It is vital to know how much money goes in and out of your business, so your business can be profitable. The money moving in and out of business is called cash flow: it is essential for the success of your business.
In more technical terms, cash flow is the net balance of cash going in and out of business during a specific period. For example, when a business purchases inventory, cash flows out of business, but cash flows into the business when a sale is made. Several essential formulas enable you to calculate cash flow, and I’ll cover all of these at length below. I’ll also talk about all the specifics related to cash flow; for now, here is an outline of the main categories of cash flow:
- Operating Cash Flow
- Investing Cash Flow
- Financing Cash Flow
Table of Contents
Cash Flow: Overview
The cash going in and out of business is called cash flow. The cash flow is measured over a specific period, usually monthly or quarterly. The cash at the beginning of the accounting period is the opening balance, and the cash at the end of the accounting period is the closing balance.
For a company to increase cash flow, it needs to sell more goods/services, reduce costs, and more. The cash flow is directly linked to liquidity: the ability of the company to cover the immediate and short-term obligations. I’ll talk about liquidity in another article; I’ve only mentioned it here to emphasize the importance of cash flow and how it is related to all facets of running a business.
What Are the Different Cash Flow Types in a Business?
As the cash flow is the net balance of the cash that moves in and out of business, it can be positive or negative. Positive cash flow points that more money is moving into the business; Negative cash flow points that more money is moving out of the business.
There are three significant categories of cash flow, and I’ll elaborate on these here:
- Operating Cash Flow – the net cash generated during regular business operation. For a company to grow and develop, it needs to keep a positive cash flow
- Investing Cash Flow – the net cash that the investment-based activities generate. Any purchase of physical assets like equipment or property is a part of the investing cash flow, as is any investment in securities, and this type of cash flow is often negative in growing companies
- Financing Cash Flow – the net cash generated to finance a business; it includes debt, equity, and dividend payments. It refers to the way cash moves between the business and its investors/owners/creditors
The fourth type of cash flow is free cash flow. It is the cash left after paying all the operating expenses and capital expenditures and is available for re-investment in the business (or paying dividends or debt). This measurement shows how efficient a business is at generating cash.
How Cash Flow Is Calculated? (Formulas)
To calculate cash flow, there are various ways and formulas that I’ll explain here. The table below contains the three basic formulas for calculating the most important parts of cash flow calculations.
|Type of cash flow||Formula|
|Free cash flow||Free cash flow = Net income + depreciation/amortization – change in working capital – capital expenditure|
|Operating cash flow||Operating cash flow = Net income + non-cash expenses – increase in working capital|
|Cash flow forecast||Ending cash = beginning cash + projected inflow – projected outflow|
Free Cash Flow Formula
Free cash flow is the cash generated by the business that is free from obligations. It is the cash that the business can invest or divide between the shareholders. Here I need to note that even though the free cash flow is a good indicator of the growth of a business, it is not always the best indicator for the future of a business.
The calculating of the free cash flow of a business is relatively straightforward: you should employ accounting software and generate your business’s income statement and use the following formula:
Here is an explanation of the basic terms used in the free cash flow formula:
- Net income – the total income after subtracting all the business expenses
- Depreciation/amortization– the costs related to the amortization of equipment and loss of value of assets over time
- Working capital – the difference between the assets and liabilities in a business: the capital used in the day-to-day operation of a business.
- Capital expenditures – the money spent on fixed assets: land, real estate, or equipment.
From the income statement balance sheet provided by your accounting software, you can easily calculate the free cash flow. I’ve outlined a real-world example for you here:
Alex is a woodworker and needs to calculate free cash flow to hire an apprentice. He needs to use the free cash flow formula based on his yearly financials:
- Net income: $150,000
- Depreciation/amortization: $5,000 (yearly maintenance)
- Change in working capital: $20,000 (cost of materials and other day-to-day expenses)
- Capital expenditure: $50,000 (Alex bought some new equipment)
When he applies the free cash flow formula, he will get the following:
Free cash flow
He has $85,000 in free cash flow that is available for reinvestment, or, in this case, hiring an apprentice.
Operating Cash Flow Formula
The operating cash flow describes the everyday cash flow within a business. It is the amount of cash generated by the regular operating activities of a business; it is used to determine how much money the business will have to cover operating expenses. To calculate operating cash flow, you’ll need to apply the operating cash flow formula:
All the necessary details are found in the income statement. In a real-world example, the operating cash formula will look like this:
- Net income: $150,000
- Non-cash expenses: $85,000 (depreciation, stock-based compensation, deferred taxes)
- Increase in working capital: $135,000
When the operating cash flow formula gets applied, the operating cash flow amounts to:
Operating cash flow
In this example, our imaginary business has generated $50,000 a year in positive cash flow from the daily operating activities.
The operating cash flow calculation helps bring an improved overview of the cash flow’s looks daily. It can be used to plan future endeavors better, as it shows a real insight into a business’s daily operations and financial success.
Cash Flow Forecast Formula
While the free cash flow and the operating cash flow show how a business has done in the past, a business needs to have a good base for planning the future. It is where the cash flow forecast comes in handy.
A cash flow forecast helps you predict how the money will flow in and out of your business in the upcoming period. It is vital to use the cash flow forecast, as it helps you determine whether the business will meet the financial obligations. The cash flow forecast uses the current cash balance, adding or subtracting the expected future inflow/outflows.
When applied correctly, the cash flow forecast can help you decide the future of your business, whether it is a good time for an investment, a business loan, or a similar move. Calculating the cash flow forecast is very simple; here is the cash flow forecast formula:
Here I’ll explain the terms used in the cash flow forecast formula:
- Beginning cash – the cash balance at the beginning of the calculating period
- Projected inflow – expected cash influx from current and future invoices for the calculating period
- Projected outflow – expenses and other payments (payroll, rent, loans, production costs, etc.) due in the calculating period
I’ve prepared a real-world example: a company seeking to make a cash flow forecast to see if it will be able to buy a new machine costing $15,000 in six weeks to increase production.
- Beginning cash: $20,000
- Projected inflow: $15,000
- Projected outflow: $25,000
After applying the cash flow formula, the ending cash for the calculating period of six weeks comes to:
From the cash flow forecast, you can see that the company will not have the necessary funds to purchase the new machine in the next six weeks, as the cash outflow is bigger than the cash inflow. By calculating a cash flow forecast, the company determined that they’ll need additional financing to purchase the new machine in the planned six-week period.
It is the most direct way of forecasting the cash flow in a business. The cash flow forecast is essential in assisting with the daily decisions when it comes to business finance. It helps plan when to spend money and when to refrain from making huge financial decisions.
What Is a Cash Flow Statement?
Above I talked about the different cash flow types, and now I’ll talk about the cash flow statement – a financial statement that summarizes the cash and cash equivalents that enter and leave a business. A cash flow statement (CFS) measures how well a business manages its cash: how well the business generates cash for paying its obligations and fund its operations. Along with the income statement and balance sheet, a cash flow statement is a mandatory part of the business’s financial reports.
Structure of Cash Flow Statement
I need to note that the cash flow statement is different from the balance sheet and income statement, as cash is different from net income. A cash flow statement consists of several main components:
- Cash from operating activities
- Cash from investing activities
- Cash from financing activities
The cash from operating activities on the cash flow statement encompasses all the sources and uses of cash in the business activities. It also shows how much cash is generated from the business’s products/services. The operating activities also include the changes made in cash (depreciation, inventory, payments to suppliers, rent payments, salary/wages payments, deferred taxes, other operating expenses).
The cash from investing activities on the cash flow statement includes all the sources of cash gained from the business’s investments. It includes purchase/sale of an asset, loans to vendors, payments regarding mergers or acquisitions, and the like.
The cash from financing activities on the cash flow statement incorporates all the sources of cash from investors/banks and the cash paid to shareholders. The paid dividends, payment for stock repurchase, and the repayment of the loans all fall under this category
How to Use the Cash Flow Statement
The cash flow statement is used for understanding the operating of a business. It helps investors understand where the money comes from, how it is spent, and how the business operation is run. The cash flow statement also tells investors if a business is on a solid footing, financially speaking. Creditors also use the cash flow statement to determine how much cash the business has available and whether it can fund its operations and pay its debts.
The cash flow statement can have a positive or a negative bottom line. The positive cash flow statement points to a healthy business that grows and earns a profit. A negative cash flow statement is not always wrong, as it may mean the business is expanding and growing. It is why it’s crucial to analyze the changes in cash flow over time, as investors and concerned sides can have a better idea of the business’s financial performance.
Cash Flow FAQ
What Is the Meaning Of Cash Flow?
Cash flow is the amount of cash (or cash-equivalent) that a business receives or gives out as payments to creditors. It is the amount of cash going in and out of business.
What Is the Difference Between Cash Flow and Profit?
Cash flow and profit are not the same. Cash flow is the net balance of cash that moves in and out of business in a specific period. Profit is the balance that remains when all the operating expenses are subtracted from the revenue: profit is what is left when the books are balanced, and all the expenses are paid.
Why Is Cash Flow Important?
As cash flow is the inflow and outflow of money from a business, it is vital to the business’s financial health. The positive cash flow indicates the business is growing and is in excellent financial health, while the negative cash flow indicates that the business’s financial health is decreasing.
How to Calculate Free Cash Flow?
The free cash flow shows the amount of cash left over after all the operating expenses and capital expenditures are paid. It is the money the business can invest in growth, paying dividends, and more. There is a simple formula to calculate free cash flow:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
How to Calculate Operating Cash Flow?
The operating cash flow is the amount of cash generated by normal business operations. It indicates if a company can generate positive cash flow to maintain and grow its operation or need an external finance source for expansion. There is a simple formula to calculate operating cash flow:
Operating cash flow = Net income + non-cash expenses – increase in working capital
Keeping track of the cash flow in a business is not a fun task, but it is a vital one, as it helps you understand the business’s financial health. With a bit of knowledge, you can easily calculate the different cash flow types in a business, and you can get a better grasp of the financial state of your business.
Use the formulas I provided above to calculate free cash flow, operating cash flow, and make a cash flow forecast for your business. Based on these results, you can make a cash flow statement, anticipate cash flow problems and make adequate arrangements to prevent them.