Cash is king! That’s so cliché, but right on the money. It’s only fitting that you know how cash flow is calculated properly.

Cash makes your business run. It allows you to purchase inventory, manufacture goods, provide services, pay your employees (and yourself), and attract investors. The more cash on hand, the more options, and possibilities for growth.

Just like an individual creates a budget and balances their checkbook to determine if they can afford a purchase, a business must gather data and calculations to determine their financial status. 

This involves preparing financial statements such as a balance sheet, income statement, and statement of cash flows. Cash flow is more detailed than your bank account balance, which means more to a business than whether it can afford lunch. 

Let’s look at what cash flow is, how to calculate cash flow, and what it means for business operations.

What is Cash Flow?

Cash flow is money coming into and going out of your business. It comes from sales of goods and services, dividends from investments, loans from creditors, and sometimes the owner’s pockets. It pays salaries, keeps the lights on, pays debts, and all other expenses involved in running your business. 

Cash flow is calculated, reported on the Statement of Cash Flows, and published periodically. The three different types of cash flow combined show how healthy a business is. 

Cash flow provides valuable information, including whether you can cover your expenses and if you have excess funds to invest in your business.

How the Cash Flow Statement is Used

There are many benefits of preparing a cash flow statement:

1. Cash flow statements illustrate where your cash is coming from and where it is going. This helps determine where you are overspending and if you need to generate more cash. It shows whether you can cover your expenses with what you’ve got, or whether you need to raise capital to continue.
2. Cash flow forecast statements are used to predict future expenses. If you anticipate a slow period around certain times of the year, you can set aside extra cash to cover expenses. Planning ahead can also ensure you have cash for expenses that occur quarterly, yearly, or non-recurring. 
3. Cash flow statements can indicate whether you can expand your business by hiring extra staff or purchasing new equipment or property. It can also show you when to cease spending and find ways to save.
4. If you have debt, a cash flow statement will highlight extra money for the repayment of loans. Investors use the cash flow statement to determine whether a company can take on and pay back debt. It will also tell investors whether the company’s management strategy is sound. 
5. Cash flow statements can also provide a detailed history of your company—when you had growth and faced challenges. You can track revenue and expenses to see their patterns and changes. If an unexpected expense arises, you can see this immediately and make adjustments.
6. Comparing cash flow statements over time will point out problems and ensure there is time to take corrective action.

Structure Of the Cash Flow Statement

The cash flow statement has three sections based on the three types of cash flow: cash from operating activities, investing activities, and financing activities. Combined, you arrive at a positive or negative cash flow.

Cash From Operating Activities

Operating activities stem from a company’s main business activities. If a company sells a product or service but owns land unrelated to these items in which it makes money, only the cash related to the product or service will be in this section.

Cash from operating activities might include selling and purchasing inventory, paying salaries, and costs associated with providing services. 

Operating cash flow is calculated using operating income plus depreciation minus taxes plus changes in working capital. 

• Operating income comes from the income statement. It starts with total revenue and subtracts operating expenses. Operating income is also called EBIT, or Earnings Before Interest and Taxes.
• Depreciation is writing off large assets based on wear and tear over their useful life. Amortization is often included, which is spreading the cost of an intangible asset over time.
• Working capital is calculated from the balance sheet. Take the current liabilities and subtract current assets. Working capital represents operating liquidity available to a business. Positive working capital means the company can pay its bills and spend money on growing the business.

This section is the most crucial of the three, as it concentrates on cash inflows and outflows related to the core money-making activities of the business. How much detail is provided depends on the method of accounting.

Cash From Investing Activities

Investing activities include cash spent or earned from capital expenditures. These expenses are outside the core activities of the business and are usually one-time entries. 

Capital expenditures include money spent on purchasing, maintaining, or upgrading fixed assets such as buildings, vehicles, equipment, or land. These investments show that the company is growing its business and investing in its infrastructure. An influx of cash in investing activities may indicate the liquidation of the same fixed assets.

Analyzing investment activities can give investors a clue as to the company’s direction—building infrastructure, changing the direction of products or services, or selling off assets to raise money for operations.

Cash From Financing Activities

This section details funding from investors, creditors, or owners. It may include repurchasing stock, proceeds from or payments to long-term debt, and payment of dividends to shareholders. The influx (or outflow) of cash is often a one-time entry. Cash from financing activities might indicate the amount of debt incurred.

How Cash Flow is Calculated

There are two methods for calculating operating cash flow: the indirect and the direct methods.

The generally accepted accounting principles (GAAP) dictate that you use the indirect method as it follows accrual accounting, but both methods provide valuable information for a business.

Direct Cash Flow Method

Under the direct cash flow method, all inflows and outflows are recorded on a cash basis. Items are recorded when money is received or spent.

All cash collected from operating activities is itemized, including cash from revenue. Then, cash paid for the production of those activities is subtracted. These might include cash paid to suppliers and employees or salaries paid to employees.

Finally, interest and taxes paid are subtracted to arrive at operating cash flow.  

The direct method provides much more detail and takes longer to prepare but makes it easier to pinpoint where you might be overspending or whether you need to generate more income to cover expenses.

Indirect Cash Flow Method

The indirect cash flow method uses accrual accounting to calculate its numbers. The accrual method records income and expenses when money is earned, regardless of whether cash is exchanged. In this method, you start with the net profit or loss from the income statement, then add back non-cash expenses and adjust for the movement of working capital.

Limitations Of the Cash Flow Statement

All financial statements provide valuable information, but none alone answer every question or paint the perfect picture of how a business performs. The cash flow statement is no exception. Here are some things to consider:

1. The cash flow statement depends on timing. Income or sales are not always regular. One month you might get an influx of cash, including people paying early or late. One could also delay paying invoices to suppliers until the last minute, which could, in turn, show up on the next period’s cash flow statement and make it look like you have more cash available. These are a few ways to make a cash flow statement look how you want.  
2. The cash flow statement will also look different depending on whether you use a cash or accrual accounting method. The cash method means that you have already received and deposited the money in your bank account or paid the invoice. Earned money or promises to pay are not tracked. As a result, a company’s accurate picture of financial health is not illustrated on a cash flow statement.
3. The cash flow statement only tracks cash transactions. If a company issues bonus shares or uses shares to purchase fixed assets, the cash flow statement would not track that information. The income statement considers both cash and non-cash transactions. 
4. If you are trying to determine the liquidity of a business, you need to look at assets that can be converted into cash, which are not tracked on the cash flow statement.
5. A cash flow statement reflects what happened in the past. It does not indicate future growth and earnings. A projected cash flow statement can be prepared to anticipate what might happen next month.

How to Calculate Net Cash Flow

Net cash flow is calculated by taking total cash inflows minus total cash outflows. Alternatively, it can be calculated by adding the three types of cash flow: operating, investing, and financing. 

Net cash flow is what is left after a company pays its liabilities. A positive net cash flow indicates the company is a good investment. It could also indicate that bills haven’t been paid yet or supplies haven’t been ordered. That’s why timing can be used to even out cash flow.

A negative cash flow may mean trouble, or the company just took out a loan to pay for operations. In that case, the lower cash flow may be short-lived.

How to Calculate Operating Cash Flow

Operating cash flow is the most complicated of the three types. To calculate operating cash flow, take your operating income, add back non-cash items such as depreciation, subtract taxes and then calculate the change in working capital.

Non-cash items include depreciation and amortization. 

Net Cash Flow Formula

Net cash is the amount of money a business makes or loses during a period of time. It helps determine how much cash your business generates and lets you know whether you can sustain your business in the short term.

You are on the right track if your company generates positive cash flow each month and shows steady growth. 

The calculation is straightforward:

Net Cash Flow = Total Cash Inflows – Total Cash Outflows 

The inflows and outflows come from operating, investing, and financing activities. The result is a good indicator of profitability.

Operating Cash Flow Formula

Operating cash flow is a fundamental metric of a business. It determines whether the business can sustain operations. Operating cash flow allows companies to launch new products or services, pay dividends, and reduce debt.

Operating Cash Flow = Net Income + Non-Cash Expenses – Change in Working Capital 

• Net income comes from the income statement
•  Non-cash expenses do not affect cash flow but impact the income statement’s bottom line. Examples include depreciation, amortization, unrealized gain or loss, impairment expenses, stock-based compensation, deferred income taxes, write-down of assets, and provisions for future losses. Non-cash items can be estimated based on calculations.
• Working capital is calculated from the balance sheet and is the difference between current assets and current liabilities. This money is used to pay short-term expenses. This impacts cash flow when assets grow, and liabilities shrink, or vice versa. This change is reported on the cash flow statement. Working capital can fluctuate. For example, if a company bought a new piece of equipment, it would alter cash flow and cause a change in current assets, but it would not affect current liabilities because the debt is not current.

A step further is calculating free cash flow, which is the amount of disposable income at hand.  Take your operating cash flow and take out money for capital expenditures. Use this to prioritize investments.

Whether an investment is wise can be further evaluated by looking at discounted cash flow.  This takes an investment and discounts it using a standard formula to find out whether the investment will hold its value or generate cash in the future.

The Final Say On Cash Flow

It pays to spend time figuring out cash flow. There are several methods to ascertain financial health. Start with the three statements—the balance sheet, the income statement, and the statement of cash flows. Analyze those results to determine where to generate more inflows and curb outflows.

Cash flow is relatively simple to determine, and there are various actions to implement to affect the numbers on the statement. The important thing about cash flow is having enough money flowing into the business to pay invoices and keep operations rolling (without accumulating too much debt). After that, you can concentrate on growth. 

Do you have more questions about cash flow or these financial statements? Do you need actionable steps to improve cash flow? Click on the top of this page for more resources to help you keep more of your cash.