Cash Flow

Definition

Cash Flow refers to the net amount of cash and cash equivalents moving in and out of a business over a specific period. It represents the actual liquidity available to fund operations, investments, and financing activities.

Cash flow differs from net income, which includes non-cash accounting items like depreciation or accruals.

Origins

The term emerged in financial reporting in the mid-20th century, gaining formal prominence with the FASB’s introduction of the Statement of Cash Flows in 1987 (ASC 230) under U.S. GAAP and IAS 7 under IFRS. It became essential for understanding a company's true financial health beyond just profit figures.

Usage

Industry Applications:

• Corporate Finance – To assess liquidity, plan capital expenditures, and pay dividends.

• Investment Analysis – DCF models rely on free cash flow to value companies.

• Private Equity & LBOs – IRR and debt repayment modeling depend on cash flow availability.

• Credit Analysis – Lenders analyze cash flow to evaluate a borrower’s repayment capacity.

• FP&A – Forecasting operational and free cash flows for strategic planning.

How Cash Flow Works

Cash flow is typically broken into three categories, forming the Statement of Cash Flows:

Net Cash Flow = Operating Cash Flow + Investing Cash Flow + Financing Cash Flow

 Key Takeaways

• Cash flow measures actual cash movement, not accounting profits.

• It’s critical for solvency, strategic flexibility, and valuation.

• Negative cash flow isn’t always bad (e.g., in CapEx-intensive growth).

• Free Cash Flow is a key valuation input in DCF models.

Types of Cash Flow

Context in Financial Modeling

Cash flow is the engine of most financial models:

• DCF Valuation: Based on future FCFF or FCFE.

• LBO Models: Cash flow used to pay down debt, determine equity returns.

• Project Finance: NPV/IRR based on forecasted cash flows.

• Three-Statement Models: Reconcile net income to net change in cash.

• Liquidity Forecasting: Tracks inflows/outflows for treasury and risk management.

Nuances & Complexities

• Working Capital Movements: Timing differences between cash and accrual accounting can obscure cash flow trends.

• Non-Cash Items: Depreciation, amortization, and stock-based comp affect profit but not cash.

• Capital Structure: Cash flow available to equity differs from that available to the firm.

• CapEx Intensity: Asset-heavy businesses often show strong earnings but weak cash flow due to heavy reinvestment.

   

Mathematical Formulas

1. Operating Cash Flow (Indirect Method):

$$\text{OCF} = \text{Net Income} + \text{Non-Cash Expenses} + \text{Change in Working Capital}$$

2. Free Cash Flow to Firm (FCFF):

$$\text{FCFF} = EBIT \times (1 - \text{Tax Rate}) + \text{Depreciation} - \text{CapEx} - \text{Change in NWC}$$

3. Free Cash Flow to Equity (FCFE):

$$\text{FCFE} = \text{FCFF} - \text{Net Debt Repayments}$$

4. Net Cash Flow:

$$\text{Net Cash Flow} = \text{OCF} + \text{Investing CF} + \text{Financing CF}$$

Related Terms

• Net Income

• Working Capital

• CapEx

• Depreciation

• WACC

• EBITDA

• Cash Flow Statement

• Discounted Cash Flow (DCF)

Real-World Applications

1. Startup Funding Needs

A SaaS startup forecasts negative cash flow for 2 years and raises $5M to cover burn rate and working capital needs.

2. DCF Valuation

An equity analyst models FCFE over 5 years, discounts using cost of equity, and derives a valuation of $250M.

3. M&A Due Diligence

Buyers evaluate historical cash flows to assess the sustainability of earnings quality and determine price multiples.

4. Debt Covenant Monitoring

A lender requires the borrower to maintain a Debt/EBITDA < 3.5x and positive operating cash flow, reviewed quarterly.

References & Sources

• FASB ASC 230 – Statement of Cash Flows

• IFRS IAS 7 – Statement of Cash Flows

• CFA Institute Curriculum – Corporate Finance & Equity

• McKinsey & Co. – Valuation: Measuring and Managing the Value of Companies

• Harvard Business Review – “The Truth About Cash Flow”

• Moody’s Methodologies – Cash Flow-Based Credit Assessments