Cash flow refers to the relationship between money inflows and outflows in a specific period of time. In theory, cash flow can be calculated for each day (or even each second), but monthly and quarterly cash flows are usually more appropriate in determining solvency.
Importance of Cash Flow
Many people link cash flow with businesses but it is also fundamentally important in personal finance. Whether it’s a person or a corporation, having a positive cash flow (or liquidity) is the key to survival. It ensures that creditors can be paid, it allows opportunities can be taken and it keeps the entity from going into bankruptcy.
When analyzing companies to invest in, cash flow is one of the key indicators of a company’s health. While underlying profit is ultimately the gauge of a company’s strength, strong cash flow is very shareholder friendly because the cash can be used in activities that help share prices like:
Example of Comparing Cash Flow
Let’s say that you are trying to compare the cash flows of the two company to see which one is a better investment. Company X with cash flows:
- Q1: +$2 billion
- Q2: +$3 billion
- Q3: +$3 billion
- Q4: +$3 billion
Company Y’s data:
- Q1: +$2.5 billion
- Q2: +$3.5 billion
- Q3: +$3.5 billion
- Q4: +$3.5 billion
Company Y looks like a better buy right? Now let’s look a little more closely.
- Q1: $4 billion Operating Revenue (OR) – $1.5 billion Net Working Capital (NWC) – $0.5 billion Capital Spending (CS) = $2 billion
- Q2: $5 billion OR – $1.5 billion NWC – $0.5 CS = $3 billion
- Q3 and Q4: same as Q2
- Q1: $4 billion OR – $1.5 billion NWC
- Q2: $4.5 billion OR – $1 billion NWC
- Q3 and Q4 same as Q2
A little more interesting. Without further information, it’s hard to figure out which is the better investment. Why did Company Y’s NWC dropped in Q2? Is it because of a layoff? Or is it operating efficiency?
Also, noticed that Company X had a higher operating revenue each quarter, and the net cash flow is only lower because there’s a capital spending of $0.5 billion per quarter. If I told you that the capital spending is an investment for a project that will bring in revenue of an additional $1 billion per quarter that starts kicking in after Q4, it would be clear that Company X is the better investment.
Cash Flow and Solvency
Having the ability to generate cash is a company’s ultimate weapon. It doesn’t matter how much earnings a company can report if they have an inability to generate enough cash to pay its creditors.
In the financial crisis of 2008 when Bear Sterns and Lehman Brothers failed. It’s not just that they were unprofitable, it was the insolvency of these two firms that brought them to failure. Cash is king. Works in personal finance. Works in a corporate world.