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  1. Account
  2. Accountancy
  3. Accountant
  4. Accounting cycle
  5. Accounting equation
  6. Accounting methods
  7. Accounting reform
  8. Accounting software
  9. Accounts payable
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  11. Accrual
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  29. Big 4 accountancy firm
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  32. Book value
  33. British qualified accountants
  34. Business
  35. Business process overhead
  36. Capital asset
  37. Capital goods
  38. Capital structure
  39. Cash
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  42. Certified Management Accountant
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  44. Chartered Accountant
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  46. Chart of accounts
  47. Common stock
  48. Comprehensive income
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  51. Corporation
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  68. Deficit
  69. Deloitte Touche Tohmatsu
  70. Depreciation
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  72. Dividend
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  74. Earnings before interest and taxes
  75. Earnings Before Interest, Taxes and Depreciation
  76. Earnings before Interest, Taxes, Depreciation and Amortization
  77. Engagement Letter
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  182. UK generally accepted accounting principles
  183. United States
  184. Value added tax
  185. Value Based Accounting Standards and Principles
  186. Write-off

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Cash flow

From Wikipedia, the free encyclopedia


In accounting, Cash flow refers to the amounts of cash being received and spent by a business during a defined period of time, sometimes tied to a specific project. Measurement of cash flow can be used to evaluate the state or performance of a business or project.

Cash flow measurement can be used to determine problems with liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable.

Measurement can also be used to generate project rate of returns. The time of cash flows into and out of projects are inputs to models like internal rate of return and net present value.

Cash flow is used to examine income or growth of a business when it is believed that accrual accounting rules do not represent economic realities. Alternately, the cash flow can be used to 'validate' the net income generated by accrual accounting.

Cash flows can be classified by:

  1. Operational cash flows: Cash received or expended as a result of the company's core business activities.
  2. Investment cash flows: Cash received or expended by making capital expenditures that will benefit the business for many years (e.g. the purchase of new machinery), investments or acquisitions.
  3. Financing cash flows: Cash received or expended as a result of financial activities, such as receiving or paying loans, issuing or repurchasing stock, and paying dividends

All three together are necessary to reconcile the beginning cash balance to the ending cash balance.

Benefits from using Cash Flow

The cash flow statement is one of the three main financial statements of a company. The cash flow statement can be examined to determine the short-term sustainability of a company. If cash is increasing (and operational cash flow is positive) then a company will often be deemed as healthy in the short-term. Increasing or stable cash balances suggest that a company is able to meet its cash needs and remain solvent. This information cannot always be seen in the income statement or the balance sheet of a company. For instance a company may be making money, but still may have difficulty remaining solvent if the company does not have enough cash to meet its needs.

Operating cash flow as proxy for income

Because of the politics involved in the formation of accounting standards (GAAP), many investors have lost faith in the published income statements. One way to by-pass them is to use cash flows instead. The feeling is that

  • cash flows cannot be fudged. This presumption is shown to be wrong by the following section.
  • cash liquidity is necessary for survival. This is true, and even more true for businesses with limited access to financing.
  • cash is tangible proof of income. The problem with this concept is that cash can be received as profit on a sale ... but also as proceeds from the sale of an asset with no profit. One asset is simply exchanged for another. This reality is expressed by non-cash expenses like depreciation, amortization and depletion. Capital assets wear out in the process of being used to generate sales. Part of the proceeds from the sale is a return of capital not income. The cash replaces the reduction in the asset's value.

Not withstanding the problems with GAAP, the growth of a business is better measured by Net Income than by Cash from Operations.

Dangers of isolating Operating cash flow

When analysts and the media refer to 'cash flow' they are most likely referring only to #1 above: "Operating Cash Flow". There are problems with isolating only this third of flows because business can easily manipulate the classification. Here are some ways the business can increase 'Operating' cash flow without changing the economic realities of the business.[1]

  • Sales - Sell the receivables to a factor for instant cash
  • Inventory - Don't pay your suppliers for an additional few weeks at period end
  • Sales Commissions - Management can create a separate (but unrelated) company to do the work. The book of business can then be purchased quarterly as an investment
  • Wages - Pay compensation with stock options
  • Maintenance - Contract with the predecessor company that you prepay five years worth for them to continue doing the work
  • Equipment Leases - Buy it
  • Rent - Buy the property (sale and lease back if you like)
  • Oil Exploration costs - Replace reserves by buying another company's
  • Research&Development - Wait for the product to be proven by a start-up lab. Then buy the lab
  • Consulting Fees - Pay in shares from treasury since usually to related parties
  • Interest - Issue convertible debt where the conversion rate changes with the unpaid interest
  • Taxes - Buy shelf companies with TaxLossCarryForward's. Or gussy up the purchase by buying a lab or O&G explore co. with the same TLCF.

Example of a positive $40 cash flow

In this example the following types of flows are included:

  • Incoming loan: financial flow
  • Sales: operational flow
  • Materials: operational flow
  • Labor: operational flow
  • Purchased Capital: Investment flow
  • Loan Repayment: financial flow
  • Taxes: financial flow

Let us, for example, compare two companies using only total cash flow and then separate cash flow streams. The last three years show the following total cash flows:

Company A:
Year 1: cash flow of +10M
Year 2: cash flow of +11M
Year 3: cash flow of +12M

Company B:
Year 1: cash flow of +15M
Year 2: cash flow of +16M
Year 3: cash flow of +17M

Company B has a higher yearly cash flow and looks like a better one in which to invest. Now let us see how their cash flows are made up:

Company A:

Year 1: OC: +20M FC: +5M IC: -15M = +10M
Year 2: OC: +21M FC: +5M IC: -15M = +11M
Year 3: OC: +22M FC: +5M IC: -15M = +12M

Company B:

Year 1: OC: +10M FC: +5M IC: 0 = +15M
Year 2: OC: +11M FC: +5M IC: 0 = +16M
Year 3: OC: +12M FC: +5M IC: 0 = +17M

  • OC = Operational Cash, FC = Financial Cash, IC = Investment Cash

Now it seems that Company A is actually earning more cash by its core activities and has already spent 45M in long term investments, of which the revenues will only show up after three years. When comparing investments using cash flows always make sure to use the same cash flow layout.

See also

  • Return of capital
  • Cash flow statement
  • Free cash flow
  • Cash is king
  • Discounted cash flow
  • Internal rate of return
  • Net present value
  • Income statement
  • Balance sheet
  • Cash on cash return


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