It is good to have cash coming in but it is even better to be liquid. A company with a high cash flow does not necessarily have a high liquidity base. For an investor thinking of investing in a company, it is important to know how much cash flow that company is generating and how liquid it is.
Cash Flow Makes the Company Go Round
If a company is not bringing in any money, then it will not be able to survive for long. A basic definition of cash flow is the money going in and out of a company. On the plus side you have the cash that a company generates through the operation of its business, such as sales, services, financing or investing. In the other direction is the money that the company must spend to run the business.
Positive Cash Flow
When a company generates more cash from its operations than the cash needed to run its business, then the company will have a positive cash flow. For example, if it cost a company $500,000 (salary of sales team, office space, advertising) to generate $600,000 from the sales of widgets, the company would have a positive cash flow of $100,000. If there were no loans or other debts needing servicing, then the company would have $100,000 in extra cash that it could keep as liquidity.
Cash Is King
Liquidity is assets held in cash. Liquidity is a part of cash flow because a company needs liquid assets, namely cash, to pay debts, run its operations and sometimes to acquire other companies. Some large corporations have billions of dollars in liquidity so they can buy other companies if opportunities arise or so they can weather an economic downturn. A company usually builds its liquidity base through positive cash flow.
Determining a Company's Cash Flow and Liquidity
Each publicly traded company is required to publish a cash flow statement each quarter. By comparing cash flow statements quarter-to-quarter and year-to-year, an investor can gauge the overall health of a company. He can see if company needs more or less money to fund its operations and if it is building its liquidity position. Many investors look for improved cash flow and build up of liquidity, which can be used for buying other companies, expansion and new equipment. Having a cushion of liquidity is usually a positive sign.
- SEC: Beginners' Guide to Financial Statements
- Securities and Exchange Commission. "Beginners' Guide to Financial Statement." Accessed Apr. 20, 2020.
- Financial Accounting Standards Board. "Summary of Statement No. 95." Accessed Apr. 20, 2020.
- Microsoft. "Financial Review: Cash Flows Statement." Accessed Apr. 20, 2020.
Scott David has been writing since 1999. He has contributed to several educational online portals, a leading business newswire in Europe, "The Wall Street Journal" and "Institutional Investor," now working as a business analyst. David earned a Bachelor of Arts in Latin American studies at UC Berkeley.