Cash flow is considered one of the most important share ratios for the fundamental analysis of companies and for many analysts plays an even more important role in share valuation than company profit or sales. Cash flow can be determined from the income statement and provides information about the liquidity and financial strength of a company. In this article, you will learn what cash flow is, what the different types of cash flow are and how they are calculated, and what methods there are to value and compare stocks based on cash flow.
Cash flow is one of the most important fundamental stock ratios and should be monitored just like corporate earnings.
What is the cash flow?
Cash flow is the inflow or outflow of funds in a company over a certain period of time (usually a year/fiscal year). Cash flow is determined by comparing all cash inflows and outflows during this period.
In contrast to profit, non-cash transactions such as depreciation and amortization or provisions are not taken into account when calculating cash flow. For this reason, the consideration of cash flow is often more suitable for making statements about the earning power and liquidity of a company.
Different types of cash flow
There are three different types of cash flow:
- Operating cash flow
- Cash flow from investing activities
- Cash flow from financing activities
Operating cash flow
Operating cash flow is the result of all cash events within the ordinary activities of the company.
Cash flow from investing activities
The cash flow from investing activities shows cash inflows and outflows resulting from investments made by the company. The aim is to determine whether the investments made result in positive or negative returns to the company.
Cash flow from financing activities
Cash flow from financing activities includes all cash flows that relate to changes in a company's equity, such as capital increases, dividend payments, etc.
Calculation of the cash flow
Two methods are available for calculating the cash flow of a company:
- Direct determination of cash flow
- Indirect determination of cash flow
Direct determination of cash flow
In the direct method of calculating cash flow, all cash inflows and outflows for a period are determined. The cash outflows are then subtracted from the cash inflows.
Cash flow = Cash inflows - Cash outflows
Indirect determination of cash flow
The indirect method of determining cash flow is used more frequently by companies in practice, as all the data required for this can be taken directly from the income statement.
Non-cash expenses (i.e. balance sheet offsetting items) such as depreciation, amortization and accruals are added to the company's profit. Non-cash income such as write-ups or the reversal of provisions is subtracted.
Cash flow = profit + depreciation and amortization - write-ups + provisions - reversal of provisions
The importance of cash flow in stock trading
With the publication of quarterly results, companies provide an insight into the company's balance sheet at regular intervals. In addition to profit and sales, the operating cash flow and free cash flow are published.
As an investor, it pays to keep an eye on the key fundamental share ratios of the companies in your own portfolio. Just like earnings, a company's cash flow can be positive or negative. A positive cash flow occurs when revenues are higher than expenses. The surplus can be used by the company for investments, to pay off debt or to pay a dividend. If the cash flow is negative, a deficit results.
Like other stock ratios, cash flow should be viewed in the long term in particular. A stable or growing cash flow is an indicator of high liquidity and financial strength.
Cash flow vs profit
In contrast to corporate earnings, cash flow often attracts more attention among analysts because it is more "honest" and cannot be manipulated by accounting tricks.
In order to be able to compare the cash flow of different companies, the following key figures, which can be calculated from the cash flow, are suitable:
- Cash flow per share (CPS)
- Price/cash flow ratio (KCV)
Cash flow per share
Cash flow per share is an indicator of the proportion of total cash flow attributable to an individual share. To calculate cash flow per share, the operating cash flow is divided by the number of all shares (outstanding shares).
Price/cash flow ratio (KCV)
The price/cash flow ratio (KCV for short) is related to the price/earnings ratio (P/E ratio) and the price/sales ratio (P/S ratio) and expresses how expensive a share is in relation to its cash flow. To calculate the KCV, the current share price is used.