The cash flow identity is a fundamental principle in finance that states that the cash flow from a company’s operations, investing activities, and financing activities must all equal each other over a given period of time. The cash flow identity is expressed by the following equation:
Cash Flow from Operations + Cash Flow from Investing + Cash Flow from Financing = Change in Cash and Cash Equivalents
The left-hand side of the equation represents the three sources of cash flow for a company, while the right-hand side represents the net change in the company’s cash and cash equivalents during the period.
Cash flow from operations includes cash generated from a company’s primary activities, such as the sale of goods or services. Cash flow from investing includes cash generated from the buying or selling of long-term assets, such as property, plant, and equipment. Cash flow from financing includes cash generated from the issuance of stock or bonds or from borrowing money.
By ensuring that the cash flow identity holds true, a company can ensure that it is accurately tracking its cash inflows and outflows. This information is critical for assessing a company’s financial health, identifying areas of risk, and making strategic decisions about investment and financing.