Cash flow is the amount of cash that an organization receives and spends in a predetermined period. Companies use cash flows to determine their present and future values. In finance, a company’s future value, embodied by anticipated cash flows, is represented by the present value. Therefore, today’s cash flow in a firm is reflection of the cash it may receive and dispense in the future. There are various ways to measure organizational cash flows in a determined time frame. For instance, cash flows, represented as Earnings before Amortization and Depreciation, can be calculated by adding the net income for the determined period to non-cash expenses for the same timeframe.
Alternatively, companies can calculate their cash flows by adding interest payments and operating incomes, to have Earnings before Interest, Taxes, Depreciation, and Amortization. Using the above method of calculating cash flows helps companies compare their performance solely based on operations ( Chapter 6: Cash Flow Analysis , n.d.). In contrast, using EBDA to calculate cash flows helps organizations check their income levels using depreciation. However, if a firm uses EBDA to calculate its cash flows, it disregards records of cash sources and uses during the predetermined period, which is a negative aspect in finance. Worth noting is that reporting company cash flows using statements was only made mandatory for firms from 1987. In the previous years, firms reported their financial positions in a predetermined period through Statements of Financial Position.
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Cash flows can be direct or indirect, depending on a firm’s adjustment techniques for the same. For instance, if a company decides to use the direct method to report its cash flows, it will record and present the cash it received and dispensed during a financial year or quarter. In contrast, if a firm wants to use the indirect technique to report its cash flows, it will adjust its net income for a financial year or quarter by considering aspects, such as depreciation, working capital, and non-cash expenses ( Chapter 6: Cash Flow Analysis , n.d.). Companies have different types of cash flows, depending on their maturity stages. For instance, young firms have negative operational cash flows but may compensate the same on their financial end. In contrast, mature organizations enjoy positive operational cash flow, and may channel part of its cash income to fund new projects.
When companies with extra cash flows invest in non-viable projects, they are deemed to have detrimental cash flow management skills. Similarly, if an organization keeps borrowing to generate its cash flow, its management of the same is questionable. The cash flows companies invest is termed “free cash flow”, and may be calculated as (operational cash flows- capital) + net borrowing ( Chapter 6: Cash Flow Analysis , n.d.). Further, cash flows can be categorized as net free cash flows, calculated as (income tax expense – increased deferred income tax). Under the net free cash flow, the organization deducts taxes, and financing costs from its net income.
Cash flows are essentials for organizations for several reasons. Firstly, firms can use can use cash flow statements to check their capital spending and debt management. For instance, a company with positive free cash flow would invest their extra cash income on viable projects and only borrow for capital spending ( Chapter 6: Cash Flow Analysis , n.d.). Secondly, a firm can use its cash flow statements to check if it over-relies on borrowing to have cash income. Lastly, cash flows can help firms check if they have a huge difference between their incomes in several periods, which suggests that its earning quality is low. Finally, cash flows can be used to measure ratio analyses in organizations. When using cash flow for the mentioned purpose, the ratio analysis is calculated as (Cash flow divided by capital expenditure) or (cash flow divided by debt), depending on the type of examination being conducted.
Reference
Chapter 6: Cash Flow Analysis [PDF]. (n.d.).
