New investors, listen up. When running a successful small business or investing in real estate, you need to understand cash flow to analyze business performance. After all, you want your investment to be profitable. Understanding how much you bring in and where all the money goes is part of managing and assessing a business’s financial health.
So dive into learning about cash flow. Understanding how this fundamental accounting concept is the backbone of running your real estate investment business – or any business– and will help inform the investment strategies you use in the future.
Defining cash flow
Cash flow refers to the amount of money moving in and out of your business.
Inflow is all your revenues–any income from customers or tenants, investment interest, royalties, licensing agreements, products sold on credit, etc.
Outflow is the cash spent on day-to-day expenses, such as employee salaries, facility maintenance, property management fees, interest payments, and lease or loan repayments.
Inflows and outflows can vary between months and quarters because business activities also shift. An equipment purchase could increase outflows; a fully booked month in a short-term vacation rental would increase inflows.
Why cash flow is important
Cash flow management is one of the critical components of creating a profitable business. Cash flow is fundamental to the success of companies and real estate investments. Even small business owners need to track the cash coming in and going out to ensure they can meet their financial obligations each period.
For investors to accurately evaluate a business’s financial health, they need to understand how liquid and flexible it is. What are their current assets? Do they have enough cash on hand for accounts payable, or will they need a business loan?
Accurately detailing the cash amounts, timing, and variability of the cash flows assesses a business’ general fiscal standing.
A business is said to have positive cash flow when cash inflows exceed cash outflows. This signals a healthy business with enough flexibility to weather more challenging economic environments like recession or rise to unexpected financial challenges. Business activities show that the company can cover all its expenses and turn a profit. Growing companies need positive cash flow to keep growing. So, if you’re a real estate investor, you need positive cash flow to acquire new properties.
Negative cash flow means cash outflows are greater than cash inflows, indicating that a business or investment may lose money. The company is at risk of going under if it cannot find a way to increase revenue or cut expenses. However, be careful of writing off a business simply because the company’s cash flow shows negative. As we’ll explain later, negative cash flow does not always mean a business is at risk.
Analyzing cash flow with a cash flow statement
A cash flow statement is a financial document used to track the movement of a business’s cash over time, so you can assess whether or not cash flow is positive or negative. All publicly held companies are required to publish a cash flow statement as part of their mandatory financial reporting. However, even small business owners benefit from creating a statement of cash flows, especially if they bring on partners, seek new working capital, or need financing.
For new investors, you can use public documents to learn how to read cash flow statements to assess a business’s financial health.
A cash flow statement divides into three sections that document the three aspects of running a business:
- Operating Activities
- Investing Activities
- Financing Activities
In the next section, we’ll break down the specifics of each of these areas.
The financial statements reconcile the ending cash balance sheet, which details the assets and liabilities, with the income statement, which shows how profitable the business was over a period of time. It will also show if all the revenues listed on the income statement have been collected.
Given the complexity of businesses and real estate investing, this statement is often prepared using accounting software or with the help of a certified accountant. However, small business owners can do it using programs like Excel or PDF templates.
One drawback is that the cash flow statement may not show all the actual expenses. There can be a delay between when the expense occurred and when the transaction happened. For example, a business takes out financing to cover property renovations, but the loan payments don’t begin until next month.
Cash Flow Types
Obviously, you’re in business or investing to make a net profit. So you’ll want to know the types of cash flow that need to be recorded on the statement.
The three primary cash flow sources are operations, investing, and financing.
Cash flow from operations (CFO) focuses on money flows directly from producing and selling goods in the day-to-day business operations. For example, if you’re a home goods business, any furniture or home decor sales would show up as cash flow from operations.
To figure out the operating cash flow, you take the profit from all your sales and subtract the operating expenses paid in cash. This figure is reported on the operating cash flow statement and demonstrates if the business can make enough revenue to cover its expenses, potentially expand its operations, or if it may need financing to grow.
Cash flow from investing (CFI), or investing cash flow, is related to money coming in and out from various investments, such as purchasing property, speculative assets, or securities. It can also include monies from selling assets or loan repayments to your business.
Investing activities often cause a negative cash flow, like if a company is investing in research and development or has acquired a new property but hasn’t begun leasing to tenants yet. It’s a sign that a business is investing in its growth, which is usually a good sign!
Finally, cash flow from financing activities (CFF) is any cash amounts related to borrowing or lending. Common financing activities for a public company include issuing common stock, issuing debt securities, and repurchasing outstanding shares. These activities could fund the company by raising cash, like with a funding round or bond issue, or taking on a loan. It might help the business increase its capital by taking on debt to expand its operations or acquisitions like a real estate investor purchasing another home for leasing.
On the cash flow statement, the CFF balance sheet will show the items like payments to long-term debt, proceeds from debt, or dividend payments.
Investors need to assess the cash flow from all three activities when analyzing the financial health of a business or investment. Any owned assets or dividends on the balance sheet may be listed as cash equivalents.
Cash flow myths
Although they may seem similar, cash flow and profit are not the same. Don’t get these terms mixed up. Cash flow is all about money coming in and out of a business for a specific period of time! Cash is always moving around; the cash flow statement simply measures how and when.
Profit is key to gauging a company’s financial success. Once all of its bills are taken care of, this is what remains after subtracting expenses from revenues, like the cost of goods, taxes, salaries, and debt payments. Another term for profit is net income. It can measure a business’s stability and overall performance in any given period. Your profit can be a positive or negative number.
When assessing a business’ health, it’s in the investor’s best interest to understand both metrics and what makes them different. For example, if you’re a new business, you could have positive cash flows but fail to make a profit. That’s often the case when you first start buying properties for your real estate investment business or if you’re an entrepreneur launching a startup.
But, by looking at the cash flow and the net income, you can better judge a business’ financial standing.
Another myth to bust: negative cash flow isn’t always a bad sign. Investors should look at the entire cash flow picture before passing judgment.
For example, a business may have negative cash flow on paper but still, have a profitable operation. This can happen if there is a large initial purchase of inventory in the period being looked at or a loan has been taken out to assist with growth. Investing in assets can also decrease the cash flow, but capital expenditures are an essential part of growing and maintaining a business.
Think of it this way: replacing a roof is a major expenditure, but you need to update the structure to protect and maintain your investment. Still, paying for the facilities update may reduce your income for a time.
Investment in structure and equipment is a sign that a business is positioning itself for future growth. That’s why a negative cash flow may not be a warning sign.
Ways to analyze cash flows
Once you have a business’s cash flow statement, you can combine it with other financial information to make more informed investing decisions.
Take the Debt Service Coverage Ratio (DSCR) as an example. It helps determine if a business can cover its yearly debt payments from its net operating income. Suppose the business has spent too much in capital expenditures or has too many accounts receivable. In that case, it can be at risk of going under.
The free cash flow (FCF) analysis provides a clearer picture of a business’s profitability. This is the amount of cash left after paying off its expenses, like rent and payroll, and all its debt payments plus any shareholder dividends. This FCF is the money the company can do whatever it wants with–invest more, buy another asset, expand research & development, etc. The analysis includes a company’s net income, depreciation or amortization, working capital, and capital expenditures.
Using the operating cash flow method or EBIT (earnings before interest and tax), you can determine how successful a company is before factoring in taxes or loan payments. For this calculation, you add the operating income, depreciation, and change in working capital and then subtract the owed taxes. Knowing this amount helps the business prepare for unplanned expenses, earnings, or investment changes. It can also project how much cash a business will need to finance future operations.
Cash flow and real estate
Cash flow is key if you’re looking to invest in real estate. To assess if a property will be profitable, you must subtract all associated costs from the rents received and any other income. If you want to invest in a property that hasn’t started leasing yet, look at the expected rents, subtract all associated costs, and compare that to the loan payments. This will help you determine whether or not an investment is worthwhile.
Using cash flow to plan ahead
By understanding what affects your cash flow in a given period, you can plan and adjust accordingly. Cash flow projections help businesses and investors anticipate busy or slow seasons and ensure you have enough cash to weather those parts of the year.
A few things to consider are changes in the market, depreciation and amortization of assets, and any new investments you may make. As we’ve learned from the pandemic, running “what if” scenarios can help your business prepare for unexpected revenue changes.
These projections will help you anticipate any cash flow problems so you can keep investing confidently.
Understanding cash flow
Cash flow can be a tricky but essential concept to understand. With the right analysis, you can make sure your investments are solid, your cash flow is positive, and you have enough net income to meet your goals. When analyzing companies and investments, consider all three cash flow activities to understand their financial stability fully. And when it comes to real estate investments, cash flow can help you determine potential profitability or when it’s right to buy your next property.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. The views reflected in the commentary are subject to change at any time without notice. View Arrived’s disclaimers.
