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What is Cash Flow?

Man in grey shirt with glasses opens box with banknotes flying out to represent cashflow

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Cash flow is a term you may have come across during your investing journey, but many people don’t fully understand its meaning. But you needn’t look any further. Today, let’s break down what cash flow actually means and how to apply it to good investing practice

What is cash flow?

At its core, cash flow refers to the money ‘flowing’ in and out of a business. If a company has positive cash flow, it normally indicates that the company has money left over after receiving revenues and paying its expenses. 

In contrast, if a company has ‘negative cash flow’, it usually indicates that money is flowing out of the company as it isn’t generating enough revenue to cover its expenses. It’s obvious which is the better situation for a business to be in!

In essence, positive cash flow enables a business to grow as it has leftover capital from its ordinary operations that it can then invest in the pursuit of higher revenues down the road.

What is a cash flow statement?

A cash flow statement is a document that every listed ASX company must provide its investors. It gives us a snapshot into a company’s revenues, expenses and cash flows. A cash flow statement is different from other reports a company provides (such as the balance sheet or income statement) because it only measures cash and cash equivalents. A cash flow statement is typically made up of 3 parts.

Cash flow from operations

Cash flow from operations (sometimes called operating cash flow) is a metric garnered from the cash flow statement. It is similar to free cash flow, but doesn’t account for capital maintenance or operational expenses. It is simply a measure of how much cash is left over after ordinary operation of the company, without taking into account other forms of income or outflow. 

Cash flow from investments

This statement reflects the income and expenses a company receives or pays from its investment operations and capital expenditures. It isn’t as useful from an investment perspective as operating or free cash flow, but it is still a handy metric to be familiar with.

Cash flow from financing

Cash flow from financing is the section of the cash flow statement where we can see cash flowing in from creditors and cash flowing out to debtors or shareholders. We can usually see ‘post-cash flow’ expenses like dividends or stock buybacks here, as well as finance from creditors or the servicing of debt obligations. While not a measure of pure cash flow, looking at cash flow from financing offers a more well-rounded view of a company’s finances.

What about discounted cash flow? 

As an investor, you may have also heard the term ‘discounted cash flow’ (DCF). No, this doesn’t indicate normal cash flows on sale. 

Instead, a discounted cash flow model is a way that many investors like to value a company as a potential (or current) investment. It is so named because it uses a company’s cash flows in order to try and forecast how valuable a company might be in the future – and therefore how much we should pay to buy the company today. It can take into account effects like inflation or the ‘risk-free rate’ in determining the value of the company’s cash flows. 

The term ‘discounted’ is used because a DCF calculation will typically work out a company’s potential future value in terms of cash flows, and then ‘discounts’ it back to what they would be worth in today’s dollars. It works off of the principle that a dollar today is worth more than a dollar tomorrow, and adjusts an investor’s potential future returns accordingly.

Discounted cash flow valuation can work better with some companies than others. It tends to work best when a company’s future cash flow is relatively easy to predict. Examples of these kinds of companies would be toll-road operators like Transurban Group (ASX: TCL), airports like Sydney Airport Holdings Pty Ltd (ASX: SYD) or utility providers like AGL Energy Limited (ASX: AGL)

In contrast, DCFs are not generally as effective when analysing small, high-growth companies that perhaps might not be profitable yet (and therefore have no positive cashflow).

How to think about cash flow when investing 

Cash flow is an important consideration for any ASX investor. Cash flow is how companies afford growth, how they pay dividends and how they manage their debt. A company with consistently positive cash flow has ready means to benefit its shareholders at the end of the day. Conversely, if a company doesn’t have cash flow, alarm bells should be ringing. A company can borrow or raise capital to fill the gap for a while, but not normally forever.

So if you’re thinking about investing in an ASX share, make sure you know how much cash is flowing through the door, and where it’s going.