Cash flow is the movement of money into and out of a business over a given period. A company can show a profit on its income statement and still run out of money. Cash flow is what keeps the doors open.
Profit is an accounting figure. It records revenue when earned and expenses when incurred, regardless of timing. Cash flow is a reality check. It shows what actually hit the bank.
The gap between the two is common and meaningful. A business that invoices $200,000 in one quarter but collects only $100,000 while paying $150,000 in expenses is profitable on paper and cash-negative in practice.
Cash flow is divided into three categories on the statement of cash flows:
Operating cash flow covers the day-to-day business: revenue collected, expenses paid, payroll, and working capital changes. This is the most important category. Sustained negative operating cash flow means the core business model is not working.
Investing cash flow covers purchases or sales of long-term assets: equipment, property, acquisitions, and investments. Negative investing cash flow is not automatically bad. A company buying equipment to grow is making a calculated investment.
Financing cash flow covers money raised through debt or equity and repayments. New loans, investor capital, and debt payments all flow through here.
Starting from net income:
FORMULA
Operating Cash Flow = Net Income + Non-Cash Expenses (like depreciation) + Changes in Working Capital
Changes in working capital include increases or decreases in accounts receivable, accounts payable, and inventory. If receivables grow, you earned revenue but did not collect it, so cash flow is lower than profit. If payables grow, you incurred expenses but did not pay them yet, so cash flow is higher.
Free cash flow (FCF) goes one step further than operating cash flow by subtracting capital expenditures:
FORMULA
FCF = Operating Cash Flow - Capital Expenditures
FCF is what remains after the business has maintained and invested in its asset base. It is the figure most commonly used by investors to evaluate the true financial output of a business.
This is more common than it should be. The reasons typically include:
The cash flow statement has three sections corresponding to the three types above. A healthy business generally shows positive operating cash flow, moderate negative investing cash flow (from productive investments), and manageable financing activity.
The ending cash balance should match the cash line on the balance sheet. If it does not, there is a reconciling error somewhere.
