While many companies are focused on net profits, cash flow is actually a much more important figure for business owners most of the time. While the profit may be used to determine the valuation or the taxes, cash flow is the real money that can be used to pay expenses, payroll, bonuses and make investments. It is the cash and cash equivalents that actually enter the business minus the same assets that go out. For that reason, business owners need to be concerned with this number above all else.
Cash Flow Composition
The cash flow is composed of three separate components that are key to understand. The free cash flow is operating cash flow minus capital expenditures. Operating activities are all of the things that actually occur on a day to day business in the company like payroll, accounts receivable and accounts payable. Capital expenditures include inventories and other accrued liabilities. The depreciation is added back in here.
Cash flow from investing is the second component. This number is the number of incoming dollars from past investments minus outgoing investment dollars from current investments.
Lastly, cash flow from financing is all of the money coming in from raising debt or equity. It is reduced by the amount paid out in dividends, interest payments, and other associated funds.
The three components are added together to get total cash flow.
There are several areas where cash flow and profit differ that might be confusing initially. Investment in equipment is the most common area. You may buy a computer or tractor and depreciate it over three years. The net profit shows that you only have a charge of $400 for the computer or $4,000 for the tractor. However, the net negative cash flow is three times those amounts in year one. So if you are capital constrained, you can only buy a fraction of the equipment you might need.
Similarly, there are many charges on the balance sheet and in intangible line items that affect the net income, yet have no bearing on the cash flow. For example, you may change the value of your outstanding investments which reduces the net income. Still, the cash flow will remain the same based on the incoming and outgoing of funds.
Cash Flow Realities
Cash flow is the funds that are actually deposited into your bank account by the end of the accounting period. You may have all kinds of outstanding assets that never become reality or cash flow. You have clients that you are still waiting to pay you or investments that have not generated a return. While you may put these funds into collections or mark them as probable income, they are not cash flow until you actually receive the funds.
Even if you have a good net profit on paper, the reality of poor cash flow can mean that you have to go out and raise additional financing from investors in the form of debt or equity. Debt offerings add more expenses from interest payments, servicing and the actual issuance. Equity offering reduces your ownership in the company, which lowers your long-term income from the business.