Cash inflow and cash outflow- the two figures are extremely important in determining the financial health of an entity. But how? Well, before we begin analyzing the two figures and assessing their differences, let’s have a look at a few basics. We will begin with discussing cashflow as a whole term and move on to discussing the differences.
Contents
What is cash flow?
Cash flow refers to any real or virtual movement of money in and out of a business. In other words, cash flow refer to the amount of cash or cash equivalents moving either in or out of the company accounts. The statement in which a company records these transactions and analyses them is the cash flow statement.
- As mentioned before the two direction the funds move in a company are- inwards and outwards.
- As is obvious we thus have two kinds of cash flow- inflow and outflow. Cash received by the company represent the inflows.
- And the money spent by the company represent the outflows.
- A company’s ability to generate a positive cash flow and maximize the long-term cash flow determines its ability to create value for its shareholders.
- There many different methods that an entity can use to analyze a cash flow statement. This includes, but is not limited to- debt service coverage ratio, unlevered cash flow, and free cash flow (FCF) etc.
- The cash flow that we generally use to determine positive cashflow ability is free cash flow or FCF.
- FCF is the cash that the company generates from its day to day normal operations. After subtracting the money it spends on capital expenditure (CapEx).
This sums up most of why cash flows are important for a business. Now let’s move on to differentiating between the two types of cash flows. Anyone interested in the field of accounting must understand these two terms properly. And must be able to differentiate between the two, so as to prepare efficient statements.
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Cash Inflow vs. Cash Outflow
In the simplest of terms, cash inflow and outflow are two sides of a balancing scale, more formally the cash flow statement. There are some intricate difference between the two terms. The subheads below explain in proper detail the said differences.
Definition:
Cash inflow refers to all the income or money brought into a business/ company through various activities. These generally include (but are not limited to)-
- Proceeds from the sales of company’s goods and/or services.
- Return on the business’s investments
- Interest being built over corresponding time period
- Other financial activities made by the company
These are the various ways cash inflows occur. However, a majority of a business’s cash inflow come from sale of products and/ or services to customers. For a business to stay healthy they must try to maximize their cash inflows by generating profits from all possible avenues.
Cash outflow refers to all the money/ expenses paid out by the business. This includes any and all debts and liabilities of the business as well as its operating costs. In short, cash outflow refers to all the funds/ money that is leaving the business.
Most usually cash outflow includes-
- Operating expenses of the business
- Debts i.e. long-term debts as well re-investments
- Other liabilities
- Annual interest rates paid out
- Expenses on wholesale funding
For business to stay healthy they try to minimize their operating costs and long-term debts. This helps in keeping a positive cash flow balance.
Sources of Cash flow:
There are three major sources of cash flow for any business. These are namely- operations, investment and financing. Even though all these business functions make for cash inflow and outflow, there are still differences between the two. Take a look at the following to understand them.
Cash flow from operating activities
Cash flow from operations refers to the money a company receives owing to its core business. That is, from the manufacturing and/ or selling of its final products, or provision of its services. By selling, a company acquires cash inflow. But, in providing these goods and/ or services, a company also makes some expenses. This shows the difference between cash inflow and outflow. Which are:
Cash inflow includes-
- Cash receipts from sales of goods and services
- Earnings made from investments
- Increase in amounts receivable and inventory.
- Decrease in accounts payable.
In contrast, cash outflow from operation includes-
- Payments made to suppliers and employees
- Payments made in form of interest and taxes
- Decrease in accounts receivable and inventory.
- Increase in accounts payable
Cash flow from investing activities:
As business grows they engage in buying and selling of investments and fixed assets, as an additional source of expanding wealth. These investing activities also lead to a series of cash inflows and outflows, which differ as follows:
Cash inflow includes-
- Sale of real estate, equipment, buildings, vehicles, and machinery
- Sale of short-term investment
- Dispositions of investment in other companies
- Interest earned on investment
In contrast, cash outflow includes-
- Purchase of real estate, buildings, equipment, vehicles and machinery
- Purchase of short-term investments
- Acquisitions of investments in other companies
- Interest paid out
Cash flow from financing activities:
This refers to the cash flow company generates via financing activities like dividend payments and stock issued etc.
Cash inflow includes-
- Increase in capital from stockholders
- Increase in debt, bonds, and note payables
In comparison, cash outflow includes-
- Payments made for stock buybacks
- Then, payments made to stockholders for dividends
- Payments on loan principals
This shows that even though cash inflow and outflow are two sides of single document, i.e. cash flow statement. But there still major differences between the two. Now that we know how these two types of cashflows differ from each other, let’s see how cashflow matters for a business.
Different Ways To Analyze Cash Flow Statements
Analysts and investors use cash flow statements along with other financial statements to draw inferences. Through these analysis they calculate various ratios and/ or metrics to get a clear picture of business’s financial situation. This then further helps them make important decisions regarding the business.
There are 3 most common ways of analyzing the cash flow statement. These are as follows:
1. Free Cash Flow (FCF):
As mentioned before FCF is one of the most common ways to measure the financial performance of the entity via Cash Flow. It is a measure many use to understand the true profitability of the business in question. The formula to calculate the free cash flow is as follows:
Free Cash Flow= Operating Cash Flow – Capital Expenditure
It is preferred over the net income measure. FFC shows how much money the company has left to return to the shareholders and/ or expand business. That is, after the company pays off dividends, buys back stocks or pays off debts.
2, Debt Service Coverage Ratio (DSCR):
One important thing that we must consider is the fact that even profitable businesses can fail. That is if they fail to generate enough cash to stay liquid. The most common causes of this is when profits are tied up in overstocked inventory, and outstanding accounts receivables etc. Or when the company spends much more than needed on capital expenditures.
It is due to such scenarios that investors and creditors may look at the DSCR. To make sure that company generates enough cash from operations to meet its current liabilities. The formula for the debt service coverage ratio (DSCR) is as follows:
DSCR= Net Operating Income/ Short-Term Debt Obligations (or Debt Service)
3. Unlevered Free Cash Flow (UFCF):
Another way to use Cash Flow and analyze a company’s financial health is via UFCF. This is the gross FCF that a firm generates. It means the company’s cash flow excluding the interest payments. This shows the amount of cash that is available with the firm before considering any financial obligations.
Both FCF and UFCF are commonly used cash flow measures of financial soundness. However, a difference between the two measures shows whether the entity is overextending its debt or operating with a healthy amount of debt.
After learning about cash flows and its analysis, let’s have a look at some terms people often assume to be similar to cash flows.
Cash flow vs. Profit
After learning about cash flow, a lot of people wonder how it’s different from profit. Many believe that these must be the same, though it’s not really true.
To see this, note that cash flow represents all the money that goes in and out of the business. Whereas profit, on the other hand, represents the financial success of the company. That is, it represents how much money the company actually makes overall. On a more technical note, profit is whatever money the company has left of its revenue after paying its expenses.
So even though cash flow and profit both say something about the company’s financial situation, they are not the same.
Cash Flow vs. Income
Many often wonder how cash flow statement is different from the company’s income statement. But one must note that income just like profit is calculated via accrual accounting principles. That is, we match revenue to the time period of delivery of product/ service, and smooth-out corresponding expenditures. These revenue recognition and matching principles essentially differentiate net income/ earnings from cash flow.
Conclusion:
As must be evident by now that there is considerable difference between Cash inflow and outflow. Cash flow statements show the sources and usage of a company’s cash over a certain time period. Many companies, investors, and other professionals spent quality time to access and analyze Cash Flow. They spend time evaluating CF to identify and help rectify existing or potential problems. But make this possible one must have proper knowledge of cash flows and accounting principles.
