The Different Types of Cash Flow Explained

Cash flow analysis is beneficial in studying the liquidity of the business. Here, we are going to take you through what cash flow represents and the different types of Cash Flow that will help you in studying the financial strength of your business.

What is Cash Flow?

Cash flow is the net amount of cash or liquid assets being transferred in and out of business during a financial year. The higher is the cash inflow in the business, the better is its ability to pay its shareholders and employees. Also, the strength of an enterprise to minimise long-term free cash flow has a positive impact on the company’s growth.

  • Financial reporting aims at assessing the amounts, timings, and uncertainties of cash flows of the business. They need to understand the various cash flows such as investing cash flow, operating cash flow, and financial cash flow of the business in order to determine company’s financial flexibility, liquidity, and overall financial performance.
  • The positive cash flows are a clear indicator of the fact that company is doing well in financial terms- is able to pay back its debtors, return interest to shareholders, reinvest in the business, create a surplus to provide for future challenges and pay for the administrative expenses incurred in the process. Also, with greater financial flexibility, they can take advantage of the promising investments and avoid financial distress situations.
  • At times, although the company is making profits, they aren’t getting paid in cash. By collecting accounts receivables, inventory, and investing more on capital assets, the company’s cash flow can become negative. This leads to creditors and other liabilities losing their confidence in the company. For escaping such a situation, the financial analysts need to look at debt service coverage ratio, depicting whether the liquidity will be able to cover the company’s debts.

However, liquidity only tells the above about the functioning and financial position of the business. It does not take into account the situations where a company is getting good cash inflow but at the cost of huge mortgages or by sacrificing its future growth potential.

There are 3 Types of Cash Flow

According to the division of activities that take place in the business, there are three types of cash flows:

  1. Cash Flow from Operating Activities:

All the cash generated and used in the course of the business activities, including the purchase of raw material and sale of goods and services.

Operating activities are of the following types:

  • Receipts from the sale of goods and services
  • Payment of interest
  • Payments made for Income Tax
  • Payments made to suppliers of raw materials used in the production process
  • Salaries and wages paid to employees
  • Rent paid
  • Other operating expenses paid in the course of business

The operating cash flow represents the difference between the cash expenses incurred for the core production and the cash income earned from the sale of goods and services.

Cash flow from Operations for an Investment Company, for example, will be the sale of loan, debt, and equity investments. However, their purchase of fixed and long-term assets will not be treated as operating expenses because they are not something they need for production. They will include it in their investment cash flow.

  1. Cash Flow from Investing Activities

Any cash transaction in the course of business that uses cash from the company’s investments. Such transactions include purchase or sale of an asset, credit taken from vendors or received from customers, or merger or takeover of another enterprise. Investing activities comprise of alteration in the asset ratio of the company, acquisition of equipment, or new investments.

When calculating cash from investing, the sale of assets is a positive change because it brings in the cash. On the contrary, the investments made in fixed assets, new equipment, and buildings are seen as an outflow of cash.

Therefore, the only time cash flow from investing activities is positive is- when the investments are disposed of.

  1.   Cash Flow from Financing Activities

Cash flow from financing activities represents the cash that comes in from investors and banks. The raising of additional capital has a positive impact on cash flow and includes raising equity share capital and releasing debentures.

Besides, the payments made on such loans such as interest paid to the shareholders is the cash outflow from financing activities. It includes repayment of interest on loans, dividends, payments for stock repurchases, and similar expenses.

Are Negative Cash Flow Statements Representatives of Company’s Downfall?        

Certainly not. Negative cash flow statements are pretty common in businesses and are less likely to represent anything more than lesser liquidity. Sometimes, the company might use the surplus cash to expand the business and fulfil the requirements for it, such as buying new equipment, building, machinery, and more. And, expansion is clearly an indicator of a company’s growth.

The Relationship between Accounts Receivable and Cash Flow

Even the changes in accounts receivables of a company has an impact on the cash flow from operating activities. While the reduction in accounts receivables shows a positive change in the cash flow statement depicting that more and more customers are paying off their debts, the increase in accounts receivables leads to an adverse change in the cash flow statement. An increase in accounts receivables means that more and more customers are taking credit from the company instead of paying in cash.

When the accounts receivables decrease, the difference should be added to the current year’s sales. However, if the accounts receivables increase, the amount should be deducted from the sales because no sale is considered as sale as long as cash is received.

How Inventory affects Cash Flow?

When you see the inventory lying with the enterprise as a mark of its success, your cash flow might not agree with you. According to cash flow, when you acquire more inventory, cash is paid out. Hence, the negative reflection.

In the end, the cash flow of an enterprise is the representative of its liquidity, financial flexibility, and strength that can further help the business grow. It is a cash flow statement that allows them to decide whether they will be able to pay off their expenses or not.