Cash Flow Logic - Trace the movement of cash

Let's start with net profit.

You get that by taking revenue, and you take away all of your cost of goods sold to get gross profit.

From gross profit you take away operating expenses to get operating profit.

From operating profit you take away taxes, and you get net profit.

Once you get net profit, you add back depreciation.

Depreciation is a term that implies "expense you take away from revenue because you invested in a machine, building, or some other asset that can't be expensed in one year."

After you consider depreciation, you have to consider how your working capital moves.

Working capital is another term for stuff you use in the regular functioning of your business.

There are three major categories of working capital: receivables, inventory, and payables.

When you sell something on credit, you book a receivable.

A receivable is revenue counted now, but money collected later.

If your receivables go up, free cash goes down.

If you receivables go down, free cash goes up (because you collected on credit sales).

When your inventory moves, your cash also moves.

If you sell more inventory than you make, your cash goes up (goods turned into receivables, which get turned into cash once collected).

If you sell less inventory than you make, your cash goes down (goods pile up at the warehouse, unsold - your cash went into inventory).

When you buy something on credit, you book a payable.

If your payables go up, your cash goes up (you are buying more on credit).

If your payables go down, your cash goes down (you are paying more than what you buy on credit).

All of these things, net income plus depreciation, plus working capital changes, ends up adding to OPERATING CASHFLOW.

From operating cashflow, we move into investing cashflow.

Investing cashflow is a fancy term for stuff that you buy or build, that lasts longer than a year, which you use to generate more revenues.

Examples of this include investments in buildings, land, factories, etc.

These investments are called capital expenditures.

When you have operating cashflow, and you take away capital expenditures, you end up with FREE CASHFLOW.

This isn't the end of the story.

Free cashflow is cash that can be distributed to the claimants in the business. (Debt holders, equity investors, promoters etc.)

If free cashflow is positive, that's good.

This is the type of established company which are on the radars of private equity firms and leveraged buy out shops.

If free cashflow is negative, that isn't necessarily bad. The company may be a growth company that needs to raise more money to expand.

This is where FINANCING CASHFLOW plays a role.

Financing cashflow is cash that either flows in because the company is raising money, or flows out because the company is paying off its lenders, or owners.

Everything held equal:

If the company borrows, financing cashflow goes up.

If the company pays down more than it borrows, financing cashflow goes down.

If the company pays dividends, financing cashflow goes down.

If the company does a stock buy back, financing cashflow goes down.

If the company sells more stock, financing cashflow goes up.

Financing cashflow is the bridge that addresses negative free cashflow.

If one takes all three together: operating cashflow + investing cashflow + financing cashflow, one gets total cashflow.?

Learn practical investment banking. I am starting the next batch of my Live Investment Banking program at Wizenius from July 14th. Drop in your details and get a call from me (Link in the comment section)