Understanding Cash Flow: Essential Types You Need to Know

Analysing both inflows and outflows provides a financial health check, revealing a company's liquidity (its ability to meet short-term obligations).

What is Cash Flow?

Cash flow, the continuous in and out movement of money, acts as the very lifeblood of a company. Inflows stem from operations, investments or financing activities. Meanwhile, outflows cover operational expenses, investments in new assets, and repayments on debt. By carefully managing these cash streams, a company can maximize its value for shareholders. A crucial metric in this analysis is free cash flow (FCF), which reveals the cash remaining after accounting for both regular business expenses and reinvestments for growth.

Analysing both inflows and outflows provides a financial health check, revealing a company's liquidity (its ability to meet short-term obligations), the sources and uses of its cash, and its overall financial well-being. Just like a personal checkbook register, a company's cash flow statement offers a transparent view of its cash generation capacity in relation to its expenses and debts.

Types of Cash Flow

There are 3 types of Cash Flow. They are as follows:

1. Cash Flows from Operations (CFO)
2. Cash Flows from Investing (CFI)
3. Cash Flows from Financing (CFF)

1) Cash Flows from Operations (CFO)

Cash flow from operations (CFO), also called operating cash flow, reflects a company's ability to generate cash from its core business activities like production and sales. It shows if a company has enough incoming cash to cover its bills and operating expenses. Calculated by subtracting cash-paid operating expenses from cash received from sales, CFO is a key metric on a company's cash flow statement, indicating its capacity to maintain and grow operations, potentially needing external financing for expansion. CFO, essentially the cash version of net income, considers non-cash expenses and changes in working capital to provide a clearer picture of a company's cash-generating ability from its core activities.

Formula: Cash Flow from Operations = Net income + Non-cash items + Changes in operating working capital +/- changes in other long-term operating assets and operating liabilities

2) Cash Flows from Investing (CFI)

Cash flow from investing activities (CFI) tracks a company's cash movement related to investments over a specific period. This includes buying or selling things like stocks, bonds, or even entire businesses. It can also involve purchases of long-term assets the company will use for a while, like equipment or buildings (capital expenditures). While a negative CFI might raise eyebrows, it's not always bad. If the company is investing heavily in its future through research and development or expanding through acquisitions, that spending can temporarily outweigh cash coming in from selling investments.

Formula: Cash Flow from Investing Activities = (Capital expenditures) + (Purchase of long-term investments) + (Business acquisitions) – Divestitures

2) Cash Flows from Financing (CFF)

A company's cash flow from financing (CFF) shows how well it manages its funding by tracking net cash inflows from issuing debt and equity (like selling stocks or taking out loans) and outflows used to pay dividends and repay debt. This information helps investors assess the company's financial health and its ability to fund future operations.

Formula: Cash flow from financing activities = Net debt + Net equity + Net capital leases - Dividend payments

Now let us understand Cash Flow with the help of a blue-chip company or Large-Cap company: Larsen & Toubro Ltd

Analysis: Cash flow analysis of Larsen & Toubro Ltd over the past five years reveals a dynamic financial landscape. In 2019, the company experienced a negative net cash flow of Rs 338 crore, largely attributed to significant investments and financial activities. However, by 2020, the tide turned with a positive net cash flow of Rs 4,658 crore, driven by improved cash from operating activities and prudent financial decisions. The following year, 2021, saw a substantial surge in cash flow, reaching Rs 2,049 crore, marked by robust cash from operating activities and a reduction in cash outflow from financing activities. In 2022, although the net cash flow dipped to Rs 397 crore, the company maintained stability amidst fluctuations, largely due to efficient management of working capital and strategic investments. Finally, in 2023, Larsen & Toubro Ltd witnessed a notable rebound in cash flow, totalling Rs 3,156 crore, underpinned by strong operational performance and prudent financial management, demonstrating resilience and adaptability in challenging market conditions.

Here are some additional details that you may find interesting:

1. Larsen & Toubro's profit from operations has increased steadily over the past five years, from Rs 16,073 crore in 2019 to Rs 22,525 crore in 2023.
2. The company has been reducing its working capital requirements over the past five years.
3. Larsen & Toubro has paid out a significant number of dividends to its shareholders over the past five years.

Conclusion

By analysing a company's cash flow statement, we gain valuable insights into its financial health and ability to generate cash. This breakdown into operating, investing, and financing activities offers a more comprehensive picture than just profitability.

Taking Larsen & Toubro (L&T) as an example, we see a company with strong operational cash flow, indicating its core business can cover expenses. However, negative cash flow from investing activities suggests significant investments in new assets and acquisitions. This may be a positive sign for future growth but requires ongoing monitoring. Finally, positive net cash flow in recent years demonstrates L&T's overall financial stability.

Understanding these cash flow dynamics is essential for investors and analysts to assess a company's true financial well-being and its potential for future success.

Also Read: What is Book Value and Book Value Per Share? Importance & limitations of book value!

Disclaimer: The article is for informational purposes only and not investment advice.