Cash Flow Drivers

What Are Cash Flow Drivers?

Cash Flows are depicted in a firm's cash flow statement, which is one of the financial statements crucial in preparing the annual report for any business. 

It represents the cash and cash equivalents movement in the business, where cash inflow means income and cash outflow means expenditure dealt for in cash. A Cash Flow statement is necessary for the shareholder's evaluation, as it indicates the company's financial health.

Positive cash flow means the company has liquid assets to perform the operating activities uniformly, whereas a negative cash flow means the company is short on funds required to run the business operations.

This essentially creates losses and affects the business profitability at large. However, the cash flow indicates several other important evaluation metrics for the shareholder, management, employees, and other business stakeholders.

Understanding Cash Flows

Cash flow consists of cash movements across three different types of business activities: 

1. Operating Activities 

Includes all the activities related to the business's day-to-day operations. Broadly, it includes activities related to sales and production. 

It shows the amount of cash and cash equivalents spent on the operating expenses and the amount of cash and cash equivalents generated through the sales of products/services.

2. Investing Activities 

Includes all the activities related to investing. It broadly comprises investing in assets or the sale of a long-term investment.

Negative cash flow from investing activity is not always a bad indication; the company is investing more and selling fewer assets.

3. Financing Activities 

Includes all the activities which are related to the financing of business. It broadly consists of the transactions associated with the issue of equity and debt, repayment of the same, and the issue of dividends and the like. In addition, it indicates the capital structure of the business.

Understanding Cash Flow Drivers

Cash Flow Drivers (CFDs) are the elements or variables that drive the trajectory of the business's cash flows. 

These elements are critical as they are important not only for the financial analyst to value the company for investment but also for the internal financing of the company by the management.

Cash Flow Drivers are important to be considered while evaluating a company's financial performance.

Failure to include any of the driving elements during the valuation process can result in variable or pivoted outcomes, leading to incorrect decision-making by the investor or management.

It is important to identify cash flow drivers due to several key factors below:

• Cash Flow Drivers are important for internal and external stakeholders such as management, investors, banks, etc. CFDs aid in better decision-making for all the stakeholders.
• CFDs help identify the company's liquidity position, which means how much cash the business has to run the day-to-day operations and whether the firm needs any short-term external financing.
• They help identify whether the cash needs to be reserved for the future and how much is needed by comparing the history of the business and forecasting the trajectory of future cash flow. 
• They are also helpful specifically for the management of the business to evaluate the need and available mechanisms for any capital restructuring exercise.

Thus, these elements are important indicators of the market performance of the business and essential to evaluate the performance to strategize further the business operations and other crucial areas of business.

Types of Cash Flow Drivers

Companies need to track and analyze several cash flow drivers to determine their liquidity and solvency. For example, money movement in and out of business throughout a certain accounting period is displayed in the cash flow statement for that period.

Depending on whether your business spends more than it earns or earns more than it spends, you will find either a negative or positive cash flow when checking your financial statements.

The many types of cash flows can be divided into three primary categories: 

1. Cash flow from operating operations

2. Cash flow from investing activities

3. Cash flow from financing activities. 

The cash flow statement of any business displays three of these categories. 

As you will find out below, bringing in money may be bad, depending on the type of cash flow. Additionally, spending money is sometimes a good thing.

Businesses correlate line items in the three cash flow categories to do a cash flow analysis to see where money is flowing in and going out. They can deduce information about the state of the industry from this analysis.

Below, we describe each type of cash flow driver in detail and its applicability, provide formulas and discuss a few common items that belong to every kind of cash flow.

Revenue Growth

First, understand that increasing revenue is usually misconstrued as increasing sales. However, sales of a product or service take a certain cost, which in accounting we refer to as the cost of sales, which includes inventory, employee, labor, etc. 

Revenue essentially means a company's income by selling its products and services; it can be increased by increasing sales volume and prices, if and when possible.

It indicates the company's performance in the market, the magnitude of revenue earned, the impact it holds, and the popularity of the company in the market compared to its peers.

A rise in sales means an increase in the time required to complete the new jobs for service-oriented businesses. 

The customer may not pay you immediately, so you should keep that in mind. In addition, it would help if you had enough cash in the bank to cover your labor and operating expenses. Increasing sales can significantly impact your cash flow if you're already running low on resources.

Profit Margins

The ratio of a company's profit to its revenue is known as the profit margin. The profit margin ratio evaluates the company's overall financial management by comparing the profit achieved against its corresponding sales. It is often stated as a percentage.

There are different types of profits an entity recognizes, all of which have various interpretations. The following are the type of profits:

1. Gross Margin 

Gross Margin (or Gross Profit Margin) is the first line profit margin indicator. This indicator shows the net revenues reduced by direct expenses incurred in generating those revenues, i.e., cost of goods sold (COGS). 

This indicator represents the difference between Revenue and Cost of Goods Sold divided by the revenue. It is calculated in terms of a percentage value, which indicates how much gross profit the firm has developed for every 100 units of revenue generated. 

The higher the margin, the better it is for the company.

2. EBITDA Margin 

Being the second line profit margin, EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is the revenue after deducting COGS and SG&A (Selling, General, and Administrative expenses). 

This profit margin represents the fraction of EBITDA (the numerator) and revenue (the denominator). 

It is expressed in terms of percentage, which essentially refers to that for every 100 units of revenue generated, what is the EBITDA achieved by the firm. The higher the EBITDA margin, the better it is for the bottom-line outlook of the company.

3. Net Margin 

Net margin (or Net Profit Margin) is the last profit line; net profit means the firm's actual profit. It is derived from subtracting all the direct and indirect expenses incurred by the firm during its operations. 

This profit margin is represented as the fraction of Net profit (being the numerator) and revenue (being the denominator). It is expressed in percentage, which means that for every 100 units of income generated, how much is the firm's actual profit? 

Cash Conversion Cycle

It is also known as Cash Cycle, which refers to the days required to convert the cash invested in operations from buying the inventories to sales. 

Simply, it indicates how much time the company's cash can be recovered in operations. 

It is represented by the sum of Days Sales Outstanding and Inventory turnover subtracted by Days Payable Outstanding.

To calculate your cash conversion cycle, you must determine the period you want to figure it out. Most businesses will have sufficient cash flow data for 12-15 weeks to calculate accurately.

Following that, you'll need the following information from your income and balance sheets:

• Revenue for the fiscal period

• Cost of goods sold for the period

• Inventory value at the start and end of each period

• Accounts receivable at the beginning and end of each period

• Accounts payable at the start and end of each period

Net Working Capital

Basically, it refers to the difference between non-cash current assets and non-debt current liabilities. It shows the company's liquidity position. However, it should be noted how important it is to identify the company's cash flow situation.

• An increase in the current assets leads to a decrease in the cash inflow. For example, the inventory of finished goods until they are not sold engages cash, which blocks the firm's cash flow. 

• A decrease in the current assets leads to an increase in the cash inflow. For example, when sold, inventory of finished goods creates cash, which increases the firm's cash flow. 

• An increase in the current liability leads to a decrease in the cash outflow. For example, Accounts payable increase the current liability, but it gives the firm some time to hold cash in hand and pay later, which does not currently decrease the cash flow.

• A decrease in the current liability leads to an increase in the cash flow. For example, paying off accounts payable decreases the current liability and increases the firm's cash outflow.

Capital Expenditure

It is also referred to as CapEx. It is the amount of money the firm spends on the maintenance or acquisition of a fixed asset. 

Capital expenditure is the purchase of a large asset, such as a vehicle, a building, or a leasehold improvement, that is not recorded as an expense in your P&L at the time of purchase.

Instead, it is listed as an asset on your balance sheet. The cost of the asset you purchased is then devalued over the asset's estimated useful life.

But how is CapEx a notable cash flow driver? 

Any firm's increased CapEx in a logical proportion indicates that it is effectively maintaining its current level of operations or expanding the capacity/level of its operations. 

Usually, the CapEx is high in capital-intensive industries. Therefore, it can be estimated as the sum of the initial costs of Fixed Assets and Current Depreciation.

Free Cash Flows

It refers to the amount of cash left over after making all the necessary adjustments depending on the type of Free cash flow in question.

There are two types of Free Cash Flows:

1. Free Cash Flow to Equity

It refers to the amount of cash left that can be distributed to the company's equity holders through the Buyback and Dividend payment after making adjustments regarding the operating, financing, and investing activities.

It can be mathematically represented as:  

FCFE = Net Income + Depreciation and Amortization + Net Borrowings +/- Changes in NWC - CapEx

2. Free Cash Flow to Firm

It refers to the cash left to be distributed among all the capital contributors (Debt and Equity).

It is also called Unlevered Free Cash Flow. It is the amount obtained after making all the adjustments about the operations and investing but not related to external financing such as interest payments to creditors.

It can be mathematically represented as:

FCFF = Net Operating Profit After Taxes + Depreciation and Amortization +/- Changes in NWC - CapEx

Researched & authored by Ayoub Mresa | LinkedIn

Reviewed & Edited by Krupa Jatania I LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Absolute Valuation
• Book Value Per Share (BVPS)
• Comparable Company Analysis
• Discounted Cash Flow DCF Formula
• Tangible Net Worth (TNW)