Understanding cash flow
Cash flow is how companies afford growth, pay dividends, and manage their debt.
At its core, cash flow refers to a company's money flowing in and out. If it has positive cash flow, this usually indicates the company has money left over after receiving revenue and paying expenses.
In contrast, negative cash flow usually indicates that the company is losing money, as it isn't generating enough cash receipts to cover its expenses. It's obvious which is the better financial situation for a business to be in!
In essence, positive cash flow enables a small business to grow as it can use excess capital from its ordinary operations to invest in the pursuit of higher revenue and a profit down the road. To achieve this, a company needs good cash flow management. This can include a cash flow analysis, cash flow budget, and a cash flow projection.
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 the company's cash position and how it manages its cash flow. This crucial financial statement includes the company's cash receipts, accounts receivable, working capital, expenses, cash balance, and cash reserve.
A cash flow statement differs from other financial statements 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:
- Cash flow from operations: Also known as 'operating cash flow', this 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 company's ordinary operations, without taking into account other forms of income or cash outflow.
- Cash flow from investments: This reflects a company's income and expenses from investing activities and capital expenditures. It isn't as helpful as operating cash flow or free cash flow from an investment perspective, but it is still a handy cash flow analysis metric to be familiar with.
- 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, as well as finance from creditors and 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 the finances of a business.
What is discounted cash flow?
You may have heard the term 'discounted cash flow' (DCF) as an investor. No, this doesn't indicate expected cash flows on sale.
Instead, a discounted cash flow model is a method by which many investors like to value a business as a potential (or current) investment. It is so named because it uses a company's cash flows to forecast how valuable it may 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 utility 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 essential 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 and even a cash reserve has ready means to reward its shareholders at the end of the day. Conversely, alarm bells should be ringing if a company has poor cash flow. A business can borrow or raise capital to fill the gap for a while, but not forever.
So, if you're considering investing in an ASX share, be sure you understand the company's cash inflow and cash outflow and where the money is going.