Cash flow represents the net inflow of cash and cash equivalents during a given period. Cash flow is important for assessing a company’s liquidity position and is an integral part of fundamental analysis.
The saying “You can hide earnings, but you can’t hide cash” underscores the importance of the cash flow statement as a central element of company valuation.
Three types of cash flows are generally distinguished:
- Cash flow from operating activities
How much cash flow is generated during day-to-day operations? - Cash flow from investing activities
This is usually negative. This means that cash outflows for investments exceed cash inflows from the sale of assets. - Cash flow from financing activities
This refers to cash inflows from financing activities. When positive, this cash flow includes additional funds from owners or third parties.
Cash flow statement format
+/− Cash flow from operating activities
+/− Cash flow from investing activities
+/− Cash flow from financing activities
= Change in cash flow
+ Beginning cash balance
= Ending cash balance
Calculation methods
- Direct method
All cash outflows necessary for operations during a period are deducted from cash inflows. Furthermore, the change in accounts receivable at the end of each period must be subtracted from net sales, since accounts receivable generate revenue but do not result in cash outflows. The direct method of calculating cash flow is difficult for external investors to implement - Indirect method
In the indirect method of calculating cash flow, non-cash expenses (depreciation and increases in provisions) are added to profit, and non-cash revenues are subtracted. The indirect method is also known as the practical method
A simplified breakdown (indirect method) of a cash flow statement looks as follows:
Net income according to the income statement
+ Depreciation/amortization / − Revaluations
+ Increase / − Decrease in provisions
+/− Decrease / Increase in accounts receivable, inventory, etc.
+/− Increase / Decrease in accounts payable, etc.
Cash flow from operating activities (operating cash flow)
+ Cash inflows from disposal of fixed assets
− Cash outflows for capital expenditures
Cash flow from investing activities
+ Cash inflows from contributions to equity
− Cash outflows to owners
+ Cash inflows from issuance of financial liabilities
− Cash outflows from repayment of financial liabilities
Cash flow from financing activities
Discounted cash flow method (DCF method)
The discounted cash flow (DCF) method determines a company's value by discounting future cash flows. The underlying principle is that the company's intrinsic value is derived from its future, discounted cash inflows. Cash flow represents the excess of a company's cash inflows over its cash outflows.
Key parameters of the DCF method:
- Discount rate used to discount periodic cash flows
- Estimates of future periodic cash flows
We distinguish between the following approaches:
Equity approach (direct or net approach)
In the equity approach, only the cash flows available to equity holders are relevant for valuation. The company value is determined as the market value of the equity. The cash flows accruing to the owners are discounted using the owner's risk-adjusted return requirements.
Entity approach (indirect or gross approach)
In the entity approach, the cash flow available to satisfy all capital providers, both equity and debt holders, is determined. This is subsequently discounted using the Weighted Average Cost of Capital (WACC).
Author
Günther Kornfellner, CFA, CAIA
Derivate Trader, Bybit EU