There are key formulas small-business owners should know for keeping track of cash inflows and outflows. These formulas help ensure you have enough cash not only to survive, but also to grow and expand. Lenders and investors also look at these metrics to assess the health of your business.
In this article, we’ll give you a rundown of the essential formulas every small-business owner should be familiar with to effectively manage their cash flow. But first, let’s look at the definition of cash flow formula.
What is cash flow formula?
A cash flow formula is a key element in financial analysis utilized by accountants and business owners alike. It allows for calculating a business’s net income, with cash flow statements providing valuable insights into various financial transactions.
Cash flow statements can range from those that focus solely on core business activities like manufacturing and sales to those that include ancillary income such as dividends from investments. Analysts and investors closely examine these diverse statements to assess a company’s overall financial standing.
4 important cash flow categories
A cash flow analysis helps company owners see the amount of money entering and exiting their organization. There are several ways to analyze cash flow, with some methods more preferable to operating managers and others mattering more to outside investors. Your company’s accounting objectives may determine which cash flow categories you choose to work with.
The key cash flow categories are:
- Net cash flow: Net cash flow is a financial metric that reflects the amount of cash generated or lost by a company within a given accounting period. You can calculate it by subtracting your total income from your total monetary expenditures.
- Operating cash flow: Operating cash flow analyzes if a company is generating net profit from core business operations like sales or manufacturing. It focuses on monetary inflows and outflows related to core work, excluding outside investing or non-core operations.
- Free cash flow: Free cash flow shows the total sum of money available after a company has completed its debt obligations and dividend payments. Free cash can be used for new business investments, distributed to shareholders, or spent on day-to-day operations.
- Discounted cash flow: Discounted cash flow is used to determine the net present (NPV) value of an investment.. NPV is the estimated future value of a business minus its current asking price.
How to calculate cash flows
Cash flow formulas can be simple or complex. While many businesses today use accounting software to calculate cash flow, understanding the calculations are important. Here are four main formulas used to calculate cash flow.
Net cash flow formula
Your net cash flow brings together the cash flows from different components of your business. All formulas that track net cash flow deduct a company’s expenses from its available cash, providing you with the net cash balance for the relevant accounting period. Here’s the formula you can use to calculate your company’s cash flow:
Net cash flow = Opening cash balance + (operational cash inflows - operational cash outflows) + (investment cash inflows - investment cash outflows) + (financing cash inflows - financing cash outflows)
Operational cash, investment cash, financing cash, opening balance—any of these elements can be positive or negative. For instance, a construction company may have a positive cash flow from financing activities, such as obtaining loans for new equipment or projects, but a negative cash flow with operations due to high material and labor costs. As the business matures, it may see a positive cash flow from operations as projects are completed and payments are received, but a negative cash flow with financing activities as loans are actively repaid.
Operating cash flow formula
Determining operating cash flow requires combining your sales-based operating income with non-cash expenses, then subtracting operating expense outflows and any changes in working capital. The formula is as follows:
Operating cash flow = operating income + non-cash expenses - operating expenses + changes in working capital
Operating income refers to the earnings generated before taxes and interest. Non-cash expenses include items such as issued stock and fixed asset depreciation. From this, subtract your operating expenses such as vendor fees, taxes, and interest payments, along with the change in your working capital, which represents the difference between current assets and liabilities.
Free cash flow formula
Knowing your company’s free cash flow is crucial for understanding operational spending. To calculate it, simply subtract your company’s capital expenditures (expenses related to property and equipment, as well as debt servicing) from its net operating profit after taxes (net income, depreciation, amortization, and working capital). The formula is:
Free cash flow = net operating profit after taxes - capital expenditures
This calculation helps you gauge the amount of funds available for day-to-day operations, providing valuable insights for strategic decision making.
Discounted cash flow formula
The discounted cash flow formula, unlike operating or free cash flow formulas, is more complex as it involves projected inflows and outflows to determine the net present value of an asset. Here’s a simplified explanation of the discounted cash flow formula, along with its inputs:
Formula: Discounted cash flow = (CF1)1/(1+r) + (CF2)2/(1+r) … + (CFn)n/(1+r)
Inputs:
- CF1: Cash flow for first year
- CF2: Cash flow for second year
- n: A future period measured in years
- CFn: Cash flow for future years
- r: Discount rate or internal rate of return (IRR)
Note: The ellipse (…) in the formula indicates that you add new inputs for each year until you reach the desired number of years in the future (denoted as n).
Investors use discounted cash flow to assess a company’s investment potential. They forecast the net income and cash balances for several years into the future to evaluate whether it is worth the risk.
Lenders also rely on it to evaluate the safety of extending business loans. If they anticipate multiple years of negative cash flow, they may choose not to lend to the company.
The discounted cash flow formula is a powerful tool for financial analysis and decision making in investment and lending scenarios.
Using cash flow formulas for your business
Keeping a close eye on cash flow is crucial for small business owners. Crunching those numbers may not be thrilling, but it’s vital to avoid unwelcome surprises. Understanding cash flow formulas gives you a holistic view of your financial health. It helps you spot and address any cash flow issues proactively.
By optimizing operations and strategically managing cash flow, you can navigate financial challenges and pave the path to long-term success.
Cash flow formula FAQ
What are three types of cash flow?
1) Free cash flow, which shows cash on hand after capital expenditures
2) Discounted cash flow, which helps investors determine the net present value of a company
3) Operating cash flow, which measures the cash flow generated from day-to-day operations
What is an example of cash flow?
Imagine a bustling coffee shop to understand the application of a cash flow formula. The shop has an operating income of $25,000 but incurs non-cash expenses of $2,000 for equipment depreciation. Additionally, it pays $3,500 in taxes and there are changes in working capital, with a decrease of $1,000 for coffee beans and milk expenses.
Let’s now apply the cash flow formula: Operating cash flow = operating income + non-cash elements - taxes + changes in working capital. By plugging in the numbers, we arrive at $25,000 + (-$2,000) - $3,500 - $1,000 = $25,500. This indicates that the shop is managing its cash flow quite well.
This example perfectly illustrates how the cash flow formula serves as a valuable tool for assessing the financial performance of a thriving coffee shop, empowering business owners to make informed decisions about their operations.
How do you calculate cash flow from a balance sheet?
A balance sheet encompasses a plethora of elements that go beyond a cash flow statement. These elements comprise assets such as accounts receivable, inventory, and fixed assets, as well as liabilities like shareholder’s equity, provisions, and financial debt.
In this case, you can determine the net cash flow by using this formula: Net cash flow = Δ financial debt + Δ payables + Δ equity –Δ receivables – Δ inventory – Δ fixed assets (where Δ signifies “change in”).
Keep in mind that this method provides an indirect means of calculating cash flow. Typically, businesses sum up the inflow of cash and subtract the outflow of cash (including cash equivalents in both cases) to determine their cash flow.