Self-financing capacity and operating cash flow

Nadia's workshop generates 12 000 € of profit and 30 000 € of self-financing capacity. Her banker looks only at the second figure, and rightly so: it says what the activity potentially leaves in the bank, before any decision to repay or invest. But one must not stop there. Of those 30 000 €, some 11 000 € are immediately reabsorbed by the growth in working capital requirement, leaving 19 000 € against 18 000 € of loan instalments.

What it measures, and what it does not

The important word is potential. Self-financing capacity does not say what reached the bank: it says what operations would have left if every customer had paid cash and every supplier been settled at the same pace.

It measures the monetary performance of the trade, stripped of the accounting conventions that move no money. It therefore sits between the result, too conventional, and cash, too dependent on settlement terms.

Its purpose is to fund three things, in that order: loan repayments, renewal of the production tools, and remuneration of the owners. A business whose self-financing capacity does not cover its loan instalments is living on its reserves.

The order matters more than it seems. Instalments are contractual and non-negotiable; renewal can be postponed for a year or two without visible damage; remuneration is the most flexible of the three. Businesses in difficulty almost always sacrifice them in reverse order.

Two methods, one answer

The subtractive method starts from the gross operating surplus and adds other collectable revenue while removing other payable charges: financial income, financial charges, profit sharing, corporate income tax.

The additive method starts from the net result and adds back everything that moved no money: depreciation and provisions, less releases, less disposal gains and plus disposal losses. The two paths must converge.

At Nadia's, both methods give 30 000 €. That convergence is not decorative: it is the only available check on a calculation where one forgotten line passes unnoticed. A gap between the two signals an error, never a subtlety.

The additive method is faster from a tax return pack, since net result and depreciation appear there directly. The subtractive method is the more instructive, because it shows where the capacity forms and where it is lost.

In practice, use both. The additive method to obtain the figure quickly, the subtractive one to understand it — and the comparison of the two as the check. Fifteen minutes of work, and a number that can be defended in front of a lender.

The disposal gain trap

A business reselling a depreciated machine records a gain in exceptional items. That gain inflates the net result, but it does not come from operations: it comes from an asset no longer owned.

Self-financing capacity therefore removes it systematically. Without that correction, a year of heavy disinvestment would show a flattering capacity while the business had in fact stripped its own production tools.

The disposal proceeds do exist in cash. They appear elsewhere, among investing flows, and it is precisely that separation which distinguishes cash earned by the trade from cash obtained by selling an asset.

From capacity to real flow: the change in requirement

Self-financing capacity ignores payment terms. To know what operations actually left behind, one must subtract the increase in working capital requirement — the money that growth in stock and receivables tied up over the year.

At Nadia's, capacity reaches 30 000 € and the requirement grew by 11 000 € with activity. Operating cash flow therefore falls to 19 000 €. That figure, and not the 30 000 €, is what can repay a loan or fund a machine.

This subtraction explains most cash surprises. A fast-growing business can show a flattering self-financing capacity and a negative operating cash flow: everything it generates is immediately reabsorbed by its own expansion.

It also explains why a slowdown can feel like relief. Declining activity releases working capital: operating cash flow can exceed self-financing capacity in a bad year, which is disconcerting until the mechanism is understood.

Appropriation: the capacity does not stay whole

Self-financing capacity measures what the year generated, not what remains after the owners' decisions. A dividend distribution draws on that amount, and it happens the following year, once the accounts are approved.

Self-financing proper is therefore the capacity less dividends paid. It is what actually feeds reserves and strengthens equity, and it is what a lender examines when assessing a company's ability to fund itself.

The trade-off is structural for a small company. Distributing improves the director's immediate income; retaining strengthens the balance sheet and future borrowing capacity. Both are defensible, but neither is decided without knowing the operating cash flow.

One case recurs: distributing a dividend larger than operating cash flow amounts to funding remuneration out of the cycle's cash, and so to borrowing implicitly from the next supplier. The distribution looks affordable; it is in fact already financed by debt.

Reading the capacity over time rather than once

An isolated amount cannot be judged. A capacity of 30 000 € is comfortable for a business turning over 480 000 € and derisory for one turning over five million. Set against turnover it becomes a comparable rate: 6,25 % at Nadia's.

Tracked over three years, that rate says most of what matters. A capacity eroding while turnover grows signals a margin deterioration that the net result, absorbed by depreciation, can mask for a year or two.

The reverse also occurs. A capacity improving while the result stagnates often indicates recent investment: depreciation has risen, weighing on the result without weighing on cash. Reading the two together avoids the wrong conclusion.

That is why the three indicators are read together and never separately: the result gives accounting performance, the capacity gives monetary potential, operating cash flow gives what survives the cycle. None of the three suffices, and the gap between them is the information.

Repayment capacity, in years

One simple ratio sums up financial solidity: financial debt over self-financing capacity. It is expressed in years and answers a concrete question — how many years would it take to repay all the debt out of what the activity generates?

At Nadia's, 112 000 € of financial debt against 30 000 € of capacity gives 3,7 years. Lenders look at that ratio before many others, and generally consider that beyond three to four years the room for manoeuvre becomes narrow.

That threshold is a convention of practice rather than a rule of law, and it varies by sector and by the nature of the assets financed. A capital-intensive business sustains a higher ratio than a service company with no fixed assets.

The ratio's value lies mostly in its trajectory. Moving from 3,7 to 4,5 years over two financial years is a signal, even if the level remains acceptable. Management accounting cares about slopes more than about levels.

Two adjustments make it fairer. Cash held can be netted against debt, since it could repay it tomorrow. And a loan taken out in December has not yet produced any of the capacity it will fund, which artificially worsens the ratio for one year.

What the cash flow statement adds

A final useful marker: self-financing capacity compares to depreciation. A capacity durably below depreciation means the business does not even generate enough to renew its tools, and is living off its productive capital.

At Nadia's, 30 000 € of capacity against 24 000 € of depreciation leaves a narrow but real margin. Renewal is fundable, provided existing loan instalments do not already consume that difference — which is precisely the case here.

The full reasoning is formalised in three blocks: operating flows, investing flows, financing flows. Their sum gives the change in cash for the year, and that breakdown says where the money came from.

Cash rising thanks to operating flows tells the story of a business earning its living. The same rise obtained through a loan or a disposal tells something else entirely, and the closing balance does not distinguish between them.

That is the limit of the balance sheet and income statement taken alone: they give state and performance, not the origin of movements. The cash flow statement answers the question the other two leave open.

The statement is not compulsory for a small company, which is probably why it stays rare. It is nevertheless built on one page from two successive balance sheets, and it answers the only question a director genuinely asks at the year end.

Building it once is also the fastest way to understand a business one has just taken over. Two balance sheets, one income statement, and an afternoon are enough to say where the money came from and where it went, which no commentary can substitute for.