Calculating cash flow is arguably the most important part of analyzing a business. You cannot pay anything with a profit, while a positive cash flow ensures that there is room for new investments and a dividend. Also takeovers, repayments of debts and the buyback of own shares cannot be done with profit, but only with cash.
In this article I explain how to calculate the cash flow, what the cash flow means and how you can apply it in the analysis of a company or stock:
- Cash flow meaning (Positive cash flow & Negative cash flow)
- Cash flow overview
- Difference cash flow & profit
- Calculate cash flow
- Cash flow formula
- Cash flow forecast
[membership_protected_content user=non-member] Unlock all premium content by purchasing Monthly Subscription plan. You’ll also get Stock buy/sell levels with charts before market open. Checkout our old stocks levels recommendation. If you already have membership please login [/membership_protected_content]
Meaning Calculate Cash Flow & Cash Flow
Meaning Cash Flow
The cash flow says something about how money flows through an organization. This term from business economics thus says something about the movement of liquid assets. With a positive net cash flow, cash remains at the end of the process. In case of a negative cash flow, the organization needs money.
Cash flow overview
The entire cash flow of an organization consists of three pieces. This is to make the whole more clear.
The first is cash flow from operations or Cash flow from operations . This really looks at the operational result. The cash flow statement only looks at the flows of money and does not include, for example, depreciation on buildings. A positive cash flow means that the activities of the organization have therefore generated cash. Please note: some costs, such as depreciation and amortization, are not included. Still, some machines will wear out over time. A positive operating cash flow is therefore not sufficient. After all, an organization also needs investments in the long term to survive.
Typically, the cash flow from operations is higher than the net profit, because certain non-cash costs are not included.
The second is cash flow from investments or investment cash flow . This involves looking at the cash flows in new investments and from divestments. New investments are needed to expand production as well as to replace old machines. Divestments, on the other hand, can generate money.
The distinction between investments in growth and investments to maintain the facilities is important in the valuation of companies and equities, but usually difficult to distinguish.
This is partly because some investments in new facilities, or even research, do not always ensure growth. A good example of this are the gigantic investments that the car industry makes every year in research and in the renovation of the factories. These investments do result in better cars, but due to the fierce competition, this often yields little turnover or profit growth for the car manufacturers.
The third is cash flow from financing or financing cash flow . This consists of incoming and outgoing dividends plus new and redeemed debt. In the US we often also see the repurchase and issue of own shares here.
Difference cash flow & profit
Profit includes depreciation and amortization, while cash flow also looks at the differences in working capital. The pros and cons of profit vs cash flow very much depend on which cash flow is being viewed. The operational cash flow does not look at investments and therefore often shows an overly favorable picture. Free cash flow, on the other hand, includes all investments. This means that the free cash flow is often negative in fast-growing companies. After all, building new factories costs a lot of capital.
It also depends a lot on which organization is being analyzed. In some organizations, the depreciation and amortization give a good picture of the costs, but this is not always the case.
Real estate companies actually see fairly high depreciation on buildings, while the true value of real estate in many cases does not decrease, but increases. In that case, it may be better not to include these debits. However, this also has risks, which recently became very clear, especially in retail real estate. As the popularity of some shopping centers is declining, more investments need to be made to keep the shopping centers attractive. As a result, depreciation on shopping centers is correct today to compensate for these extra costs.
Many other companies have much higher investments than depreciation and are still seeing little growth. Especially companies that use a lot of capital goods and have to deal with many new developments are sensitive to this. Consider, for example, car manufacturers, oil companies and the semiconductor industry.
Calculate cash flow
The cash flow can be calculated in various ways and depends on which cash flow you calculate. The two main cash flows used in investing are operating cash flow and free cash flow.
The operational cash flow is actually the basis and to calculate the free cash flow the investments are deducted from this.
Operational cash flow
The operational cash flow consists of the cash flows / cash flows from the daily activities. You calculate this by adding up all incoming and outgoing cash flows that have nothing to do with financing or investments.
Another way of calculating the operational cash flow is based on the net profit. The net profit is known and therefore the starting point. What is not included in the net profit are changes in working capital . So these differences should be added to the profit when they are negative and subtracted when working capital has increased. After all, less cash will then remain.
Other important expenses that are included in the profit, but are not cash costs, are depreciation and amortization . Machines wear out and goodwill also declines in value every year in some cases. These costs are not directly linked to changes in the amount of cash. Therefore, these depreciation and amortization costs must be added back to the profit to arrive at the operating cash flow.
After these changes you have calculated the operational cash flow.
Free cash flow
An extra step is needed for the free cash flow. Machines wear out and therefore depreciation is also deducted from the profit. We have added these back to the operational cash flow. This means that in many cases the operational cash flow paints a too favorable picture of the situation. To correct this, all investments are deducted from the operational cash flow when calculating the free cash flow.
Depending on the amount of investments, the free cash flow therefore gives a better picture than the profit. This mainly depends on whether depreciation and maintenance investments are roughly the same.
If this is the case and a lot of investments are made in new growth, the free cash flow will usually be very low.
Cash flow formula
The easiest way to calculate cash flow is to subtract all outgoing cash flows from all incoming cash flows.
The operational cash flow = profit + working capital + depreciation & amortization
Free Cash Flow = Profit + Working Capital + Depreciation & Amortization – Investments
Cash flow forecasting
Forecasting is difficult and in general people have too much faith in the forecasts they make themselves or that others have made. Still, forecasts and predictions are necessary to make decisions.
The cash flow forecast predicts how a company’s cash flows will develop in the coming years.
These forecasts are used in the planning and valuation of a company. Growing cash flow forecasts simply result in a higher valuation than falling forecasts.
Cash flow is an important measure of operational success. Companies that consistently generate a lot of cash can make acquisitions, invest for growth and reward shareholders with dividends. The meaning of cash flow and its calculation are therefore important when you want to value a company as a businessman would. However, there are other ways to analyze stocks as well. Cash flow, along with the income statement and balance sheet, is at the heart of any fundamental analysis.
Some analysts place more value on the profit account and others on the balance sheet. For example, you can analyze the profit account by means of earnings per share , EBIT or EBITDA . The strength of the balance sheet can also be viewed with the help of the quick ratio , solvency, liquidity or profitability . Combining all this information provides the most complete picture of the intrinsic value .