What is cash generation, and how is it calculated?
A firm’s long-term success is contingent on its cash generation proficiency. When a firm creates and maintains adequate cash balances, it can follow through with its investment plans, scale operations, meet operating expenses, service debts, and pay dividends to shareholders.
Cash generation: Meaning
Cash generation is the money accumulated by a business after providing for all cash outflows, including operating costs, capex plans, and refinancing. In other words, it is the net cash flow of a business from its operations, investments, and financing activities.
It is represented by a positive cash flow, which means the company has received more cash than it can spend, or cash inflows > cash outflows.
Cash generation: Formula
The formula for cash generation is stated as follows:
Cash generation = Cash inflows – Cash outflows
Cash generation calculation
In order to calculate cash generation, you will need the firm’s cash flow statement (CFS), which provides a detailed overview of the firm’s cash inflows andoutflowsfrom operating, investing, and financing activities.
Cash generation’s calculation involves a comparison between the firm’s total cash inflows and outflows. If the firm earns net cash from its core operations after accounting for the cash payments made towards investing and financing activities, it has generated cash, also called net cash positive.
Cash generated from operating activities (CFO)
The CFO refers to the money made from the company's core operations after paying off operating expenses. It takes cash inflows from sales and other revenue streams and subtracts cash outflows from the cost of goods sold, salaries, and overheads.
Cash generated from investing activities (CFI)
CFI is concerned with the amount of cash generated from investment assets. It is ascertained by reducing the cash spent on purchasing new plant and equipment, securities, or speculative assets from the sale proceeds of the firm’s assets. CFI can be negative when a company spends heavily on research and development.
Cash generated from financing activities (CFF)
CFF entails the cash earned from funding the firm. It includes the issue of new equity and debt and deducts share buybacks, dividend payouts, and debt redemptions to arrive at the final cash generation figure.
Cash generation example
Assume a manufacturing company, FHK Ltd., with the following cash flow statement for the year ending 31st December 2022:
In this example, FHK is experiencing positive cash flow from its core operations (CFO), but negative cash flows from both investing and financing activities. Netting out the three, the company has generated positive cash flow for the fiscal year.
Cash generation vs profit
Cash generation is the difference between cash inflows and cash flows. It is solely concerned with cash transactions. Thus, transactions involving credit sales, bad debts, and depreciation are ignored while computing cash generation.
In contrast, profit is the rise in the firm’s assets over a certain accounting period. This increase can either be in the form of higher cash balances or an expansion of other assets. As profit is determined based on the accounting principles of matching and accruals, it also considers non-cash transactions.
Thus, cash generation is about the in and out movement of cash in the business, while profit is the money left after providing for all expenses.
Cash generation ratio
A cash generation ratio, also known as the operating cash flow ratio, determines whether a firm generates sufficient cash from its operations alone to meet its short-term liabilities. It is measured in terms of the number of times current liabilities can be paid off with the cash generated during the accounting period.
Cash generation ratio = Operating cash flow / Current liabilities
The purpose behind calculating a cash generation ratio is to ascertain the company's ability to generate cash purely from its operations, disregarding other cash inflows. A ratio greater than 1 indicates that the business is following healthy cash management practices and retains the ability to further reinvest in the business, service debt, or pay dividends.
Businesses operating in a steady sales environment with limited peer competition tend to have higher cash-generating efficiency.
Cash generation cycle
A cash generation cycle tracks the time it takes for a company to convert its inventory and other asset investments into cash. It serves as a precise indicator of how efficiently an enterprise manages its cash flows.
What are the features of a healthy cash-generating business?
Businesses that follow healthy cash-generation practices exhibit the following characteristics:
- In addition to growing their revenue by generating new leads, attracting new customers, and retaining old clients, firms also focus on raising their cash surplus. This can be done by incentivising immediate cash payments through better terms, promotions, or discount offers.
- They display lower reliance on external funding from banks, as they generate enough cash to reinvest.
- They show greater flexibility in investing in business opportunities that can fuel their growth further without being limited by resources.
Key takeaways
Cash generation is the total money created by a business in an accounting period after providing for all its operating, investing, and financing expenses. Maintaining positive cash flows is vital for businesses to ensure long-term success.
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