Negative Cash Flow

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Negative Cash Flow Meaning

Negative cash flow refers to the situation in the company when cash spending of the company is more than cash generation in a particular period under consideration; This implies the total cash inflow from the various activities, which include operating activities, investing activities, and financing activities during a specific period under consideration is less than total outflow during the same period.

In simple words, it means a business scenario when the firm spends more cash than it generates. It is a prevalent situation for firms in their growth phase as they need to spend money to fuel growth, acquire customers, or set up distribution channels. In simple terms, it's a game of numbers where the incoming cash is less than the outgoing money. In such a situation, the deficit should be supported by equity infusion, debt funding, or both.

Negative Cash Flow Meaning

Formula

This concept is not new but very much implicit in the cash flow calculations. The simplest equation to understand this concept mathematically is understanding the negative cash flow calculation from core business activities.

Cash Flow = Cash Inflows - Cash Outflows

If this number is negative, it denotes a deficit and is termed negative cash flow.

Basic Calculation (with Example)

Consider a firm XYZ with the following statement of cash flows.

At first glance, the company looks in a very bad state as the cash flow is $ -80,000. However, if we dive in further and, rather than looking at the final cash flow number, look at its various constituents, our perception of the current state of the business might change. The cash flow from operating activities is positive, suggesting that the firm is doing well in core business activities. However, cash flow generated from investing and financing activities is negative. It might be because the management seeks good potential in future growth and wants to spend on it. For example, a large part of the money has been spent on buying additional equipment and plans, emphasizing that a firm is laying out plans for future expansion and growth.

Practical Example

Consider below the snapshot of cash flow from operating activities of internet Major Netflix. Looking at the final numbers, it may seem like the firm is doing badly. However, diving further reveals that the firm is trying to increase content on its portal, leading to negative cash flow. Therefore, it should be a long-term strategic initiative as part of growth expansion plans.

source: Netflix SEC Filings

Interpretation of Negative Cash Flow

#1 - Negative cash flow is very much a part of the business - No business across the globe has not faced such a situation. It might be a temporary situation that might have arisen due to the cyclic challenges to the business in which the firm operates or a new competitor entry, cash flow crunch due to some natural disaster, or sudden regulatory changes.
#2 - Better assessment of growth opportunities and evolution for the future - Negative cash flow is sometimes an indicator of how the firm is trying to expand and how aggressively it is doing so. A firm should consider it an opportunity cost to draw out its expansion plans and execute them. It becomes imperative for the firm to grow and evolve. Else the ruthless competition will kill them. We have numerous such examples in history where the firms were not only cash-rich but also market leaders. But they were too complacent and refused to evolve. Who can forget the words of the Nokia CEO – "we didn't do anything wrong, but somehow we lost." They didn't invest and adapt to the changing market conditions. Eventually, they were acquired by Microsoft.
#3 - Growth potential - It is an indicator of the firm's financial health. I studied it as a pattern; it can help investors gauge their investments and calculate ROI. If the pattern suggests that negative cash flow is regularly decreasing, it should suggest that the firm is recovering well and the long-term strategic growth is intact. However, if there is acyclicity in a pattern, it should suggest that external factors play a lot in the firm's business. For example, crude prices weigh a lot on the airline business. This is certainly not a favorable scenario for investors.

Disadvantages

#1 - Cash Crunch - Negative cash flow can lead to a cash crunch. It might, in turn, lead to a delay in payments to suppliers and vendors. This may affect your relationship with the vendors leading to poor service or even termination of contracts. Similarly, cash crunch situations can also force management to delay the employees' salaries. This can lead to a high attrition rate and loss of talent to competitors.
#2 - Increased Bank Charges and Interest Rate Risk - As discussed above, negative cash flow must be funded by either the equity infusion or debt funding. Debt finding comes with a cost as the interest has to be paid back. This can put constraints on the long-term profitability of the firm. Also, there is an interest rate risk involved as the interest rate may rise in the future, leading to increased interest payout (in the case of floating loans).
#3 - Equity Dilution - If the external funding is done through equity infusion, it may be at the cost of diluting equity ownership, which has its implications. It affects the management's decision-making power, which makes it tough to implement long-term strategic plans. Also, there is always a danger of a hostile takeover.

Conclusion

Unless the problem of negative cash flow becomes a common practice across multiple quarters, investors need not worry. It is part of business activities where firms sometimes have to spend more to evolve and find growth opportunities. However, investors should exercise caution as it can be a sign of a flawed business plan, lack of growth opportunities, or a case of missed opportunities or fraud.