What is cash flow?

Cash flow is a term you may have come across during your investing journey. Here, we break down what it means and how to apply it.

Man in grey shirt with glasses opens box with banknotes flying out to represent cashflow
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What is cash flow?

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

In contrast, negative cash flow usually indicates that the company is losing money, 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 excess 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 to its investors. It gives us a snapshot of a company’s revenues, expenses, and cash flows. 

A cash flow statement is different from other reports that listed companies provide (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 three parts:

  1. Cash flow from operations
    Cash flow from operations (sometimes called ‘operating cash flow’) 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 the ordinary operation of the company, without taking into account other forms of income or outflow. 
  2. Cash flow from investments
    This reflects a company’s income and expenses received and paid from its investment operations and capital expenditures. It isn’t as helpful as operating or free cash flow from an investment perspective, but it is still a handy metric to be familiar with.
  3. Cash flow from financing
    Cash flow from financing is where we can see money flowing in from creditors and out to debtors or shareholders. We can usually see ‘post cash flow’ expenses like dividends or share buybacks here and 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 is 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 method by which 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 to forecast how valuable a company might be in the future and, therefore, how much we should pay to buy the company today. 

It can consider 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 ‘discount’ it back to what it would be worth in today’s dollars. It works off the principle that a dollar today is worth more than a dollar tomorrow and adjusts an investor’s potential future returns accordingly.

A 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 include toll road operator Transurban Group (ASX: TCL) and utilities provider 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 cash flow).

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, pay dividends, and manage their debt. 

A company with consistently positive cash flow has ready means to reward its shareholders at the end of the day. Conversely, if a company doesn’t have good cash flow, alarm bells should be ringing. A company can borrow or raise capital to fill the gap for a while, but not 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.

Updated 20 April 2022. Sebastian Bowen contributed to this article and has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.