Imagine your business as a vast, intricate river system. Just as a river has its currents, tributaries, and flows, a business has its own types of cash flow.
Instead of water, though, the business river is made up of cash. It ebbs and flows, sometimes rushing in torrents during periods of heavy rain (or high sales seasons), and at other times, trickling in a steady stream during drier spells (or slower business periods).
By mapping out the topography of the river system, you can get a better understanding of how and when the water will flow; by understanding your types of cash flow, you can predict your business’ needs and opportunities well in advance.
I’ll be covering the types of cash flow, explaining how to think of each one, and connecting it back to your SaaS business.
Types of Cash Flow
There are three primary categories of cash flows, which each hold a unique meaning in the language of business. They are the:
Operating Cash Flow
This is the cash generated from the day-to-day operations of a business. It includes cash received from customers, cash paid to suppliers and employees, interest received or interest payments, and taxes paid. The operating cash flow indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations. For many traditional businesses, long-term viability is mainly indicated by positive profits and free cash flow; however, in SaaS, that can often take a backseat to other metrics, like user growth and percentage of market share.
Operating Cash Flows are a key indicator of a company's financial health. It shows whether a company can generate a sufficient amount of cash from operating activities to maintain and grow its operations. If a company consistently generates more cash than it uses in operating activities, it will have excess cash to return money to shareholders, invest in its business, withstand economic downturns, and meet other financial liabilities.
Operating Cash Flow (OCF) is typically calculated using the indirect method, which starts with net income and then makes adjustments for non-cash expenses and changes in working capital. Here's a step-by-step guide on how to calculate it:
- Start with Net Income: The calculation of Operating Cash Flows begins with net income from the bottom of the income statement.
- Add Back Non-Cash Expenses: The next step is to add back non-cash expenses that were deducted when calculating net income. The most common non-cash expense is depreciation and amortization. Other non-cash items that might need to be added back include deferred taxes and any losses on the sale of assets.
- Adjust for Changes in Working Capital: Working capital is the difference between a company's current assets (like cash, accounts receivable, and inventory) and current liabilities (like accounts payable). Changes in these accounts need to be adjusted for when calculating OCF.
- If current assets (excluding cash) increase during a period, cash flow from operations will decrease, and vice versa. This is because an increase in current assets represents a use of cash.
- If current liabilities increase during a period, cash flow from operations will increase, and vice versa. This is because an increase in current liabilities represents a source of cash.
The formula for calculating Operating Cash Flows using the indirect method is:
Operating Cash Flow = Net Income + Non-Cash Expenses + Changes in Working Capital
Remember, the goal of calculating Operating Cash Flows is to determine how much cash a company generates from its core operations, so it's important to accurately account for all cash inflows and outflows related to those operations.
Investing Cash Flow
This represents the cash impact of the investment activities of a business. It includes cash spent on long-term assets such as property, plant, and equipment (also known as capital expenditures), as well as investments in securities or the sale of long-term assets. Negative investing cash flow is not necessarily a bad sign, as it could indicate that a company is investing in its future growth.
Investing Cash Flows provide an overview of a company's investments in the long-term health and growth of the company. It can give investors an idea of how much the company is investing in itself and how it's financing those investments.
Investing Cash Flow is calculated by identifying the cash inflows and outflows from a company's investment activities. Here's a step-by-step guide on how to calculate it:
- Identify Cash Inflows from Investment Activities: This is the cash received from the sale of long-term assets (like property, plant, and equipment), the sale of investment securities (stocks, bonds, etc.), and the collection of principal on loans made to others. These amounts are usually listed in the investing activities section of the cash flow statement.
- Identify Cash Outflows for Investment Activities: These are the cash paid for the purchase of long-term assets, the purchase of investment securities, and loans made to others. Like cash inflows, these amounts are usually listed in the investing activities section of the cash flow statement.
- Subtract Cash Outflows from Cash Inflows: The formula for calculating Investing Cash Flows is:
Investing Cash Flow = Cash Inflows from Investment Activities - Cash Outflows for Investment Activities
Remember, a positive investing cash flow indicates that the company has sold more assets than it has purchased, while a negative investing cash flow indicates that the company has spent more cash on buying assets than it has received from selling assets. Neither is inherently good or bad, as it can depend on the company's stage of growth and investment strategy.
Financing Cash Flow
This shows the cash flow between a company and its owners and creditors. It includes proceeds from issuing stock, repurchases of company shares, dividend payments, and repayment of short-term and long-term debt capital. Negative financing cash flow can be a sign of a company that is reducing its debt, paying dividends, or buying back stock.
Financing Cash Flows provides an overview of a company's financial strategy and capital structure. It can give investors an idea of a company's financial strength and how well it manages its capital structure.
Financing Cash Flow is calculated by identifying the cash inflows and outflows from a company's financing activities. Just like before, here’s a step-by-step guide for calculating it:
- Identify Cash Inflows from Financing Activities: These are the cash received from issuing stock or debt. This can include proceeds from issuing bonds, bank loans (financial leverage, anyone?), issuing new shares, or other forms of debt (such as non-bank loans or revenue-based financing). These amounts are usually listed in the financing activities section of the cash flow statement.
- Identify Cash Outflows for Financing Activities: This is the cash paid out as dividends, the repurchase of company shares (also known as treasury stock), and the repayment of debt (both principal and interest). Like cash inflows, these amounts are usually listed in the financing activities section of the cash flow statement.
- Subtract Cash Outflows from Cash Inflows: The formula for calculating Financing Cash Flow is:
Financing Cash Flow = Cash Inflows from Financing Activities - Cash Outflows for Financing Activities
Remember, a positive financing cash flow indicates that more money has been raised by the company than it has paid out to investors, while a negative financing cash flow indicates that the company has returned more money to investors (through dividends and share buybacks) than it has raised.
Depending on the near-term goals of the company, a positive or negative financing cash flow could represent good or bad actions. If the business says they want to invest in growth, a negative financing cash flow would be questionable, whereas investors in a highly leveraged company that’s looking to reduce its risk exposure would want to see a negative financing cash flow.
These three types of cash flows are reported in a company's cash flow statement, which is one of the main financial statements (along with the balance sheet and income statement) used by all companies in their financial reporting.
Purpose of the Statement of Cash Flows
The purpose of the statement of cash flows is quite simple. It exists to provide:
Operating Performance Evaluation
It provides information about a company's free cash flows generated from core business operations/business activities within a specified accounting period, which is a key indicator of a company's ability to generate sufficient cash to maintain and grow its operations within the given period. It's a more direct measure of performance than net income, as it's harder to manipulate with accounting techniques.
The statement of cash flows shows how a company is investing its cash balance in long-term assets and other investments. This can give investors and other stakeholders an idea of the company's strategy for growth and how effectively it's investing its resources.
It provides information about a company's financing activities, including borrowing, an issuance or repurchase of stock, and paying dividends. This can give an idea of a company's capital structure and its strategy for financing its operations and growth.
The statement of cash flows provides a clear picture of a company's ability to pay its bills in the short term. By showing the inflows and outflows of cash, it helps assess the company's liquidity and financial flexibility.
Reconciliation of Other Financial Statements
The statement of cash flows reconciles the income statement (which is based on the accrual method of accounting) with the changes in cash on the balance sheet from one period to the next.
In essence, the statement of cash flows provides a detailed picture of how a company is generating and using cash. It's a valuable tool for investors, creditors, and others to understand the company's financial health beyond just income and balance sheet figures.
Value of Monitoring Cash Flows in a SaaS Company
In a Software-as-a-Service (SaaS) company, cash flows play a crucial role in various aspects of the business. While they certainly don’t represent everything, they can give some clear insight into:
Sustainability and Viability
Cash flows, particularly operating cash flows, provide insights into the company's ability to generate cash from its core operations. This is critical for the sustainability and viability of the business. A SaaS company with positive and growing operating cash flow is generally seen as healthy and well-managed.
Investment in Growth
SaaS companies often need to invest heavily in customer acquisition, product development, and scaling their infrastructure, especially in the early stages. These investments can lead to negative cash flows in the short term, but they're necessary for long-term growth. The investing cash flow section can provide insights into these investments.
SaaS companies often rely on external financing (venture capital, debt financing, private equity, or public markets) to fund their growth. The financing cash flow section provides insights into these activities. It shows how much cash the company is raising from or returning to investors.
In the SaaS business model, companies often spend a significant amount upfront to acquire customers (CAC), expecting to recoup this investment over the lifetime of the customer relationship (LTV). Cash flows can help in understanding these dynamics.
For instance, if a company's cash flow is consistently negative despite growing revenues, it might indicate that the company is spending too much on customer acquisition and not getting enough return on that investment.
Cash Burn Rate
This is particularly important for startups and growth-stage SaaS companies. The cash burn rate is the rate at which a company is spending its cash reserves. It's crucial for understanding how long the company can continue to operate with its current cash balance.
Valuation and Profitability Metrics
Cash flows are also used in various valuation and profitability metrics, such as Free Cash Flow (FCF), which is often used in valuation models, and cash flow analysis, which is a measure of profitability.
The Perfect Cash Flow Structure
In terms of what might be considered "perfect" cash flows for a SaaS company, it would typically be a scenario where the company can generate positive and growing cash flow from its operations, invest in its growth, manage its financing effectively, and demonstrate a healthy balance between customer acquisition costs and lifetime value.
If you find that perfect business, let me know - I’d love to invest.
In reality, though, that isn’t the reality for most businesses. All businesses are different, and given the wide nature of SaaS businesses, there is no one size fits all answer for what the types of cash flow should look like.
The most critical thing for investors to look at is this: Does the business have enough cash from financing and operating income to cover their cost of goods sold and operating expenses, along with their required cash payments to lenders and investors? If not, can they raise the cash to do so?
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