Important Facts About A Company’s Cash Flow

Julie Furnas
9 Dec 2020

First and foremost, what exactly is cash flow in basic accounting terms? Cash flow is the net amount of cash and cash equivalents that are being transferred in and out of a business. Every size business needs to make a profit and create value for investors and shareholders, and this is determined how the business generates positive and long-term free cash flow, a measure used by analysts to assess a company’s profitability and represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. 

Cash flow is so important that negative cash flow is the reason 30% of small businesses close their doors for good.  

Three Forms of Cash Flow

Cash flow is explained in three forms: operating, investing, and financing 

  • Operating cash flow is all forms of cash generated by a company’s main business activities (products or services or both) 
  • Investing cash flow includes investments in other business ventures and includes purchases of capital assets. 
  • Financing cash flow includes all proceeds gained from issuing all debts and equity as well as payments made by the company. 

Using Cash Flow

Financial reporting in a business is way beyond counting the register at the end of the night. The timing, amount and uncertainty of cash flow is essential for strong financial reporting. Understanding cash flow statements with the three different types of cash flow explained above will determine a company’s overall financial performance. 

Positive cash flow indicates that a business’s liquid assets are increasing which allows it to pay expenses such as payroll taxes, enables it to settle any outstanding debts, reinvest in its business and return money to shareholders. 

Companies with strong financial flexibility can take advantage of different types of investments. In the event of a recession, businesses with more cash flow are better prepared in the event of a downturn.  

Correctly Analyzing Cash Flow

Even profitable businesses can fail if their operating activities do not generate enough cash flow to stay liquid. This happens if profits are tied up in outstanding accounts receivable, too much inventory, or if a company spends too much on capital expenditures and falls short of it’s free cash flow. 

Investors, shareholders, and creditors will always want to know if the business has enough cash and cash-equivalents to settle short-term liabilities and debts and can pay large expenditures, such as payroll taxes. To see if a business is able to meet its several liabilities with the cash it generates from operations, analysts look at the Debt Service Coverage Ratio.

  • Debt Service Coverage Ratio: Net Operating Income / Short-Term Debt Obligations (also referred to as “Debt Service”

The Debt Service Coverage Ratio Formula is: Divide the net operating income (NOI) by the annual debt. 

For example, in real estate terms: most lenders will require a minimum DSCR of 1.20x. If a DSCR is 1.0x, this is called breakeven, and a DSCR below 1.0x would signal a net operating loss based on the proposed debt structure. 

A business may show that it has a lot of liquid cash because it is mortgaging its future growth potential by selling off its long-term assets or taking on unsustainable levels of debt. Analyzing Debt Service Coverage Ratio is a lengthy, yearly accounting analysis of major corporations and companies

Unlevered Free Cash Flow vs. Levered Free Cash Flow

  • Unlevered Free Cash Flow: a company’s cash flow before taking interest payments into account and shows how much cash is available to the firm before taking financial obligations into account.
  • Levered Free Cash Flow: the amount of money a company has left remaining after paying all its financial obligations. LFCF is the amount of cash a company has after paying debts.

For a measure of the gross free cash flow generated by a firm, use unlevered free cash flow. This is a business’s cash flow excluding interest payments, and it shows how much liquid cash is available to the firm before taking financial obligations into account. 

The difference between levered and unlevered free cash flow shows if the business is overextended or operating with a healthy amount of debt.

The formula for Unlevered Free Cash Flow is: 

Unlevered free cash flow = earnings before interest, tax, depreciation, and amortization – capital expenditures – working capital – taxes 

Click on this link to see a real-world example of an Unlevered Free Cash calculation which results in how much cash is netted or available before taking on its financial obligations:

The formula for Levered Free Cash Flow is: 

Levered free cash flow: earned income before interest, taxes, depreciation, and amortization – change in net working capital – capital expenditures – mandatory debt payments.

Click on this link to see a real-world example of a Levered Free Cash calculation which results in its mandatory debt payments that need to be made:

Julie Furnas