Cash flow guide: find out what it is and why it’s important for investment

Cash flow is a key term when it comes to long-term investments. However, this term can be quite confusing: what exactly is it, what are the types of cash flow, and what do they mean?

In this article, we’ll explain what cash flow is and introduce you to some key ratios to help you understand the company’s financial health.

What is cash flow?

Cash flow is a crucial measure to assess a company’s financial health. The company’s ability to survive depends on whether it receives more cash than it spends.

Now, let’s break down the three primary types of cash flow a company deals with.

Three types of cash flow

  • Operating cash flow: This is the cash flow related to a company’s core business activities. It includes income from sales and expenses like salaries, purchasing inventory, and other business-related activities.
  • Cash flow from investing activities: This is cash received or spent on the company’s investments. It covers purchases of physical assets (such as equipment), investments in financial assets, or sale of assets/financial assets.
  • Cash flow from financing activities: This cash flow category involves money received from issuing shares or debt and subtracts cash paid out as dividends or used for debt repayment. A positive cash flow means the company is bringing in more money from financial activities than it’s spending. A negative flow could result from debt repayments, dividend payouts, or share buybacks.

From these cash flows, we can derive a key metric often followed by analysts: free cash flow.

  • Free cash flow (FCF): This is calculated as operating cash flow minus capital expenses. FCF represents the money available to the company for expansion, acquisitions, or maintaining financial stability during challenging periods.
  • Capital expenditure (CapEX): CapEX refers to investments in productive assets such as vehicles, machinery, and equipment. OpEx refers to operating expenses, such as rent, investor costs, marketing, and other costs related to the company’s normal operations.

Cash flow ratios

Now, let’s have a look at some ratios that incorporate cash flow in relation to other aspects of a company, such as sales, debts, dividends, and capital expenses.

  • Operating cash flow/net sales (cash flow to sales ratio): This ratio reveals the company’s ability to convert its sales revenue into actual cash received. In other words, it shows how efficiently the company collects cash from its sales.
  • Free cash flow/operating cash flow (FCF/OCF ratio): The higher this ratio, the stronger the company’s financial position. To calculate it, subtract capital expenses from operating cash flow and then divide this result by the operating cash flow. This ratio provides insights into the company’s financial strength for activities like expansion and acquisitions. Essentially, it measures how much of the operating cash flow remains available for these purposes after deducting the expenses related to asset maintenance or acquisition.

Numerous studies have confirmed that leading analysis firms consider free cash flow as a key metric for evaluating an investment’s quality.

Coverage ratios

Debt-service coverage ratio (DSCR)

This ratio is calculated by dividing the operating cash flow by short-term debt:

DSCR = Net Operating Income/Total Debt Service

This ratio shows the company’s ability to cover current debt at a given income level. The DSCR essentially indicates how healthy the company’s cash flow is and if it is likely to get a loan.

Dividend coverage ratio (DCR)

This ratio calculates how many times the company’s net income covers dividend payments to its shareholders. In other words, it shows the investor’s risk of not receiving their dividends.

The higher the ratio, the more likely the company is to be able to make dividend payments, but a very high DCR could also mean that the company is withholding too much money (that could be invested for future growth, for instance).

On the other hand, a very low DCR could indicate that the company is currently borrowing money to pay dividends (which is expensive for the company in the long term).

DCR = Net Income / Dividend Declared

Cash flow to capital expenditures (CF to CapEX)

This ratio shows the company’s ability to purchase long-term assets using its free cash flow. Long-term assets may include equipment, vehicles, machinery, and others.

Cash Flow to Capital Expenditures = Cash Flow from Operations / Capital Expenditures

What are CapEX and dividend coverage?

CapEX stands for “Capital Expenditures,” representing investments made in assets like buildings and machinery. It is a key ratio when it comes to fundamental analysis. Unlike other expenses, CapEX cannot be deducted from income for tax purposes. Instead, it becomes part of the company’s assets, accounting for yearly amortization and depreciation.

CapEX is a primary method for companies to invest their cash flow in essential assets. The expense incurred for repairing or acquiring these assets is subtracted from the cash flow, resulting in the calculation of free cash flow.

Adding the CapEX and dividend coverage together shows a company’s ability to cover both its investment in long-term assets and its dividend payments to shareholders.

Undoubtedly, the fundamental analysis of a company is more complex, and it should include more ratios than just capex, dividend coverage, or cash flow.

Read more about financial analysis

Cash flow: summary

In conclusion, understanding cash flow and its various ratios is crucial for assessing a company’s financial health and investment potential. From short-term debt coverage to dividend and capital expenditure coverage, these ratios provide valuable insights into a company’s ability to manage its finances, make strategic investments, and reward shareholders.

By examining these metrics, investors and analysts can make more informed decisions, ultimately contributing to sound investment strategies and sustainable business growth.


What is the difference between cash flow and profit?

Cash flow is the actual money coming in and going out of a company, while profit is the difference between revenue and expenses, often calculated on an accrual basis. A company can be profitable but still face cash flow challenges if it doesn’t manage its cash effectively.

How can a company improve its cash flow?

Companies can improve cash flow by reducing accounts receivable days (the time it takes customers to pay), extending accounts payable days (the time taken to pay suppliers), controlling expenses, and managing inventory efficiently. They can also consider obtaining short-term financing if needed.

Can a company have negative cash flow and still be healthy?

Yes, a company can have negative cash flow in the short term and still be healthy if it’s investing heavily in growth opportunities, such as expanding operations or launching new products. However, sustained negative cash flow without a clear plan for improvement can be a cause for concern and may indicate financial instability.

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