Net cash flow in business represents an accurate representation of the financial position of a company. Many times companies report high earnings or net profit, but the cash flow situation represents an entirely different picture. Companies need to track their cash flow for accurate depiction of their financial health.
Net cash flow represents the total cash received(cash inflow) by a company from sales, investing and other income minus the cash paid(cash outflow) by the company for expenses, interest, liabilities and investments. Cash flow is a measure of the company’s run way and longevity in business.
Net Cash Flow for Valuation
For evaluating a company, net cash flow is an important metric. There are many high growth companies that are unable to sustain for long without external capital & funding. These companies despite their fast paced growth leak money and end up with losses. However, companies with high net cash flow can survive longer and they are usually built on solid fundamentals.
Sometimes, the P/E ratio, which is Price to earnings ratio of a company, does not represent the true financial health. Take an e.g. of a company that has a P/E ratio of 20, but represents negative cash flow per share. It could be due to investments in fixed assets or other capital expenses. In this case, the P/E ratio doesn’t necessarily indicate the right picture.
Price to free cash flow per share along with the P/E ratio is a good measure of its business value. It shows the actual cash coming in and going out of business. There are many companies that need high levels of capital expenditures and investments for their operations. Even though they may be reporting high levels of net income or profits, but they would always need more capital for sustenance and growth.
How to Calculate Net Cash flow
Net cash flow is the difference between total cash inflow and the total cash outlflow in a given time period.
Net Cash flow = total cash received – total Cash spent
Further, total net cash is broken down as:
Net Cash flow = Net cash received from operations(sales) + Net cash from investing activities + Net cash flows from financial activities.
Net cash received from operations: Net cash from operations represents revenues generated by the company. The net income represents the difference between revenues and expenses for a given time period. The expenses could include interest payments, salaries, etc.
Net cash received from investing activities: Net cash from investing activities represents the difference between sale of assets and investments made by the company. For e.g. company could sell its property for given leading to cash inflows and it could buy assets like warehouses leading to cash outflows.
Net cash received from financial activities: A business loan represents a financial activity, it will increase the cash flow for a company. Payment of business loans or its interest payments will reduce the cash flows for a business.
Net Cash Flow Explained
Consider a company XYZ is assessing its net cash flow for a financial year:
Here are the statements representing the cashflows
- Cash from operations: $600,000
- Cash flow from investing: ($125,000)
- Cash flow from financing: $100,000
Net cash flow = $600,000 -$125,000 +$100,000= $475,000
Price to Free Cash Flow
The price to free cash flow combined with earnings growth, P/E ratio and revenue growth represents a more accurate depiction of a business. When capex is high, it can lead to high net profits but poor free cash flow for a business.
Price to free cash flow can be low for companies with high depreciation and amortisation. In this case, even though the company may have less net income or profits, it will have a high price to free cash flow per share. It shows companies that have hidden value, even though they may not look profitable or valuable, yet they provide high value for every share.
Essentially, it makes more sense to evaluate P/E and P/FCF together for a business. One without the other could provide a misleading picture.
The free cash flow is crucial for analysing the financial health of a company. Consider the case when the net cash flow of a company can increase due to a loan. It doesn’t differentiate the revenue or loan. Hence, free cash flow can be used for distinguishing between operating cash flow from loans or debts etc.
Free cash flow= Operational cash flow(Sales/Revenues) – Capital Expenses – Dividends – Debts payments for period + Non cash expenses (Depreciation, amortisation etc)
- Cash from operations: $600,000
- Cash flow from investing: ($25,000)
- Debt payments: $24,000
- Depreciation for given period: $6,000
Free cash flow= $600,000 -$25000 -$24,000 + $6,000 = $557,000
The free cash flow per share represents the cash generated by the company for every share. Say, the earnings per share for XYZ company is $20 and free cash flow is $22, it indicates low capex. In general, the lower the free cash flow per share, the more valuable a company. However, negative free cash cash flow represents a company making losses.
Net Cash Flow & Investments
There are many companies that invest their capital for expansion, growth and future roadmap. These companies might not have high price to free cash flow ratios, but they could be investing their resources for long term opportunities.
A low net cash flow doesn’t always mean an unsustainable business, infact, companies like Amazon have routinely invested large amounts of capital in building valuable assets for their business. For e.g. Amazon invested billions for developing the AWS platform, now it generates over $18 billion in revenues for Amazon.
So, net cash flow may be low for companies that are capitalising and building long term assets. Understanding the core business is fundamental to growth opportunities for a company. Many high growth companies have negative cash flows owing to their investments that may bring cash flows in the future.
A positive net cash flow is a good indicator for company performance, but there are cases when cash is invested for long term growth, thus leading to reduced net cash flow. Net cash flow generated from debts or leverage may also falsely represent the financial health of a company. In this case, free cash flow can be used to analyse the cash position of the company.
AI and automation for accounting can help SMBs monitor their company performance real time. The difference between net income and free cash flow is critical to the growth of a company. An online accounting software can help a company analyse its financial health and proactively suggest measures for operational improvements by analysing the data patterns.
Kreyon Systems provides business accounting software & allied bookkeeping automation for SMBs. Our accounting software is used to automate bookkeeping , accounting, compliance management & financial reporting. If you have any queries or need assistance, please get in touch with us.