Calculating Cash Flow (2024)

When you need to know how a business is performing, measuring cash flow can tell that tale.Experts advise startups to make decisions that prioritize being cash flow positive, evenmore than profitability, while established firms know that having a comfortable financialrunway is all about cash on hand.

In other words, positive cash flow indicates that during a given time period, a business withliquidity has room to maneuver,enabling it to pay expenses and elicit positive interest from lenders thanks to itsperceived ability to return money to shareholders.

Negative cash flow is a cash flow problem thatdemands immediate remediation if there isn’t sufficient working capital.

What Is Cash Flow?

Cash flow is a measure of a company’s net cash inflows and outflows. It’sreported in a cash flow statement,also known as a statement of cash flows. When you want to measure a business’sfinancialhealth, one of the first places to look is its cash flow.

CFOs and finance teams need to work on improving cash flow andtake immediate action should it dip below what the business has defined as sufficient tooptimize inflow and outflow.

Examining which areas in a business may affect cash flow with a cash flow analysisreveals a business’s cycle of cash inflows and outflows. This analysis lets businessleadersand investors make the best possible financial decisions. The ultimate goal is to ensureadequate cash flow as well as provide a method for cash flow management.

Calculate Cash Flow

With good bookkeeping and accounting habits, it’s easy to generate a cash flowstatement fromyour company’s accounting or ERP software. Behind the scenes, this is the formula usedtocalculate a company’s cash flow:

Cash Flow = Cash from OperatingActivities + (-) Cash from Investing Activities + (-) Cash From FinancingActivities

To summarize: Cash flow is the inflows and outflows from operating activities, investingactivities and financing activities. It is possible for a company to be cash flow negative,which means more cash is going out the door than coming in, and still be profitable.That’swhy it’s important to look beyond the income statement to get a full picture of acompany’sfinances.

Cash vs real cash

When looking at a company’s net cash flow, there are a few ways to break down theinformation. One is to look at nominal cash flow compared to real cash flow.

Nominal cash flow, the number most people think of when they visualize acompany’s cash position, measures total cash in less total cash out.

Real cash flow is adjusted for inflation, which is a useful filter whencomparing results over time.

Cash vs profit

The concept may be a little counterintuitive, but a company can earn a profit even with anegative cash flow and vice versa. Cash flow focuses solely on a change in cash over aspecific period of time. Profitabilityconsiders other factors, like operating margin, assuming the company uses accrual basisaccounting versus cash accounting. Those can make a company more or less profitable withouthaving any impact on cash flow.

Cash flow vs income vs revenue

When calculating cash flow, revenue is one of the most important numbers. But revenue on itsown doesn’t represent a company’s cash flow. Revenue represents the value ofgoods orservices sold and delivered to customers. It may include sales that have been paid for andsome with outstanding invoices.

Revenue factors into profitability, but it isn’t a part of cash flow until customerspaytheir bills. The income statement shows a business's total revenues and expenses and netincome, or a company’s profits over a specific period of time.

Key Takeaways

• Cash flow is a measure of how much cash goes in and out of a company over a period oftime.
• Cash flow statements are typically broken down into cash flow from operating activities,financing activities and investing activities.
• When examined alongside income statements and balance sheet details, cash flow providesa clear picture of a company’s financial health and ability to stay in business.

How Does Cash Flow Work?

Cash flow is a measure of a business’s total cash inflows less cash outflows. When acompany’s liquid assets exceed its short-term liabilities, it is considered cash flowpositive.

Negative cash flow occurs when a company has more money going out the door, such as to buyinventory, cover operating expenses or pay other bills, than it has coming in.

Cash flow is generally broken down into three categories: cash flow from operations, cashflow from investing and cash flow from financing. These represent cash paid or received fromthe company’s core business activities, the purchase or sale of securities, andraisingmoney or paying down debt.

Why Does Cash Flow Matter?

Along with the income statement and balance sheet, a company’s cash flow statement isconsidered one of the three main financial reports that executives, finance teams, lendersand investors use to understand what’s happening under the hood of a business.

Its importance can’t be overstated. In Brainyard’s Fall 2020State ofthe CFO Role Survey, three-quarters of CFO respondents said their jobs are eithersomewhat (58%) or much more difficult (17%) than before the pandemic. The main challengegiven the ongoing pandemic is they’re juggling too many responsibilities (51%), butmanagingcash flow and the related developing accurate financialplans are tied for second, both cited by 43% as a top challenge now.

Cash vs accrual accounting

Accrual accounting and cash accounting are two accounting methods that indicate how cashmoves within the financial statements within a company.

Accrual accounting is legally required for all public companies. Under this method revenue isrecognized when it’s earned, not when payment is received. Expenses are recorded asincurredeven if cash payments haven’t been made. Cash accountingrecords payments when cash is received. Expenses are also recorded whenever cash is paid.

Understanding these methods helps when looking at a company’s profit, shown as the netincomeon an income statement. Since net income is a company’s bottom line, in accrualaccounting,net income may not mean that all payment has been received from customers.

What this means is a company may look profitable from an accounting standpoint, but couldstill struggle financially if customers pay late or don't pay at all. That’s why acash flowstatement is an important tool in assessing a company’s future financial healthbecause evenprofitable companies can fail to manage cash flow effectively.

Types of Cash Flow

Depending on your goals, you may want to drill down into the details that comprise a cashflow statement to understand a specific aspect of the company’s cash performance. Herearesome common metrics helpful in analyzing a company’s cash flows:

Cash From Operating Activities

Cash flow from operating activities measures how much money a company brings in and spends onits core business operations. It excludes financing and investment activities and can helpyou get an idea of how a company performs financially in the regular course of doingbusiness.

Free Cash Flow to Equity (FCFE)

Free cash flow to equity (FCFE) measures how much cash is left over after operations, payingdebts and investing in the company. This “leftover” cash is available to returntoshareholders. To calculate FCFE, you’ll need the company’s net income,depreciation andamortization expense, non-cash expenses, capital expenditures, change in working capital andtotal debt. Free cash flow to equity can help you determine if a company can afford to pay adividend or reinvest in growing the company. It’s commonly used by stock analysts todetermine a company’s total value and estimated target share price.

Free Cash Flow to Firm (FCFF)

Free cash flow to firm (FCFF) is a measure of a company’s profitability. Acompany’s FCFF iscalculated using all cash flow as it pertains to revenue, expenses, and all reinvested cash.What’s left over is the company’s FCFF. In other words, It represents cashthat’s availableto investors after a company pays all of its business costs, current and long-terminvestments.

The main difference between FCFF and FCFE is that FCFE deducts debt payments and interest,providing what some consider a more accurate indication of financial health. In other words,FCFF doesn't consider the impact of long-term debit on free cash flow.

FCFF is an important factor in many Wall Street stock analysts’ valuation processes. Apositive FCFF value signals a company has enough cash remaining to cover costs and invest inthe business. A negative result signals the company doesn’t have enough revenue tocover itscosts.

Though not necessarily a cause for alarm, a deeper analysis may be necessary to assess whythere isn’t enough revenue. In some cases it could be due to a business taking onoutsideinvestments, or a sign that it may have trouble staying in business in the long term.

Net Change in Cash

Net change in cash tallies all cash inflows and outflows over a period of time. The resultsindicate how much a company’s cash stores have increased or decreased in an accountingperiod. This higher-level number includes cash flows from operations, financing andinvesting.

How Is Cash Flow Used?

There are many ways a company’s leadership, lenders and investors may use cash flowinformation. Here’s a look at some of the most common:

• Management decisions: Successful managers and executives typically payclose attention to cash flow. Looking at past cash flow statements can help establishtrends and identify opportunities for improvement. Cash flow forecasts are also usefulwhen making decisions about borrowing and capital allocation. For example, the projectedcash flows for an expansion project may be used to calculate the project’sinternal rateof return (IRR), which is used to decide if an investment makes financial sense.
• Lender underwriting: When a business wants to borrow money, the lenderwill review its credit history and finances, including cash flows. This can help thelender determine if the business can pay back a loan as agreed.
• Investment analysis: Investors use cash flow to help determine acompany’s value. Cash flow details may flow into a discounted cash flow (DCF)model ormultiple analysis like the price-to-cash flow ratio. These tools help investorsdetermine a stock’s intrinsic value, which is used in stock buying decisions.

Managing Cash Flow

Financial managers can’t just focus on operations and let cash flow sort itself out.It’sessential to take an active role in managing cash flow, whether the business earns $50,000per year or $5 billion.

Cash flow management strategies can help a business qualify for more favorable financingterms and improve the company’s valuation. Some larger businesses employ teams offinancialanalysts and accountants to optimize cash flow. At smaller businesses, that responsibilitymay fall to the owner, controller or chief financial officer.

How to Improve Cash Flow

Improving cash flow isn’t always easy, but managers can use a combination of strategiestomove the needle in the right direction. Here are some common cash flow improvement tacticsto consider:

• Negotiate a discount with vendors for faster payment: Early paymentdiscounts reduces the amount of cash leaving the business.
• Automate AP and AR: Automated accounts payable andaccounts receivablesystems can help bookkeepers better track incoming and outgoing payments. Better paymentmanagement can help a business take advantage of optimal payment terms and avoid latepayments from customers.
• Embrace just-in-time inventory management: Inventory sitting in awarehouse or on retail shelf ties up cash. Keeping less inventory can boost cash flow.“Just-in-time” is an inventory managementsystem where a business tries to synchronize inventory with forecast demand,which improves cash flow by reducing inventory carrying costs.
• Lease instead of buy: Property and equipment purchases often require large capitalexpenditures. With a lease, a business offloads the up-front cash expenditure(and depreciation expense) to a leasing company. Leasing works like a loan in many ways,so it’s important to look at all of the costs involved before adopting a leasingstrategy.
• Improved workforce management: Most companies prefer to avoid layoffs,and more efficient workforce practicesand a human resourcesmanagement system can conserve cash and help better align HR spending withbusiness needs.

Every business is unique, so what works for one company may not work for another. If you areworking to improve your company’s cash flow, look at your accounting statements andcloselyexamine critical KPIs, like customer acquisition cost, gross margin and burn rate, that mayindicate ways to work more efficiently.

Cash Flow Analysis

Stock analysts and accounting teams may use cash flow details to determine if a stock iswell-priced and to make financial decisions. Here are some common analysis ratios andmeasures that may be useful to know:

Debt Service Coverage Ratio

The debt service coverage ratio measures a business’s ability to pay its outstandingdebtobligations. If debt servicing payments exceed cash flow from operations, a company maystruggle to keep up with payments.

Free Cash Flow

Free cash flow is a measure of how much cash a company generates from operations. Free cashflow is cash available for debt payments, dividends or to reinvest in the company forgrowth. A high free cash flow level means a company is likely in a healthy financialposition for ongoing operations. Negative free cash flows could indicate a problem before itshows up on the income statement.

Unlevered Free Cash Flow

Unlevered free cash flow, also known as free cash flow to firm (FCFF), calculates acompany’scash flow before interest payments. This is a useful data point as it shows how muchuncommitted cash a company has available for operations.

Positive Cash flow

Positive cash flow is an indication of a business’ health. When a company brings inmore cashthan it spends consistently over time, it usually indicates a healthy business that cancontinue indefinitely. But cash flow that is higher than average may indicate issues, suchas limited reinvestment to foster company growth.

Negative Cash flow

Negative cash flow means that a company had more cash go out over a given period than camein. That isn’t always a concern if it only happens for one or two quarters, or in thecaseof heavily seasonal businesses. It could also indicate that a large investment or expansionproject is underway. But negative cash flow for a long period of time can signal seriousproblems, perhaps even the potential for a future bankruptcy.

Cash Flow Forecasting

Business leaders often create cash flow forecasts to inform stakeholders of projected futurecash position changes. This information can help the business make decisions aroundborrowing, investments, employee bonuses and shareholder dividends.For investment analysis, cash flow forecastsgenerally plug into a discounted cash flow model to determine a company’s value andtargetstock price.

What Is a Cash Flow Statement?

A cash flow statement is a summary of a business’cashflow details. It’s typically divided up into sections for cash flow fromoperating,investing and financing activities.

Large companies generally create a consolidated cash flow statement that includes the cashflow details from all subsidiaries and holdings that require disclosure.

Small businesses can generate their own cash flow statements by working with their accountantor using bookkeeping or accounting software. For example, Oracle NetSuite includes reportingtools that allow users to easily generate a cash flow statement.

Using a Cash Flow Statement

Cash flow statements give managers, investors, lenders and analysts critical details about acompany’s finances and overall health. Whether you’re a business manager or aninvestor,it’s wise to pay close attention to cash flows.

To make life simpler, accounting software can automate functions, make workflows andprocesses more efficient, reduce errors and lower staff cost, and the ability to generatestatements is included in the core functionality of most accounting software.