Revenue is vanity, profit is sanity, but cash is king! This very common expression highlights the importance of cash flow. The financial statement of any company consists of three main sections – the balance sheet, the income statement and the cash flow statement. But why is cash flow so important – and how is the cash flow statement structered? Find out how to calculate, separate and interpret cash flow.
Cash flow is basically the flow of cash in and out of the business. It can be calculated in two different ways: The direct method and the indirect method. In fact, most of us are aware of the direct method, since we apply it everyday in our life. The incoming and outgoing payments are simply compared. In the end, a positive or negative cash flow remains. The direct method ensures a high level of detail. But you may imagine that for established companies this method is very time-consuming, as the number of cash-in and cash-out transaction can reach an immense scale. Thus, companies often apply the indirect method. This method starts with the net income/loss and is than adjusted by further cash and non-cash positions. By using the indirect method, companies can limit their calculation scheme to already existing and easily retrievable accounting positions.
Breakdown of Cash Flow
Within the cash flow statement, the cash flow is partitioned into three types that are linked to the underlying cash-generating activities: cash flow from operating, investing and financing activities. In our roovestor company score we’re fully focusing on operating cash flow (OCF). It is crucial for companies to keep its OCF positive as it results from the core business and thus indicates the financial success of the operating business activities. OCF is calculated as the net cash provided by operating activities. This measure consists of net income/loss adjusted by provisions and depreciation/amortization and other non-cash expenses and income, but also by changes in working capital (WC).
What is Free Cash Flow?
In addition to the cash flow types already mentioned, there is also free cash flow (FCF). This KPI represents the cash available for investors to pay dividends and interest. The easiest way (which is also very common) for calculating the FCF it simply to deduct capital expenditures (CAPEX) from OCF. FCF is a very important measure in the investment area. It can be used to determine the shareholder value using the discounted cash flow (DCF) method.
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