Understanding how money moves in and out your business is important, as it shows you how your business is doing, how efficiently it’s being run and in what areas you can improve. That’s where cash flow comes in. We’ll show you how you calculate cash flow with our free cash flow formula.
Calculating cash flow is important for businesses of all sizes. Whether you’re an entrepreneur, a small business owner, or a personal finance enthusiasts, you can master cash flow management. This article makes it easy to calculate cash flow, explaining the different types of cash flow and giving you step-by-step guides on how to calculate them, including a free cash flow formula.
Understanding cash flows
At its core, a cash flow show the movement of money in and out of a business or personal finance system. Positive cash flow indicates that a company’s liquid assets are increasing, enabling it to settle debts, reinvest, pay out money to shareholders, pay expenses, and plan for future financial challenges. Negative cash flow, on the other hand, suggests the outflow of cash exceeds the incoming, which could spell trouble over time.
The free cash flow formula
A cash flow statement is a financial document that provides an overview of earnings and incoming investments, as well as payments and investments during a given period. To understand what a cash flow is, let’s break it down into a simplified formula:
Cash flow = cash from operating activities ± cash from investment activities ± cash from financing activities
What’s included in a cash flow statement?
A cash flow statement is divided into three main sections, each highlighting a specific type of activity:
Cash flows from financing activities: Transactions related to loans and repayments, issuing and repurchasing company stock, and paying dividends.
Cash flows from operating activities: Transactions directly related to the core business operations, including revenue from sales, cash paid to suppliers, and salaries paid to employees.
Cash flows from investment activities: Transactions related to the purchase and sale of long-term assets like property, plant, equipment, and investments. It includes cash spent on capital expenditures and proceeds from sales of assets.
To use the free cash flow formula, add or subtract the net cash from each of these three activities to find your net cash flow.
Download our free cash flow forecast template.
Why is cash flow important?
Cash flow is extremely important for several reasons. It’s an indicator of a business’s liquidity and shows the company’s ability to generate cash and use it effectively. Here are some of the key reasons why net cash flow is crucial:
- Financial health and stability: Net cash flow shows the company’s capacity to cover its expenses, pay off debts, and navigate financial uncertainties. A positive net cash flow is a sign of operational efficiency and financial robustness, and makes the company more likely to appeal to investors and lenders.
- Investment opportunities: Businesses with a strong net cash flow are better positioned to seize investment opportunities without the need to rely on external financing. This can be a significant competitive advantage.
- Dividends and repayments: A positive net cash flow equips a business to reward its shareholders through dividends, repurchasing shares, or repay debts ahead of schedule, which builds trust and confidence among stakeholders.
- Strategic planning and budgeting: Understanding the net cash flow helps businesses forecast future cash flow, enabling more informed budgeting and planning.
Read also: The ultimate guide to liquidity and cash flow
Why do you need cash flow statements?
Cash flow statements are important for several reasons:
- They provide a clear picture of how well a company manages its cash, which is crucial for maintaining liquidity and solvency.
- Investors and creditors use them to gauge a company’s financial health and its ability to generate cash and cover debts.
- They help identify trends in cash management and can drive strategic business decisions, such as whether to expand operations or cut expenses.
How to prepare a cash flow statement
There are several steps to setting up a cash flow statement:
- Start with the opening balance: Identify the cash balance at the beginning of the period.
- Calculate cash flow from operating activities: Adjust the net income by adding non-cash expenses and accounting for changes in working capital.
- Calculate cash flow from investing activities: Sum up all cash spent on investments and proceeds from the sale of assets.
- Calculate cash flow from financing activities: Tally the net cash from issuing debt or equity, repaying loans, and paying dividends.
- Compute the net cash flow: Add the total cash flows from operating, investment, and financing activities.
- Determine the ending cash balance: Add the net cash flow to the opening balance to arrive at the closing balance for the period.
Limitations of cash flow
While cash flow is important, there are also several limitations:
- A cash flow statement doesn’t account for non-cash activities: Net cash flow calculation doesn’t fully cover a company’s financial health, as it doesn’t include non-cash activities such as depreciation, which can significantly impact the company’s financial statements.
- Short-term perspective: Net cash flow focuses on the liquidity in a given period and may not necessarily indicate the long-term profitability or viability of a business. A business might show positive net cash flow while facing long-term profitability issues.
- Seasonal fluctuations: For businesses subjected to seasonal variations, the net cash flow might not accurately reflect the annual financial situation. A company might experience high positive net cash flow during peak seasons and struggle during off-peak times.
- Doesn’t highlight the origin of cash: Although net cash flow indicates the amount of cash generated or used, it doesn’t specify whether the cash originated from operating activities, investments, or financing. This distinction is critical because cash from operations is a more sustainable source than cash obtained by borrowing or selling assets.
While net cash flow is an essential metric for assessing a company’s financial status, it should be considered alongside other financial indicators for a comprehensive understanding of the company’s overall health and performance. Acknowledging the limitations of a cash flow statement can help stakeholders make more nuanced and informed decisions.
What is operating cash flow?
While a cash flow statement covers all cash inflows and outflows, there’s another type of cash flow that often dictates how well a company is doing financially: Operating cash flow (OCF). Operation cash flow shows how a business’s primary activities directly impact its ability to generate cash, providing a more granular view of its efficiency.
Transitioning from cash flow to operating cash flow
Cash flow paints a broad picture of a company’s financial activity, covering everything from operating activities to investments and financing. However, for businesses and stakeholders, the ability to maintain a healthy cash flow and expand the business lies at the core of financial health. This is where operating cash flow comes in, honing in on how much cash is generated from selling goods and services, after accounting for the direct costs associated with these activities.
How to calculate operating cash flow
To calculate operating cash flow, we look specifically at cash transactions directly tied to the company’s operational activities. It can be calculated using the following formula:
Operating cash flow = net income + non-cash expenses + changes in working capital
- Net income: Start with net income, which can be found at the bottom of the income statement.
- Add non-cash expenses: Add any non-cash expenses such as depreciation and amortization since they don’t involve actual cash outflow.
- Adjust for changes in working capital: Account for changes in working capital (current assets minus current liabilities). An increase in current assets (other than cash), or a decrease in current liabilities, decreases cash flow, and vice versa.
Cash flow vs. profit and loss statement
While both cash flow and profit and loss (P&L) statements offer insights into a business’s financial health, they serve different purposes:
- A cash flow statement measures how and where a company generates and uses its cash over a particular period. The goal is cash management in regards to operational expenses, investments, and financing.
- A P&L statement, or income statement, calculates a company’s profitability over a specific period. It lists revenues, costs, and expenses to determine the net profit or loss incurred.
While cash flow is about the liquidity (the actual flow of cash in and out of the business), the P&L statement looks at the overall profitability without directly considering cash transactions. Together, they provide a comprehensive view of a company’s financial state.
Download our free profit and loss statement.
Being able to calculate cash flows is vital in order to make informed financial decisions. By knowing the cash flow formula, understanding how to work out net cash flows and operating cash flow, you can get a better overview of the financial health of your company. Armed with this knowledge, you can make strategic decisions about investments, budgeting, and financing to become more data-driven and ultimately more successful.
See also: What is profit and loss statement?
