Cash Flow: Understanding and Measuring

Tips:

Cash—not profit—keeps your office (remote office) lights on.

Track the three streams separately; they tell different stories.

Guard working capital: every extra day of receivables or inventory burns cash.

Prefer the direct method for clarity; reconcile with the indirect method.

Monitor free cash flow— it shows what is genuinely available to reward capital providers.

Financing or asset sales can patch cash flow gaps temporarily, but only a positive, recurring operating cash flow secures longterm survival and growth.

Why Cash Beats Profit

A growing, profitable firm can still fail if it simply runs out of cash. While studying for Chartered Accountancy Degree or for Master’s in Business Administration, I was handed over research that showed four out of five bankrupt businesses in developed markets were technically profitable when they closed their doors. This issue spans across travel, entertainment, construction, energy and more. Some examples that come to my mind are ToyRus, Carillion, Thomas Cook. They died or struggled because suppliers, lenders, or tax authorities expected to be paid cash and not in Profits! Profits matter only when they are quickly converted into cash in the bank.

The Three activities under which Cash flows

Flow of Cash can be broadly categorized to one of three activities:

Operating activities – Cash flow for daytoday operations. Cash is received when customers pay for the invoices you send them; it goes out of your bank when you buy inventory, pay salaries, rent, advertising, or taxes.

Investing activities – Cash flow for purchase or sale of longlived assets. Buying a new solarpanel, acquiring a long-term asset, or selling land.

Financing activities – the capital side of the balance sheet. Cash flow related to borrowing from a bank, raising venture capital, repaying loans, or distributing dividends to shareholders are categorised under this activity.

In earlystage of companies or small or medium size businesses, the operating cash flow tends to be the primary source of liquidity. If bank balance increases by selling assets or drawing new loans, then it does not reflect strong and sustainable operating business.

How do you read Operating Cash Flow

Let us start with sales or revenue and operating expenses, then adjust for timing. Under accrual accounting you book revenue when an invoice is raised, not when the cash is received in your bank account. If accounts receivable rise as compared to previous period , you generated less cash than the income statement suggests; if they fall as compared to previous period, you collected more. Also keep in mind, depreciation in P&L or Income statement is an expense with zero cash impact.

Operating Cash Flow = Operating Profit + Noncash charges (eg: depreciation) – Increase in Working capital

A retailer or supermarket like carrefour or SM in Phlippines or NTUC Fair Price in Singapore or Mydin in Malaysia record negative working capital. Why? Because we as their retail customers pay instantly at the cash counter while suppliers to these supermarkets would have longer payment terms. That creates a healthy cash cushion. Conversely, a manufacturer that stocks raw materials for months must finance that inventory first, draining liquidity.

Working Capital: Key indicator of your business

Working capital is receivables  +  inventory  –  payables.

An increase means cash is tied up; a decrease means cash is released. Rapid growth without tight credit control can starve even profitable companies—they, in effect, may lend to their customers!!! It sounds crazy right?

Two Ways to Report Cash Flow

Financial statements show operating cash flow by either:

Direct method – lists actual cash received from customers and cash paid to suppliers, staff, and the tax office. Transparent but requires detailed records.

Indirect method – starts with profit after tax and adjusts for noncash items and workingcapital changes. This is a controversial method and has been criticised by experts as many companies have used this method to hide problems.

Both arrive at the same number, yet the direct method lets managers (and investors) see the real source of cash inflow and outflow.

Free Cash Flow: The Ultimate Litmus Test

Free cash flow (FCF) is what remains for lenders and shareholders after funding operations of business and necessary capital spending:

FCF= Operating Cash Flow - Net capital expenditure

FCF = Sales – Costs of Goods Sold-Operating expenses- Taxes – Change in Working Capital- Capital expenditure