Cash Flow

Definition of

Cash flow is a financial metric used to assess a company’s financial strength. To determine cash flow, the difference between a company’s inflows and outflows of cash and cash equivalents over a specific period—such as a fiscal year—is calculated. The result can be positive or negative.

The Importance of Positive and Negative Cash Flow

If a company's revenue exceeds its expenses during the specified period, it has a positive cash flow. The resulting surplus can be used, for example, for future investments.

A negative cash flow, on the other hand, occurs when a company’s expenses exceed its revenue. Since no cash was generated, a deficit—also known as a shortfall—exists. There can be many reasons for this. For example, high investments or financing costs can result in significant expenses, which—unless revenue also increases—can lead to liquidity shortages.

The Different Types of Cash Flow

A company's cash flow consists of three different categories:

Operating Cash Flow: Operating cash flow is the amount resulting from a company’s day-to-day business activities. It includes, among other things, revenue from customer prepayments as well as expenses for wages or the production of goods. As an indicator of internal financing capacity, it assesses a company’s ability to cover ongoing operating costs and make investments using its own financial resources.

Cash Flow from Investing Activities: Cash flow from investing activities results from the inflows and outflows of cash and cash equivalents arising from a company’s investing activities. These include, for example, the sale or purchase of long-term assets or equity interests. This metric thus provides an overview of the return generated by investments.

Cash flow from financing activities: Cash flow from financing activities encompasses a company's financial transactions. These include activities such as raising or repaying loans and paying dividends.

The Importance of Cash Flow for Companies

Cash flow provides companies with an overview of their financial health and performance, thereby serving as a basis for internal financial planning.

Furthermore, cash flow is a highly meaningful indicator for external parties. External lenders, such as banks or investors, use this metric to gain insights into a company’s financial stability and profitability. A positive cash flow boosts the confidence of potential investors, as it signals the company’s ability to make payments from its own funds or to pay dividends.

Negative cash flow, on the other hand, can raise concerns about the company’s financial stability and thus lead to less favorable financing terms, such as higher interest rates on loans. It can also reduce the overall willingness of potential investors to invest in the company, as the profitability of the investment is called into question.

However, a negative cash flow is not always a bad sign. This is especially true if it is only temporary—for example, because the company has paid off large debts or made significant investments. In the short term, such phases can be bridged without necessarily posing a serious threat to the company’s liquidity. Nevertheless, when cash flow is negative, the reasons should always be identified to ensure that there is indeed no risk of long-term liquidity problems.

How is cash flow calculated?

There are two ways to calculate cash flow: the indirect method and the direct method.

To calculate direct cash flow , the difference between all cash-affecting transactions is determined. Therefore, this method requires internal company data. The formula is:

Direct Cash Flow = Cash Revenues – Cash Expenses

Cash-based items include all payments that result in a direct cash outflow from or inflow into the company. Revenue includes, for example, customer payments and interest income. Expenses include, among other things, costs for wages and materials.

As an example, consider a company that reported total revenue of 100,000 euros and collections on outstanding receivables totaling 30,000 euros in the last fiscal year. This results in cash-generating revenue of 130,000 euros. Labor costs amounted to 30,000 euros, material costs to an additional 20,000 euros, and rent to 10,000 euros, for a total of 60,000 euros in cash-based expenses. The company’s direct cash flow can be calculated as follows:

130,000 euros – 60,000 euros = 70,000 euros in direct cash flow

Unlike the direct method, the indirect method uses net income after taxes as the basis for calculation. All non-cash items are offset against this amount. Cash inflows and outflows are not considered individually, which is why all necessary data can be derived from the balance sheet. The formula for this is as follows:

Indirect Cash Flow = Net Income + Non-Cash Expenses – Non-Cash Income

Non-cash transactions do not result in any direct cash flow. They include, for example, reversals or increases in provisions, as well as depreciation and amortization.

For example, a company has a net income after taxes of 200,000 euros. During the fiscal year, provisions totaling 20,000 euros and depreciation totaling 10,000 euros were recorded. Thus, cash-outflow expenses total 30,000 euros. In addition, provisions totaling 15,000 euros were reversed, which corresponds to non-cash income. The indirect cash flow is therefore calculated as follows:

200,000 euros + 30,000 euros – 15,000 euros = 215,000 euros in indirect cash flow

When comparing the two methods, the direct method provides a more transparent view of a company's financial situation by showing actual cash flows. This is particularly helpful for a company's liquidity planning.

The indirect method, on the other hand, focuses more on the balance sheet and provides less specific information about the company's actual cash flow. Unlike the direct method, however, it is easier to implement, since all the necessary data is already available in the annual financial statements.

What is a cash flow statement?

The cash flow statement is a financial report that shows the movements of a company’s cash and cash equivalents over a specific period. It is broken down into the three types mentioned above. Pursuant to Section 297(1) of the German Commercial Code (HGB), the cash flow statement is a mandatory component of consolidated financial statements, as well as of annual financial statements for capital market-oriented corporations pursuant to Section 264(1) HGB. If companies prepare monthly financial statements, the cash flow statement is usually included in those as well.

Cash Flow Management

Cash flow management involves managing, monitoring, and controlling a company’s current cash flow. This ensures that sufficient cash is available to cover ongoing operating expenses and meet financial obligations. To this end, once cash flow has been calculated, a cash flow analysis must first be conducted. This involves evaluating a company’s revenues and expenses over a specific period using the calculated key figures. Based on the insights gained, a company can assess its financial situation, identify potential bottlenecks in a timely manner, and counteract them through actions taken as part of cash flow management.

Cash Flow Planning

Cash flow planning involves forecasting future cash flows based on expected revenues and expenses. To do this, a cash flow forecast can be created by first compiling an overview of cash flow figures from past months. Based on this data, estimates for upcoming incoming items are determined in a forecast, and the resulting expected month-end balances are calculated.

To ensure the most accurate planning possible, expected variations—such as seasonal fluctuations that can affect product demand—must also be taken into account.

By preparing cash flow forecasts, future bottlenecks can be identified before they arise and avoided through appropriate strategies. In addition, accurate planning provides a solid foundation for making informed decisions regarding planned investments and financing, as well as the timing of these decisions.

How can cash flow be improved?

To optimize cash flow, the identified bottlenecks must be addressed in a targeted manner, and effective countermeasures must be taken. The following areas offer opportunities to increase cash flow:

Budgeting: Improved budgeting processes enable companies to manage their financial resources more effectively. By setting clear budget goals and regularly reviewing budget performance, unnecessary expenses can be identified and adjusted, which helps increase cash flow.

Cost Management: By identifying and optimizing cost centers, companies can reduce costs and thereby improve cash flow. Companies should critically review their expenses and look for ways to reduce them. There are many areas where cost optimization can be achieved. Examples include negotiating more favorable supplier contracts or implementing more efficient work processes, which can reduce the time required to complete certain tasks.

Revenue Source Planning: Relying on a variety of revenue sources rather than a single product helps reduce dependence on individual factors, such as seasonal fluctuations, and mitigates the risk of a sudden decline in revenue. By offering a broader product range or, for example, through geographic diversification, companies minimize the risk of sharp negative fluctuations in their earnings and thereby promote the stability of their cash flow.

The Difference Between Cash Flow and Profit

Profit and cash flow are both financial metrics that companies use to assess their profitability and, consequently, their financial performance. However, they differ in the scope of the items they include. Unlike profit, direct cash flow does not include non-cash items, such as provisions and depreciation. Profit represents the difference between a company’s total revenue and total expenses, while cash flow reflects the actual movements of a company’s cash and cash equivalents over a specific period.

In addition, these two figures are reported in different financial statements: Profit is reported in the income statement, while cash flow is reported in the statement of cash flows.

The Difference Between Cash Flow and Liquidity

Both cash flow and liquidity are financial metrics that relate to the inflow and outflow of cash and cash equivalents within a company. Liquidity refers to the immediate availability of cash and cash equivalents at a specific point in time, while cash flow describes a company’s financial performance over a longer period.

What is free cash flow?

Free cash flow is the amount of cash a company has at the end of an accounting period after all necessary expenses and investments have been deducted. The company can use this money at its discretion, for example, to pay dividends, repurchase shares, or make further investments. Free cash flow provides insight into the company’s ability to repay debt using its own funds, as well as its capacity to pay dividends. As such, free cash flow is a key metric for both lenders and investors.

The formula for calculating free cash flow is:

Free Cash Flow = Operating Cash Flow – Cash Flow from Investing Activities

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