Know what your cash flow is telling you

The term “cash flow” is one of the most misunderstood financial terms. To some extent, this is because there are several definitions. Among the many uses are simple cash flow, operating cash flow, net cash flow and free cash flow. As a result, the term has different meanings depending on the situation.

Cash flow is an important measure of financial health. Basic company value relies on predictable cash flow. Most business owners use the term to mean discretionary cash available for use outside basic business operations. Let’s examine several definitions to see if we can clarify a definition that is helpful.

Simple cash flow is defined as profit plus non-cash expenses such as depreciation and amortization. While easy to calculate, this definition may not be very helpful. Actual cash available to the owner may be substantially more, or less, than determined by the simple cash-flow calculation.

This discrepancy arises because the change in working capital needs may consume or release cash. Business growth mandates an increase in working capital, which is all too often left out of business plan projections. If the term “change in working capital” is unfamiliar, ask your accountant to show how it is calculated. This is a critical concept needed to effectively manage the financial aspect of your business.

Operating cash flow is more helpful because it is a quick way to determine the operating health of the business. Operating cash flow is the cash received or expended in the firm’s operational activities. It is the cash profit, plus or minus changes in working capital. The result must be positive for the medium term if the business is to remain solvent.

Accountant-prepared financial statements often include a calculation of net cash flow, which is the combined effect of operating cash flow, investment cash flow (the effect of acquiring and disposing of fixed assets), and financing cash flows (from taking on and paying off debt as well as owner distributions). This calculation is important to understand from where cash is coming and to where it is going.

Free cash flow, while perhaps the least understood, is the calculation most owners are looking for when they talk about cash flow. Free cash flow, or FCF, is the cash available for discretionary use after payment of all taxes and allowing for working capital changes and capital expenditure needs.

It is the cash available to the owners. It can be distributed to the owners, used to finance expansion, reduce debt or any other purpose. FCF is what savvy buyers are looking for when they buy a business. FCF is the reward from a well-managed business.

Implicit in the calculation of cash flow is maintenance of accurate records. For all, but the simplest of businesses, this means accrual accounting. This is accounting that records all income whether yet received or not, and all expense whether yet paid or not. If records are not accurate, the determination of profit, and the resulting cash flow will not be accurate.

Businesses need both profit and cash flow to survive and thrive. Dan Bowser is president of Value Insights Inc. of Durango; Chandler, Ariz.; and Summerville, Pa.