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Cash Flow is a measure of how much cash the company is gaining or losing. Some see it as a more honest, or pure, measure of profitability than earnings.
There are two types of cash flow measures that are commonly used: operating cash flow and free cash flow. Operating cash flow measures cash from operations; free cash flow measures cash from operations minus cash spent for new equipment. Free cash flow a more strict measure; basically, it attempts to calculate how much money is leftover for shareholders after all business-related cash expenditures are accounted for.
Mathematically, the calculations are as follows:
Operating Cash Flow = Revenue - Operating Expenses - Cost of Goods Sold + Depreciation - Taxes
Free Cash Flow = Revenue - Operating Expenses - Cost of Goods Sold + Depreciation - Taxes - Change in Working Capital - Capital Expenditures
As an example, imagine a lemonade stand with the following attributes for the past month:
It earned $40 in sales
The cost of cups, lemons, and sugar are the cost of goods sold; for the month, they equalled $8
Suppose they need to pay for lights and chairs. These are operating expenses, as they are not related to the cost of goods sold, but they are related to running the business. Suppose they spend $12 on such expenses.
In total, they have $20 worth of sales in which they have not yet recieved payment (they have extended credit to customers). They do not owe anyone any money. Last month, they owed $4 and had $10 worth of payments that were due from customers.
They are growing and are investing in a new lemonade stand across the street. To get the sign, they spent $10.
The FCF calculation for this business for its past month is as follows: 40 - 8 - 12 - (20 - 6) - 10 = -4
The (20-6) is the change in working capital, which is basically (in our simplified model) the change short-term receivables - short-term payables.Since they paid debt this month, they sent cash out, and since they had more sales on credit, those sales need to be subtracted from the revenue (since they have not received cash for them yet; when cash is sent for them, that will be recorded as a favorable change in working capital and cash flow measurements). This example illustrates how a business with growing sales and reasonably low operating costs may still have negative cash flow. Such instances may not be a problem if the business can collect payments for sales easily and has cash on hand, but for value investors, understanding the details can help greatly in formulating an opinion on the company.
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