Financial Concepts to Better Understand Cash Flow

Here are definitions of financial concepts to better understand cash flow. Cash flow is the lifeblood of companies. Understanding it will help you to analyze companies more accurately and avoid unpleasant surprises.

The concepts to better understand cash flow relate to money coming in to the company, the profit made after paying expenses, expenses that don’t affect cash, and the liquidity on hand.

Is a company’s revenue equal to its total sales?

Revenue is the income a company gains from its activities, calculated before any expenses are subtracted. A lemonade stand generating $30 million in sales with $10 million in expenses still has a revenue of $30 million.

Revenue includes all sales plus other increases in owners’ equity that aren’t obtained from selling goods or services; for example the sale of a brand to another company or interest income on investments.

So, if a company’s revenue comes exclusively from selling goods or services, the revenue and the sales are the same number.

Increasing revenue over time is a good sign of a company’s growth and solidity.

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How do net income and earnings per share differ?

Net income is what’s left of a company’s revenue after subtracting all costs. It’s also called net profit, earnings, or the bottom line.

Earnings per share (EPS) is the amount of that net income that “belongs” to each share of common stock. It’s a valuable tool investors often use to determine the value of a stock.

Net income that’s not paid out in dividends is added to retained earnings. Increasing (decreasing) net income is a good (or bad) sign for a company’s profitability. Companies with consistent and increasing net income over time are looked at very favorably by stockholders and analysts.

How is EPS calculated?

EPS = (Net Income – Preferred Dividends) / Weighted Average Number of Common Shares Outstanding

Companies that issued preferred stock subtract the dividends owed to preferred shareholders from net income to figure out the part of earnings available for common shareholders.

Usually, they identify the Average number of shares outstanding (denominator) by averaging the number of shares at the beginning of the earnings period and at the end of the period. For example:

• Company earned $1 million in a year
• Start of year, it had 900,000 shares
• End of year, it had 1.1 million shares
• EPS is $1 million/ [(0.9 million shares + 1.1 million shares)/2] = $1/share.

Companies report annualized EPS for the most recent fiscal year. Occasionally, you’ll see “TTM” (Trailing Twelve Months). This means that the number is the sum of the earnings of the four previous quarters, which isn’t always the same as the previous fiscal year.

The calculation of net income, and by extension EPS, subtracts non-cash charges and impairments, both important concepts to better understand cash flow.

OK then. Define non-cash charges and impairments

Non-cash charges are expenses that don’t involve actual outflow of cash, for example, depreciation and amortization, two methods used to spread the cost of assets over their entire useful life.

• Depreciation applies to physical assets that have a predictable lifespan and wear out or become obsolete over time. Examples include machinery, vehicles, and equipment.
• Amortization applies to intangible assets, i.e., non-physical assets with limited useful lives. Examples include patents, copyrights, trademarks.

Impairments occur when the value of an asset on a company’s balance sheet is reduced to reflect a decline in its worth. Impairments can apply to tangible assets such as property, and intangible assets like patents.

When calculating net income, non-cash charges and impairments are subtracted, even though they don’t involve cash outflow. They are subtracted to account for the economic wear and tear of assets and potential losses in asset value.

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What is cash flow from operations?

You’ll also hear Cash from Operations and Operating Cash Flow, it’s basically how much cash the company generates from its operations. It’s calculated from what is going into the company minus what goes out to run the business. Think of it as “how much did the company generate in its day-to-day operations?”

Cash from Operations indicates if the company generates sufficient positive cash flow to maintain and grow its operations; if not, it might need external financing for capital expansion.

Cash Flow from operations = Net Income + Non-Cash Items + Change in Working Capital

It differs from net income because to calculate Cash Flow from Operations, we add back non-cash items and something called change in working capital.

See also Importance of Cash from Operations.

Change in working capital, what does that mean?

It’s the difference between the working capital amounts at the end of two different quarters or moments in time:

Change in Working Capital = Working Capital at End of Quarter 2 – Working Capital at End of Quarter 1

It can be a positive or a negative value. It would probably help to know what working capital is all about, right?

Working capital

Working capital is the amount of liquid assets available to a company to build its business. It’s the difference between current assets (cash, accounts receivable, inventory, etc.) and current liabilities (accounts payable, short-term debt, customer deposits, etc.).

Working Capital = Current Assets – Current Liabilities

Companies often need short term liquidity during their regular operations. Large quantities of working capital indicate the potential to expand quickly and make it easy for companies to buy equipment quickly. Without sufficient working capital (or negative amount), a company might have to borrow from other sources, potentially slowing down growth.

While having a surplus of working capital is good to fuel growth, a company with excessive amounts of working capital might need to find better uses for its current assets.

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Change in working in capital

We add the change in working capital to net income and non-cash charges to come up with cash flow from operations.

• A negative change can happen when a company spends to invest in assets or if it becomes less efficient, for example, struggling to collect accounts receivable.
• A positive change can occur when a company depletes assets, perhaps by selling non-operating assets, expensing more non-cash charges, etc. This results in more cash in its coffers, either from the sale proceeds or from fewer taxes to pay on lower income. Another explanation is that the company is more efficient at lowering current liabilities.