Chapter 2

The cash flows of a company can be divided into four categories, i.e. operating and investment flows, which are generated as part of its business activities, and debt and equity flows, which finance these activities.

The operating cycle is characterised by a time lag between the positive and negative cash flows deriving from the length of the production process (which varies from business to business) and the commercial policy (customer and supplier credit).

Operating cash flow, the balance of funds generated by the various operating cycles in progress, comprises the cash flows generated by a company’s operations during a given period. It represents the (usually positive) difference between operating receipts and payments.

From a cash flow standpoint, capital expenditures must alter the operating cycle in such a way as to generate higher operating inflows going forward than would otherwise have been the case. Capital expenditures are intended to enhance the operating cycle by enabling it to achieve a higher level of profitability in the long term. This profitability can be measured only over several operating cycles, unlike operating payments, which belong to a single cycle. As a result, investors forego immediate use of their funds in return for higher cash flows over several operating cycles.

Free cash flow can be defined as operating cash flow minus capital expenditure (investment outlays).

When a company’s free cash flow is negative, it covers its funding shortfall through its financing cycle by raising equity and debt capital.

Since shareholders’ equity is exposed to business risk, the returns paid on it are unpredictable and depend on the success of the venture. Where a business rounds out its financing with debt capital, it undertakes to make capital repayments and interest payments (financial expense) to its lenders regardless of the success of the venture. Accordingly, debt represents an advance on the operating receipts generated in the future by the investment that is guaranteed by the company’s shareholders’ equity.

Short-term financial investment, the rationale for which differs from capital expenditures, and cash should be considered in conjunction with debt. We will always reason in terms of net debt (i.e. net of cash and of marketable securities, which are short-term financial investments) and net financial expense (i.e. net of financial income).