When analyzing a potential investment opportunity, profitability is often the ultimate deciding factor. Without knowing how profitable an investment will be, it’s impossible to tell whether that opportunity is worth your time or money. To make this decision, you need to analyze the cash flows of the project being considered. Here is a brief overview of three cash flow types and their meanings.
What is a Cash Flow?
A cash flow measures how much cash is generated or used by a company in a certain period. Cash flow is often confused with net income, but they are two very different things. Net income is a company’s profit after accounting for all expenses, deductions, and taxes. On the other hand, cash flow is a measure of the cash that a company generates.
In other words, it’s the amount of money a company brings in less the amount it spends. To determine the amount of cash a company has generated or used in a specific period, accountants will use a “cash flow statement.” This statement lists every cash flow event during a particular period, such as a company’s daily operations, an investment in another company, or a dividend payment to shareholders. Cash flow statements are prepared using the accrual method of accounting, which means that they record events when they are incurred, not when they are paid.
When Is Cash Flow Analysis Important?
The cash flow generated by a business is its lifeblood. Cash is needed to fund day-to-day operations, long-term investments, and debt repayments. If a business doesn’t have enough money, it can’t pay its bills on time and could face serious consequences, such as lawsuits, repossessions, or even bankruptcy.
A company’s cash flow is determined by three things:
- How much cash it is bringing in
- How much cash it is spending
- How it finances its activities
The cash flow statement differs from the income statement, which measures profitability. Cash flow analysis is the process of studying a company’s cash flow statement to determine its financial health.
Cash Flows From Operations
Operating cash flows are generated by a company’s daily operations, such as sales and collections of receivables. This is the cash flow that most people think about when they discuss the cash flow of a business. Businesses with healthy operating cash flows are more likely to be financially successful.
There are many factors that can affect operating cash flows, including the price of the product or service being sold, the cost of materials, and the time customers take to pay their bills. Operating cash flows are also known as “continuing operating cash flows” because they are expected to continue over the long term. These cash flows do not depend on financing or the sale of assets. Below are the three types of cash flows.
Cash Flows From Investments
These cash flows are generated by the company’s investments in other companies and intangible assets, such as patents and trademarks. A company may also invest in tangible assets, such as real estate, machinery, equipment, or inventories. Investments in these types of assets are known as “financing activities that require payment of cash.” When a company invests in another business, the transaction may involve the payment of cash, securities, or other assets.
The investment might also be made by purchasing a company’s bonds or stocks. When a company makes an investment that does not require cash payment, such as when it purchases intangible assets, it is considered a “financing activity that does not require payment of cash.”
Cash Flows From Financing Activities
Financing activities involve using cash, such as when a company repays debt or makes dividend payments to shareholders. Financing activities that do not require cash payment are called “investments that do not generate cash.”
Making a payment on a loan is an example of a financing activity that uses cash. Companies also make payments to their shareholders, either by paying out dividends or buying back company stock. These types of payments do not require the use of cash.
Conclusion
Cash flow analysis is essential for understanding how a business generates, uses, and manages its cash. A company’s operating cash flows represent its current cash flow, while cash flows from investments represent a company’s future cash flow potential. Knowing how much cash is flowing in and out of a company can help you determine your company’s financial health and identify potential problems before they become serious.