Cash Flow
Cash flow refers to the movement of cash into or out of a business, a project, or a financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used
* to determine a project's rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such as internal rate of return, and net present value.
* to determine problems with a business's liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable.
* as an alternate measure of a business's profits when it is believed that accrual accounting concepts do not represent economic realities. For example, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a case, the company may be deriving additional operating cash by issuing shares, or raising additional debt finance.
* cash flow can be used to evaluate the 'quality' of Income generated by accrual accounting. When Net Income is composed of large non-cash items it is considered low quality.
* to evaluate the risks within a financial product. E.g. matching cash requirements, evaluating default risk, re-investment requirements, etc.
Cash flow is a generic term used differently depending on the context. It may be defined by users for their own purposes. It can refer to actual past flows, or to projected future flows. It can refer to the total of all the flows involved or to only a subset of those flows. Subset terms include 'net cash flow', operating cash flow and free cash flow.
* to determine a project's rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such as internal rate of return, and net present value.
* to determine problems with a business's liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash, even while profitable.
* as an alternate measure of a business's profits when it is believed that accrual accounting concepts do not represent economic realities. For example, a company may be notionally profitable but generating little operational cash (as may be the case for a company that barters its products rather than selling for cash). In such a case, the company may be deriving additional operating cash by issuing shares, or raising additional debt finance.
* cash flow can be used to evaluate the 'quality' of Income generated by accrual accounting. When Net Income is composed of large non-cash items it is considered low quality.
* to evaluate the risks within a financial product. E.g. matching cash requirements, evaluating default risk, re-investment requirements, etc.
Cash flow is a generic term used differently depending on the context. It may be defined by users for their own purposes. It can refer to actual past flows, or to projected future flows. It can refer to the total of all the flows involved or to only a subset of those flows. Subset terms include 'net cash flow', operating cash flow and free cash flow.
Statement of cash flow in a business's financials
The (total) net cash flow of a company over a period (typically a quarter or a full year) is equal to the change in cash balance over this period: positive if the cash balance increases (more cash becomes available), negative if the cash balance decreases. The total net cash flow is the sum of cash flows that are classified in three areas:
1. Operational cash flows: Cash received or expended as a result of the company's internal business activities. It includes cash earnings plus changes to working capital. Over the medium term this must be net positive if the company is to remain solvent.
2. Investment cash flows: Cash received from the sale of long-life assets, or spent on capital expenditure (investments, acquisitions and long-life assets).
3. Financing cash flows: Cash received from the issue of debt and equity, or paid out as dividends, share repurchases or debt repayments.
Ways Companies Can Augment Reported Cash Flow
Common methods include:
* Sales - Sell the receivables to a factor for instant cash. (leading)
* Inventory - Don't pay your suppliers for an additional few weeks at period end. (lagging)
* Sales Commissions - Management can form a separate (but unrelated) company and act as its agent. The book of business can then be purchased quarterly as an investment.
* Wages - Remunerate with stock options.
* Maintenance - Contract with the predecessor company that you prepay five years worth for them to continue doing the work
* Equipment Leases - Buy it
* Rent - Buy the property (sale and lease back, for example).
* Oil Exploration costs - Replace reserves by buying another company's.
* Research & Development - Wait for the product to be proven by a start-up lab; then buy the lab.
* Consulting Fees - Pay in shares from treasury since usually to related parties
* Interest - Issue convertible debt where the conversion rate changes with the unpaid interest.
* Taxes - Buy shelf companies with TaxLossCarryForward's. Or gussy up the purchase by buying a lab or O&G explore co. with the same TLCF.
The (total) net cash flow of a company over a period (typically a quarter or a full year) is equal to the change in cash balance over this period: positive if the cash balance increases (more cash becomes available), negative if the cash balance decreases. The total net cash flow is the sum of cash flows that are classified in three areas:
1. Operational cash flows: Cash received or expended as a result of the company's internal business activities. It includes cash earnings plus changes to working capital. Over the medium term this must be net positive if the company is to remain solvent.
2. Investment cash flows: Cash received from the sale of long-life assets, or spent on capital expenditure (investments, acquisitions and long-life assets).
3. Financing cash flows: Cash received from the issue of debt and equity, or paid out as dividends, share repurchases or debt repayments.
Ways Companies Can Augment Reported Cash Flow
Common methods include:
* Sales - Sell the receivables to a factor for instant cash. (leading)
* Inventory - Don't pay your suppliers for an additional few weeks at period end. (lagging)
* Sales Commissions - Management can form a separate (but unrelated) company and act as its agent. The book of business can then be purchased quarterly as an investment.
* Wages - Remunerate with stock options.
* Maintenance - Contract with the predecessor company that you prepay five years worth for them to continue doing the work
* Equipment Leases - Buy it
* Rent - Buy the property (sale and lease back, for example).
* Oil Exploration costs - Replace reserves by buying another company's.
* Research & Development - Wait for the product to be proven by a start-up lab; then buy the lab.
* Consulting Fees - Pay in shares from treasury since usually to related parties
* Interest - Issue convertible debt where the conversion rate changes with the unpaid interest.
* Taxes - Buy shelf companies with TaxLossCarryForward's. Or gussy up the purchase by buying a lab or O&G explore co. with the same TLCF.
Cash flow forecasting
Cash flow forecasting is (1) in a corporate finance sense, the modeling of a company or asset’s future financial liquidity over a specific timeframe. Cash usually refers to the company’s total bank balances, but often what is forecast is treasury position which is cash plus short-term investments minus short-term debt. Cash flow is the change in cash or treasury position from one period to the next; in the context of the entrepreneur or manager, forecasting what cash will come into the business or business unit in order to ensure that outgoing can be managed to as to avoid them exceeding cashflow coming in. If there is one thing entrepreneurs learn fast, it is to become very good at cashflow forecasting.
Methods (corporate finance)
The direct method of cash flow forecasting schedules the company’s cash receipts and disbursements (R&D). Receipts are primarily the collection of accounts receivable from recent sales, but also include sales of other assets, proceeds of financing, etc. Disbursements include, payroll, payment of accounts payable from recent purchases, dividends, debt service, etc. This direct, R&D method is best suited to the short-term forecasting horizon of 30 days or so because this is the period for which actual, as opposed to projected, data is available. (de Caux, 2005)
The three indirect methods are based on the company’s projected income statements and balance sheets. The adjusted net income (ANI) method starts with operating income (EBIT or EBITDA) and adds or subtracts changes in balance sheet accounts such as receivables, payables and inventories to project cash flow. The pro-forma balance sheet (PBS) method looks straight at the projected book cash account; if all the other balance sheet accounts have been correctly forecast, cash will be correct, too. Both the ANI and PBS methods are best suited to the medium-term (up to one year) and long-term (multiple years) forecasting horizons. Both are limited to the monthly or quarterly intervals of the financial plan, and need to be adjusted for the difference between accrual-accounting book cash and the often-significantly-different bank balances. (Association for Financial Professionals, 2006)
The third indirect approach is the accrual reversal method (ARM), which is similar to the ANI method. But instead of using projected balance sheet accounts, large accruals are reversed and cash effects are calculated based upon statistical distributions and algorithms. This allows the forecasting period to be weekly or even daily. It also eliminates the cumulative errors inherent in the direct, R&D method when it is extended beyond the short-term horizon. But because the ARM allocates both accrual reversals and cash effects to weeks or days, it is more complicated than the ANI or PBS indirect methods. The ARM is best suited to the medium-term forecasting horizon. (Bort, 1990)and the advantages are as follows
Methods (entrepreneurial)
The simplest method is to have a spreadsheet that shows cash coming in from all sources out to at least 90 days, and all cash going out for the same period. This requires that the quantity and timings of receipts of cash from sales are reasonably accurate, which in turn requires judgement honed by experience of the industry concerned, because it is rare for cash receipts to match sales forecasts exactly, and it is also rare for suppliers all to pay on time. These principles remain constant whether the cash flow forecasting is done on a spreadsheet or on paper or on some other IT system.
A danger of using too much corporate finance theoretical methods in cash flow forecasting for managing a business is that there can be non cash items in the cashflow as reported under financial accounting standards. This goes to the heart of the difference between financial accounting and management accounting.
Cash flow statement
In financial accounting, a cash flow statement, also known as statement of cash flows or funds flow statement, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and cash out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet.[1] As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7 (IAS 7), is the International Accounting Standard that deals with cash flow statements.
People and groups interested in cash flow statements include:
* Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses
* Potential lenders or creditors, who want a clear picture of a company's ability to repay
* Potential investors, who need to judge whether the company is financially sound
* Potential employees or contractors, who need to know whether the company will be able to afford compensation
* Shareholders of the business.
Discounted cash flow
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) – the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.
Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite process – taking cash flows and a price and inferring a discount rate, is called the yield.
Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.
Discount rate
By far the most widely used method of discounting is exponential discounting, which values future cash flows as "how much money would have to be invested currently, at a given rate of return, to yield the cash flow in future". Other methods of discounting, such as hyperbolic discounting, are studied in academia and said to reflect intuitive decision-making, but are not generally used in industry.
The discount rate used is generally the appropriate Weighted average cost of capital (WACC), that reflects the risk of the cashflows. The discount rate reflects two things:
1. the time value of money (risk-free rate) – according to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay.
2. a risk premium – reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all.
An alternative to including the risk in the discount rate is to use the risk free rate, but multiply the future cash flows by the estimated probability that they will occur (the success rate). This method, widely used in drug development, is referred to as rNPV (risk-adjusted NPV), and similar methods are used to incorporate credit risk in the probability model of CDS valuation.
Income statement
Income statement, also referred as profit and loss statement (P&L), earnings statement, operating statement or statement of operations, is a company's financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the "top line") is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as the "bottom line"). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.
The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.
Charitable organizations that are required to publish financial statements do not produce an income statement. Instead, they produce a similar statement that reflects funding sources compared against program expenses, administrative costs, and other operating commitments. This statement is commonly referred to as the statement of activities. Revenues and expenses are further categorized in the statement of activities by the donor restrictions on the funds received and expended.
The income statement can be prepared in one of two methods. The Single Step income statement takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line. The more complex Multi-Step income statement (as the name implies) takes several steps to find the bottom line, starting with the gross profit. It then calculates operating expenses and, when deducted from the gross profit, yields income from operations. Adding to income from operations is the difference of other revenues and other expenses. When combined with income from operations, this yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured.
Income statement, also referred as profit and loss statement (P&L), earnings statement, operating statement or statement of operations, is a company's financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the "top line") is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as the "bottom line"). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.
The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.
Charitable organizations that are required to publish financial statements do not produce an income statement. Instead, they produce a similar statement that reflects funding sources compared against program expenses, administrative costs, and other operating commitments. This statement is commonly referred to as the statement of activities. Revenues and expenses are further categorized in the statement of activities by the donor restrictions on the funds received and expended.
The income statement can be prepared in one of two methods. The Single Step income statement takes a simpler approach, totaling revenues and subtracting expenses to find the bottom line. The more complex Multi-Step income statement (as the name implies) takes several steps to find the bottom line, starting with the gross profit. It then calculates operating expenses and, when deducted from the gross profit, yields income from operations. Adding to income from operations is the difference of other revenues and other expenses. When combined with income from operations, this yields income before taxes. The final step is to deduct taxes, which finally produces the net income for the period measured.
