder the responsibility of categorizing company cash flows to construct a comprehensive cash flow document. This document serves a dual purpose:

• Analyzing historical cash flow patterns (commonly referred to as a cash flow statement)
• Forecasting future cash flow trends over varying time frames (a cash flow budget or plan)

With this objective in mind, we will now demonstrate how cash flows can be classified into one of the following processes:

• Activities that form part of the industrial and commercial life of a company:
  • Operating cycle
  • Investment cycle
• Financing activities to fund these cycles:
  • The debt cycle
  • The equity cycle

The Significance of the Operating Cycle

Let’s illustrate with the scenario of a greengrocer, concluding his day’s transactions. What does he find? Initially, he calculates the cash spent at the wholesale market in the morning, followed by the cash proceeds from fruit and vegetable sales during the day. Assuming the greengrocer sold all purchased produce in the morning at a markup, the day’s balance between receipts and payments often yields a cash surplus.

However, practical scenarios tend to be more complex. It’s unusual for all morning purchases to be sold by evening, particularly in manufacturing businesses. A company’s operating cycle involves processing raw materials, with its duration varying significantly across sectors. This cycle entails a time lag between raw material purchases and the sale of corresponding finished goods.

Yet, time lags aren’t the sole complication. Companies typically engage in non-cash transactions, with suppliers often granting extended payment periods. Consequently, the revenue received on a given day might not originate from sales made on the same day. As a result of customer credit, supplier credit, and production-to-sale durations, every company’s operating cycle spans a certain period, leading to timing differences between operating outflows and inflows.

Each business has its unique operating cycle, potentially resulting in positive or negative cash flows at different times. These flows are analyzed periodically, by month or year, culminating in the operating cash flow balance.

In concrete terms, operating cash flow reflects the cash flows generated by a company’s day-to-day operations. In essence, it represents the difference between receipts and regular expenses like food, electricity, and car maintenance costs. Typically, barring exceptional circumstances, the balance of operating receipts and payments should be positive.

Operating cash flow is independent of accounting policies, focusing solely on cash flows. Neither the company’s depreciation and provisioning policy, nor its inventory valuation method, nor the techniques used to defer costs over several periods have any impact on the figure.

Investment and Operating Outflows

Let’s revisit our example with the greengrocer, who now plans to expand his business by introducing frozen food.

This expansion will inevitably alter the business’s operating cycle. For instance, the greengrocer may opt for weekly deliveries, necessitating larger inventories. While the extended operating cycle due to increased inventories may be offset by extended credit from suppliers, it’s essential to acknowledge this shift. The operating cycle varies across businesses, typically correlating with the complexity of the end product. Notably, before venturing into this new activity, our greengrocer must invest in a chest freezer.

What’s the difference, solely from a cash flow perspective, between this investment and operating expenses?

The expense on the chest freezer appears to be a prerequisite, laying the groundwork for a new venture with uncertain success. It carries higher risks and will only be beneficial if it boosts the overall operating cash flow generated by the greengrocer. Investments are made with a long-term outlook, lasting several operating cycles, although not indefinitely due to technological advancements’ rapid pace. This justifies distinguishing between operating and investment outflows from a cash flow standpoint.

Ordinary outflows differ from investment outflows in that they offer immediate enjoyment, while investments entail deferred gratification. Investments are worthwhile only if foregoing immediate pleasure leads to greater satisfaction. From a cash flow perspective, an investment is an outlay expected to increase operating cash flow, leading to greater satisfaction in the long run. This defines the return on investment from a cash flow standpoint. Like the operating cycle, the investment cycle involves a series of inflows and outflows over a longer duration.

The purpose of investment outlays, also known as capital expenditures, is to alter the operating cycle, boosting or enhancing the cash flows it generates. The impact of investment outlays spans several operating cycles. Financially, capital expenditures are worthwhile only if inflows generated by these expenditures exceed the outflows, yielding at least the expected return on investment. Moreover, a company may divest assets previously invested in. For instance, our greengrocer may decide after
several years to upgrade his freezer to a larger model, with the proceeds becoming part of the investment cycle.

Free cash flow

Free cash flow, whether calculated before or after tax, forms the basis for the most important valuation methods. It’s determined as the disparity between operating cash flow and capital expenditure, adjusted for fixed asset disposals.

Operating cash flow hinges on the classification of expenditure between operational and investment outflows. However, this distinction isn’t always straightforward, leading to limited practical use of operating cash flow. Instead, free cash flow enjoys widespread popularity.

If free cash flow dips into negative territory, the company must seek additional financial resources to fulfill its cash flow needs.

2. FINANCIAL RESOURCES

The timing discrepancy in cash flows arises from the operating and investment cycles. Payments to employees and suppliers precede customer settlements, while investments precede revenue generation. Naturally, these cash flow gaps necessitate filling, and this is where financial resources come into play.

Financial resources serve a simple purpose: to cover these shortfalls resulting from timing differences, ensuring the company has adequate funds to balance its cash flow. These resources, provided by investors such as shareholders and debt holders, come with expectations of future returns in the form of dividends, interest payments, or capital gains. The financing cycle acts as the counterpart to the investment and operating cycles. At its core, it involves financing these shortfalls using capital that bears the business’s risk—shareholders’ equity. This equity cycle involves inflows from capital increases and outflows in the form of dividends.

Alternatively, businesses may seek assistance from lenders to cover cash flow shortages. Lenders, cautious of business risks, provide debt capital, representing the company’s borrowings. The debt cycle involves commitments to repay capital and make interest payments regardless of operating and investment cycle trends.

A business’s life involves operating and investment cycles, resulting in positive or negative free cash flow. Negative free cash flow prompts reliance on the financing cycle to cover funding shortfalls. However, free cash flow cannot remain negative indefinitely, investors must eventually receive returns or repayments.

Equity and debt capital represent distinct commitments: equity allows shareholders to benefit from venture success, while debt capital obligates meeting repayments and interest regardless of outcomes. Debt can be viewed as an advance on future cash flows, guaranteed by shareholders’ equity.

While businesses seek funds for investments, they may also accumulate cash surpluses over time. These surpluses are invested in short-term financial instruments generating revenue known as financial income. It’s important to view debt and short-term investments as interconnected, with readers advised to consider them collectively rather than independently.

To illustrate this, here’s a concrete example of a cash flow statement and the way in which a company’s various flows are presented:

The foundations of cash flow have now been laid, enabling us to move on to other concepts that are essential to understanding the financial management of a company: the study of income and wealth generation.