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Background
Cash flow is the life blood of a company. Simplistically, it is the amount of cash generated or consumed by an activity over a certain period of time.
OUTLINE
Definitions
Importance and Background
Commonly Used Terms
Internet LinksThere are many misconceptions regarding cash flow. Profits are not equal to cash flow. An example (Taken from Clinical Laboratory Management. 1997. Williams and Wilkins.) commonly given is a company that loses control of its accounts receivable. It allows its customers increasing time to pay or it may produce more merchandise than it sells. The accountant may register a profit in the books but the sales may not be generating sufficient cash to replenish the cash outflows required for the production and investment. This is insolvency, when a company has insufficient cash to pay its obligations.
Another example can be a company which manages its accounts receivables and inventory but has a rapid sales growth. This growth requires an increasing investment in its sales. This investment can literally sap the company of its cash, leading once again to insolvency.
Cash flow is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA). Cash flow is most commonly used to value industries that involve tremendous up-front capital expenditures and companies that have large amortization burdens. For depreciation and amortization, these are called non-cash charges, as the company is not actually spending any money on them. Depreciation allows companies to get a break on capital expenditures as plant and equipment ages and becomes less useful. Amortization normally occurs when a company acquires another company at a premium to its shareholder's equity, usually accounted on the balance sheet as goodwill and is forced to amortize over a set period of time
In a private or public market acquisition, the price-to-cash flow multiple is normally in the 6.0 to 7.0 range. When this multiple reaches the 8.0 to 9.0 range, the acquisition is normally considered to be expensive. In a leveraged buyout (LBO), the buyer normally tries not to pay more than 5.0 times cash flow because so much of the acquisition is funded by debt. A LBO also looks to pay back all the cash used for the buyout within six years, have an EBITDA of 2.0 or more times the interest payments, and have total debt of only 4.5 to 5.0 times the EBITDA.
Henry JB. Clinical Diagnosis and Management by Laboratory Methods. Twentieth Edition. WB Saunders. 2001.
Clinical Laboratory Management. 1997. Williams and Wilkins.
Analysis for Financial Management Sixth Edition. 2001 McGraw-Hill.
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Commonly Used Terms
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Last Updated 1/31/2003
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