Cash flow is important for business owners, CFOs, and CEOs to understand because it helps you analyze how much cash is generated (cash inflows) and how much money has been used (cash outflows) in a particular financial year from the operating activities, financing activities, and investing activities.
In this article, we will let you know the difference between cash flow and free cash flow, the two important terms related to the analysis of cash for all the new CFOs in the industry.
According to C2FO’s Working Capital Survey in 2022 , almost 53% of the companies across the globe are dependent on cash flow from operations, 46% are dependent on owner’s capital and 45% are dependent on a credit line or term loan from banks which are the top three sources of funding in the business.
Therefore, the analysis of cash inflows and cash outflows are very important for today and the future of the business.
Top three sources of finance used by businesses across the globe.
The analysis of both the terms, cash flow, and free cash flow together will help the business owners to see how much a business is generating cash from its operations, where the cash is utilized for the purchase of assets or other investments, and how much cash it uses to pay its debt or take out loans. It also helps investors in a way that shows how much money is left with the business to pay dividends to its equity holders.
Meaning of Cash Flow
Cash flow is the net cash flow a business will generate in a period of a year, month, or quarter. This net cash flow is calculated in one of the three important financial statements that a business prepares at the end of the financial year, which is the cash flow statement. The other two are the profit & loss statement and the balance sheet.
The net cash flow is the total cash inflows minus the total cash outflows in a financial year. The positive net cash flow indicates that the business is going well and does not have to borrow money from outsiders.
The negative net cash flow indicates that the cash outflows are much greater than the cash inflows and they have to borrow money from outsiders to cover the expenses. It is a normal situation generally faced by start-ups and small businesses because they are expanding and setting up the business, but in later periods it needs to generate positive net cash flows.
Formula to calculate the Net Cash Flow
1.Operating Activities
It includes the cash inflows from the business’s primary operating activities, which can be selling goods or providing services, liquidation of accounts receivable, etc. The cash outflow activities are the operating expenses that are recorded in this section, such as decreases in inventories, salaries paid to employees, taxes paid to the government, money paid to the creditors, rent paid, etc.
If the net cash flow from operating activities is negative or low, this indicates that the business is not generating enough cash to finance its operations and pay its creditors. If the net profit is much higher than this amount, then the business is not able to convert its accounts receivable into liquid cash and there might be chances of an increase in bad debts in the future.
2.Investing Activities
To expand or start business operations, businesses have to first invest in capital expenditure activities that lead to cash outflows, such as the purchase of assets, plant, and machinery, PPE, and investments in securities.
After some time, businesses also sell some of their assets and investments, which brings cash into the business and therefore results in cash outflows from investing activities.
3.Financing Activities
The cash inflows in financing activities are from raising capital from equity holders by selling shares to the public, from the money brought in by the business owners, or from raising capital by taking a loan from a bank and issuing debentures and bonds.
The cash outflow would be the repayment of loans and redemption of debentures, paying dividends to equity holders, etc.
Meaning of Free Cash Flow
After discussing the cash flow statement and its recording activities, it is important to understand why free cash flow analysis is important to understand for every business and why it is essential to know free cash flow vs cash flow.
It is one of the important ways to understand whether a business is earning enough cash or not. This will measure the amount left over after a business pays all its capital expenditures, such as the purchase of land, machinery, plants, and equipment in a financial year, and then subtracts this amount from the total operating cash flow (taken from the cash flow statement).
It helps to analyze whether a business has enough cash for its equity holders and creditors or not. FCF amount can be used to pay the principal amount, interest on the loan, buy-back of shares from the market or acquire and purchase another company.
It also helps in finding out the DCF (Discounted cash flow) valuation of the business in order to find out the intrinsic value of a stock as compared to the market value.
The DCF valuation technique is one of the most important techniques used by CFOs these days to determine a business’s present value based on its free cash flow over a forecasted period of say 5 or 10 years, thereby determining the business’s long-term value.
Formula to calculate the Free Cash Flow (FCF)
If a company has a higher and positive amount of free cash flow, then either it offers higher liquidity or the amount is not properly utilized for capital expenditure projects.
If the company is having negative free cash flow, then the business is not able to generate liquidity for owners and creditors or they have invested in heavy Capex assets or improve fixed assets that will give returns later on.
Difference between Cash Flow and Free Cash Flow
Let’s see the comparison between the two and the analysis of cash flow vs free cash flow.
| Sr. No. | Points of Difference | Cash Flow (CF) | Free Cash Flow (FCF) |
|---|---|---|---|
| 1. | Meaning | CF means the net cash flow in a financial year. | FCF is the net cash flow after the business’s capital expenditures. |
| 2. | Activities included | In CF includes the three activities of a business which are operating activities, financing activities, and investing activities. | FCF includes the money left for the business owners or equity holders and creditors after all its capital expenditures. |
| 3. | Profit & Loss Statement required | A profit and loss statement is required to prepare the cash flow statement because the net profit and loss need to be included in that. | It totally depends on the formula used to calculate FCF. |
| 4. | Process | Cash flow statement preparation is a complicated and time-consuming process | FCF is simple and easy to calculate using formulas. |
| 5. | Usefulness | It is useful to know about the net cash flow in a financial year. | FCF helps in finding out the DCF valuation or current net worth of the business |
| 6. | Mandatory requirement | A CF statement needs to be prepared by every registered company and is a mandatory requirement | The FCF calculation decision totally depends on the management’s discretion and is not a mandatory requirement. |
| 7. | Professional help | Companies typically hire professionals with extensive knowledge of accounting standards, such as CAs or CFOs. | FCF can be calculated by any scholar or academic who has general finance knowledge. |
| 8. | Interested stakeholders | The interested stakeholders are generally the management of the business | The interested stakeholders are investors or prospective buyers. |
| 9. | Importance | CF is important to know the solvency or liquidity of the business. | FCF is important for understanding the business’s liquidity and efficiency. |
| 10. | Formulas used | Cash flow statements should be prepared in a format provided by the authority and following the accounting standards. Net CF = Total Cash Inflows – Total Cash Outflows (from all three activities) | Different formulas can be used. FCF = (Net Income) + (Non-Cash Expenses such as D&A) – (Change in Working Capital) – (Capital Expenditure) Or FCF = EBIT X (1 – Tax Rate) + Depreciation + (Net Working Capital) – (Capex) |
Improve cash flow efficiency with IBN
The ten points of cash flow vs free cash flow clearly present it to the industry’s new CFOs and how important it is to the business to analyze the cash flow and free cash flow.
The new business era demands that CFOs follow a holistic approach while analyzing the business. They should not just focus on net cash flow but also do further analysis of various measures related to that.
Therefore, the need to analyze free cash flow is becoming so important. Cash flow follows the past approach and free cash flow helps them analyze the present as well as the future of the business.
The CFO’s role in today’s world is not limited to the company’s internal affairs. It also includes determining whether the company can generate enough cash to meet the needs of all of its stakeholders and if any find a way to avoid cash flow mistakes.
Alternatively, the company can think about outsourcing its bookkeeping activity to the firm, as it has many benefits to hire a specialized service, and then the CFO can focus more on the strategic work and work on the analysis provided by the outsourced firm.
With the help of IBN outsourcing and bookkeeping services , the company can focus more on its core operating activities to generate cash and improve its overall efficiency
Frequently Asked Questions (FAQs)
- Which cash flow is free cash flow?
- The cash flow left after deducting capital expenditures from net cash flow from operations is referred to as “free cash flow.” It is the money left with the company to pay shareholders or creditors or incur other expenses.
- What are the 3 types of cash flows?
- The three types of cash flows that a business generates or spends on these activities are operating, investing, and financing activities.
- What are the 3 types of cash flows?
- The two types or other names of FCF are free cash flow to the firm (FCFF or unleveled cash left for both the shareholders and creditors) and free cash flow to the equity (FCFE or levered cash left only for the equity holders after paying all its debts).
