Farwah Jafri | June 9 2022
More than a quarter of small businesses fail due to cash flow problems. Calculating the cash flow may appear unimportant to some, yet it’s a task of high importance. To move forward without a hitch and keep your business financially stable, you need to master how to calculate cash flow.
Luckily, it is not too hard to do, and there are multiple cash flow metrics and formulas that make it even simpler. Just learn some basic metrics, their uses, and formulas. However, first, let’s explore the importance of calculating cash flow and how it helps avoid failure and ascertain success.
Cash flow presents a vivid picture of your business’s financial health, one you can use to lure investments, get loans, and procure the finances to take your business forward. An entity that doesn’t calculate its cash flow is deemed uninvestable by investors who use cash flow statements to assess the business value and predict the rate of return.
In addition, cash flow helps business owners take winning decisions. When you don’t know where your cash comes from and where it goes, it becomes harder to make the right decisions. Simply put, you must know what brings you money and what is sucking your business dry to make your business a success.
Perhaps the most important document for a small business is its cash flow statement. It is simply a record of your financial transactions over a defined period. Populated by three kinds of activities; operating, investing, and financing.
Operating Activities – It entails the money spent on day-to-day business operations. All kinds of financial activities, like cash payments or credits, fall right into this category.
Investing Activities – This column includes the expenses you pay to make your business work. All your investments go right into investing activities.
Financing Activities – Unlike the two, financing activities aren’t spent but attained. It includes the finances you get through capital contributions, funding, and loans.
Write down and sum up all three activities. May the individual total be positive or negative just add or subtract the three. Once you have done it, add the final sum to the cash balance at the start of your venture. The result you get is your cash flow.
Cash Flow = Operating Activities +(-) Investing Activities +(-) Financing Activities + Initial Cash Balance
Free Cash Flow, FCF, is what your business generates after factoring in the expenses spent to keep your business running daily; the cash outflows, the residual cash left over after you have incurred money on operations and physical assets needed to keep your business afloat. The first falls into operating expenses and the latter into capital expenditure.
Thus, Free cash flow is the amount left after you paid all essential business tasks and activities like payroll, taxes, rent, etc.
Calculating free cash flow is simple once you know what’s net income, depreciation and amortization, working capital, and capital expenditure.
Net Income – It is the business profits or losses after interests and taxes, the actual money that remains.
Depreciation and Amortization – The first is the loss of value of the current asset over time, and the latter is the practice of stretching the cost of a business asset (Intangible) over its lifetime.
Working Capital – It is the same as day-to-day business expenses and is the money spent on daily business activities.
Capital Expenditure – They refer to fixed business assets, including equipment, machines, and property.
Free Cash Flow = Depreciation/Amortization + Net Income – Working Capital Variance – Capital Expenditure
In words, just sum up net income and amortization/depreciation and then subtract the change in working capital and capital expenditure, and you get the free cash flow.
Operating cash flow is the cash amount generated by the business through regular operating activities over a defined period. Often, it is used in conjunction with free cash flow, net income, and other metrics to perform proper financial analysis and get a clearer picture of business financial health.
Operating income, also called earnings before interest and taxes (EBIT), is not hard to calculate. All you need to do is sum up net income, change in working capital, and depreciation and then subtract taxes from it. This metric gives you the correct picture of your business growth and profitability.
Operating Cash Flow = Operating Income + Working Capital Change + Depreciation – Capital Expenditure
To assess your business’s financial health, procure investments, and raise more capital, you must learn how to calculate cash flow. However, it isn’t so hard to do so. Just know the three basic formulas and calculate the metric you need to calculate your cash flow.
Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.