I was asked the other day to define Cash flow… by my 6 year old daughter. Seriously, she asked what I was doing and I told her I was writing about something called cash flow. I think the word of the day at her school must have been “define” because for the rest of the weekend that’s all I did – define everything imaginable.
I gave her a very short blurb about cash flow in relation to real estate investing, but that didn’t satisfy the inquiring mind of my “student”. Not at all! Instead, she insisted that I was wrong and that I should try again. Well then! I shook my head in disbelief and decided to entertain the challenge. I gave her as many answers as it took to try and get her approval. The way it’s written below is definitely cleaner than how it sounded, but essentially here’s how it went…
Me: Well honey how about this…
Cash flow is an economic measure that represents net income generated from operations as well as cash equivalents during a given period. This measure allows assessment (cash flow analysis) in regards to the financial health of an income property – how it generates the necessary revenue for maintaining the assets in its balance sheet and to make expansion investments.
My daughter: Hmmm… I don’t know dad. Try again.
Me: Okay then. How about this…
It’s defined as a positive cash surplus of economic activity. The surplus or balance relates to income and expenses. Financial flow on the balance sheet is adjusted for non-cash factors. It is considered an important indicator of ability to pay and the internal financing potential of an income property. This financial aspect is a measure of liquidity and says something about a investments well being.
My daughter: That sounds boring dad.
Me: Oh but it isn’t honey…
(I stand up and start with the exaggerated hand gestures) A positive cash flow enables an investor to be in a position to wipe out loans or to make new capital investments. The study of financial flows within a company can be used to determine liquidity issues. An income property can actually have cash flow problems, and still be profitable. To examine the practicality of projects, the financial flows are the cornerstone for computing the net present value as well as internal rate of return (that line caused her to give me the big ol’ stinky face look!) To evaluate the viability of a rental, accounting rules may not necessarily reflect the economic reality.
My daughter: I didn’t like that one at all. I’m leaving.
Me: Wait there honey. I know I can get this. I’ll give you a cookie if you stay.
(Yes I bribed her to stay. I wanted to win – I’m very competitive… I decided to change it up and throw in more visuals) Okay honey, usually cash flow is calculated using a matrix with columns and rows (lot’s more hand gestures.) Free cash flow shows how much money is left for dividend payouts and/or debt financing. For financial institutions, these funds are an indicator of the ability to repay mortgage or loan and are therefore often used as the basis for calculating the financing capacity of an investment property.
My daughter: I’m not done my cookie yet so you can keep going.
Me: Okay dear, I will…
Analysis of an income property enables the generation of financial resources and their use in a given period of time. In accounting, projected cash flows show all payments expected in a given period of time. Cash flow is a great tool to help management in decision making. The year end results are the quintessential standard of profitability (she tried repeating “quintessential” and to my surprise she did quite well.) Results for the year depend on several components including valuation of inventories, amortization and depreciation.
My daughter: Okay I’m done now.
Me: Wait! Wait! One more try.
(my daughter is grunting at me now) The advantage of cash flow relative to earnings is that it’s an objective concept, that is unequivocally undeniable! (okay, that was a bit much – but I’m going for the big finish here and I’m loosing horribly!) Financial flows can be divided into three main cycles: the investment cycle, operating cycle and the financial transactions which consists of capital transactions and…
My daughter: Where’s the tablet? I’m going to play Angry Birds.
Me: Okay honey. Thanks for listening… 🙂
And that my friends is a basic overview of cash flow analysis. You tell me, did I win the challenge?