Understanding the key cash flow terms.
Cash flow is the lifeblood for any business and knowing how to manage it effectively will be crucial to running a successful business. There are many different types of cash flow with a variety of important uses when running a business and performing general financial analysis. In our Cash Flow Terms UK section, we'll explore the key terms associated with cash flow.
Free cash flow is the cash a company has left over after all the cash it needs to pay for its operations and the cash needed to pay for the maintenance of its assets have been taken away.
It tells a company how much money it is generating from its business after all the costs required to remain in business are taken away.
A cash flow ratio is a measure of the number of times a company can pay off current debts with cash generated within the same period. A high number, greater than one, indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities.
A cash flow ratio of less than one indicates the opposite—the firm has not generated enough cash to cover its current liabilities. To investors and analysts, a low ratio could mean that the firm needs more capital.
However, there could be many interpretations, not all of which point to poor financial health. For example, a firm may embark on a project that compromises cash flows temporarily but renders substantial rewards in the future.
The indirect method is when cash flow is calculated by taking the value of net income at the end of the reporting period and adjusting this based on the figures within the balance sheet, removing the effect of non-cash movements shown on the profit and loss statement.
A Cash flow statement comprises cash flow from 3 different areas, Operating, Investing and Financing cash flow.
The cash flow from the 3 sections are added together and become the opening cash balance of a reporting period.
The indirect method applies to the way the operating cash flow section of the cash balance is calculated. It takes net income and adds back the value of the non-cash transactions. For example depreciation or amortisation, increase or decrease in current assets, trade receivables (sales on credit) and trade payables (monies owed) as none of these represent actual cash in hand for the business.
Cash Flow Analysis analyses the 3 types of cash flow statements that show, over a specific period of time, how much cash is coming in and going out of the business. The analysis is helpful to determine the liquidity and solvency of the business.
A Cash Flow Statement is a financial statement that allows you to see how much cash is coming in and how much is leaving a business over a particular period of time (could be monthly,quarterly,yearly). It presents a record of how much cash is available on hand for the business to access in order to keep it operating successfully.
Net Cash Flow is the difference between the cash coming into a business and the cash going out of a business during a specific period of time and this is the net cash flow from 3 different areas.
Operating cash flow is the cash flow calculated from the revenues generated from a company’s operational activities over a specific period of time.
Operational activities include the sale of goods, provision of services, manufacturing of goods, payment of rent, wages, marketing, bills, research and development. The difference between the cash coming in and the cash going out from these activities will provide the operational cash flow figure.
This cash flow figure will give an indication of the cash generating abilities of a company that can be produced from its core business activities
Discounted Cash Flow is a tool that can be used to determine whether an investment is worth investing in. It can be used when looking to invest in projects, assets, stocks or any investment that produces a cash flow.
The method of calculation is based on projected future cash flows discounted to take into account the time value of money. The time value of money operates under the assumption that £1 today is worth more than £1 in the future if money today can earn interest.
Receiving cash flow as cash after 1 year is not as valuable as getting the money today as it won’t have had the benefit of a year’s interest from investment so needs to be discounted in order to accurately reflect its current day value.
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