Calculating cash flow for your business

Your business's cash flow is an accurate measurement of how much money is moving into and out of the business at a certain point in time. Whether calculated monthly, quarterly or yearly, cash flow estimations can help you prepare for financial stability by predicting upcoming shifts in your earnings and identifying potential areas of surplus or shortfalls. To help with cash flow management and give you insights into how to calculate cash flow and use those calculations to their full potential, Capital One has gathered some of the most important details for you to know.

There are several cash flow analysis formulas that you can use. Each formula provides unique insights into a cash for your business strategy, so it's important to use the one that's most appropriate for your purposes. There are 5 valuable cash flow projection formulas:

• Cash flow statement
• Free cash flow
• Operating cash flow
• Cash flow forecast
• Discounted cash flow

A cash flow statement is probably the most common way to calculate cash flow. One of the 3 core financial statements used in business accounting, the cash flow statement shows how cash is moving into and out of your business over a specific period of time. It provides insights into why your cash flow is what it is, such as from unrealized earnings or unsettled debts. You'll likely need information from your business's profit and loss statements to fill in the cash flow statement spreadsheet. It's important to note that a cash flow statement does not specifically give insights into profits or losses.

The cash flow statement formula should look like this:

Cash from business operations +/- Cash from investments +/- Cash from financing + Initial cash balance = Final cash balance

You may notice the plus and minus signs in 2 places in the formula. This is to account for expenses and earnings in each cash category. These categories include:

• Business operation activities: Money earned from or put toward running your business's daily operations
• Investing activities: Money put into investments and assets like securities, bonds and equipment, and money earned from selling these assets
• Financing activities: Money from loans or owner capital contributions and money spent to reduce loan balances or pay shareholders or owners

As you work through the formula, you'll subtract expenses and add earnings appropriately to gain insight into how money has moved within your business.

Here's a simple example of a cash flow statement for a fictional small business called Patty's Pet Portraits:

In this example, Patty's business earned total income of $2,375 for the month, as seen in the net income row. The following explains each row: 

Additions to cash

• Depreciation: Patty's equipment depreciated by $100. But depreciation does not decrease cash, so it is added back to her net income.
• Increase in accounts payable: Patty owes $400 to a contractor for repairs to her studio. This is money owed but not yet paid, so it is added back to her cash on hand.
• Decrease in accounts receivable: Patty invoiced clients $500. That money has not yet been received, so it is not considered cash. It is added to the cash her business does have. She had a decrease in accounts receivable, which means an increase in cash.

Subtractions from cash

• Increase in inventory: Patty purchased $45 in supplies to use in the business. Inventory is not cash, so that amount must be deducted.
• Taxes payable: Patty must put away $62 this month to meet her year-end tax bill. This is money owed but not yet paid, so it is added back to her cash on hand.
• Net cash from operations: Patty has $3,392 in net cash from operations this month, which is the product of adding and subtracting the previous amounts from net income.

Cash flow from investing

• Purchase of equipment (capital expenditure): Patty purchased $350 in equipment. It is deducted from net cash from operations.

Cash flow from financing

• Notes payable: Patty tapped her line of credit for $200. This amount is added to the net cash from operations amount. 

Even though the net income for the business was $2,375 for the month, Patty's Pet Portraits actually has $3,242 in cash entering and leaving.

Unlike a cash flow statement, a free cash flow calculation shows how much cash your business has available to spend after paying for expenses that support operations and capital expenditures—the money spent to purchase or maintain fixed assets like land, buildings and equipment. This calculation can show how efficient your business is in generating cash and profits. The calculation does have limitations because each individual business may have different guidelines that determine which assets will be used as capital expenditures, which can affect the accuracy of the calculation.

The free cash flow calculation should look like this:

Net income + Depreciation and/or amortization - Change in working capital - Capital expenditure = Free cash flow

Reference your company income statement, balance sheet and cash flow statement to find the components that you use in the free cash flow calculation. Those components include the following:

• Net income: You'll find the net income figure on your income statement. It is the amount of money your business earned during a specific period of time after you deduct all expenses, including salaries, cost of goods or materials, taxes, rent, marketing, advertising and more.
• Depreciation and/or amortization: You'll find the depreciation and amortization figures on your income statement. Depreciation is the amount of value your business’s assets (like vehicles or equipment) lose over time. Amortization spreads out the cost of an intangible business asset like a trademark or patent over time.
• Working capital: Working capital is your business's total current assets minus its total current liabilities, and you can find these figures on your balance sheet. To calculate the change in working capital, you would find the difference between the current period's working capital and the previous period's working capital.
• Capital expenditures: You'll find the capital expenditures figure on your statement of cash flow. It's the amount your business spends on fixed assets like buildings, computers, other office equipment, machinery and vehicles that will be used for more than one year.

To calculate Patty's Pet Portraits' free cash flow, begin by looking at her balance sheet and income statement.

Using figures from both charts and the calculation, her business’s free cash flow statement would look like this:

Net income + Depreciation and/or amortization - Change in working capital - Capital expenditure = Free cash flow

While the cash flow statement indicates that Patty’s business has generated $2,375 in cash for the month, that amount does not include payment for this month’s operating expenses. The free cash flow statement shows that her business will have $1,025 this month once she pays her expenses.

While free cash flow gives you a picture of the cash position of your business after expenses are deducted, operating cash flow shows what your business earns from normal daily operations. It can accurately calculate how successful your business is in generating cash flow that can cover general operating expenses. A positive operating cash flow indicates that your business is able to successfully sustain operations over time. A negative operating cash flow may indicate that your business needs an infusion of cash from a loan or owner equity.

There are two ways to calculate operating cash flow: the direct method and the indirect method, depending on reporting and regulatory compliance requirements. 

The direct method of calculating operating cash flow is pretty straightforward but only works if your business uses a cash-based accounting system. Following is the direct method of calculating operating cash flow:

Total revenue - Operating expense = Operating cash flow

• Total revenue: You'll find the total revenue figure on the income statement. This is the total amount a company earns from selling its products or services. 
• Operating expenses: You'll find the operating expenses figure on the income statement. These are the costs for normal business operations, including rent, inventory expenses, insurance and more.

Most businesses don't use a cash-based accounting system. Instead, they use an accrual-based accounting system that records revenue when it is earned and expenses as they occur. Following is the indirect method of calculating operating cash flow:

Net income +/- Changes in operating assets and liabilities + Non-cash expenses = Operating cash flow

• Net income: You'll find the net income figure on the income statement. Often referred to as the bottom line, this figure is the result of subtracting all expenses and costs from all earnings in a given time period.
• Changes in operating assets and liabilities: You'll find the changes in operating assets and liabilities figures on the balance sheet. These can include increases or decreases in accounts receivable, inventory, prepaid expenses and more. To calculate changes in operating assets and liabilities, find the difference between the current and previous period’s assets and liabilities.
• Non-cash expense: You'll find the non-cash expense figure on the income statement. This expense includes depreciation, amortization, depletion and deferred charges, asset write-downs and more.

To calculate Patty's Pet Portrait's operating cash flow, begin by looking again at her balance sheet and income statement.

To calculate operating cash flow using the direct method, use the figures from both charts and the calculation. The operating cash flow calculation would look like the following: 

Total revenue - Operating expenses = Operating cash flow
 

To calculate operating cash flow using the indirect method, use the figures from both charts and the calculation. The operating cash flow calculation would look like the following: 

Net income +/- Changes in operating assets and liabilities + Non-cash expenses = Operating cash flow
 

Both show what the business earned from normal daily operations this month.

Successful businesses look to the future to plan and manage trends that can help the business grow. A cash flow forecast helps business owners understand how much cash the business is likely to have within a future window of time. This provides you with insights into where and when your business may need additional funds in order to prevent a cash flow shortage. It can also help pinpoint when there is likely to be excess cash to invest in your business.

Keep in mind that a cash flow forecast is an estimate, so there is a degree of probability involved. You will need to make assumptions for this forecast, like predicting inflation, changes in tax requirements and company growth. It’s important to update these assumptions regularly based on business goals and economic insights for your forecast to be as helpful as possible. Overall, a cash flow forecast is a good short-term tool used with other business planning solutions and tools to guide an enterprise.

The cash flow forecast formula should look like the following:

Beginning cash + Projected inflows - Projected outflows = Ending cash

In the Patty's Pet Portraits example, assume Patty has kept good records and has a clear understanding about typical income inflow and expense outflow. For this calculation, you need to understand:

• Beginning cash: You'll find your cash on hand in your cash flow statement. This is the current amount of cash on hand today. 
• Projected inflows: Estimate projected inflows of money by looking at your previous accounts receivable on your balance sheet.
• Projected outflows: Estimate projected outflows of money by looking at your previous accounts payable on your balance sheet.

To calculate Patty's Pet Portraits' cash flow forecast, begin by looking again at her balance sheet and income statement.
 

To calculate the cash flow forecast, use the figures from both charts and the calculation. The cash flow forecast calculation is as follows:

Beginning cash + Projected inflows - Projected outflows = Ending cash

In this calculation, Patty can predict that there could be some additional cash flowing into the business next month and then plan on how to best use that. Perhaps it can pay down debt or be used to increase marketing initiatives.

As a company grows, there may be an advantageous opportunity to purchase another business, hire a larger group of employees, start a large capital project or, alternatively, sell the business. A discounted cash flow formula evaluates the value of that investment or your business based on the expected future cash flow of the business. It provides insights to help you understand whether an investment will be worthwhile or to prove to a buyer that purchasing your business would be a good financial decision.

A discounted cash flow valuation is complex, and inaccurate estimations may skew outcomes. This type of valuation is best provided by the CPA or financial professional who knows your business.

The discounted cash flow valuation formula should look like this:

Sum of cash flow in period ÷ (1 + discount rate)^{period number} = Discounted cash flow

For this calculation, you'll need to understand the following: 

• Cash flow in period: This number is the amount of cash flow the company has after subtracting expenses at the start of the valuation.
• Discount rate: This number is the interest rate used to discount future project cash flows back to current-day value. It also represents the rate of return the business expects on its investment. This requires its own calculation: (Future Value/Present Value)^{Number of Periods} - 1.
• Period number: This is the number of months, quarters or years you want to determine the discounted cash flow for.

Calculating discounted cash flow valuation is complex and best provided by the CPA or financial professional who knows your business.

Here's an example of what a discounted cash flow valuation for Patty's Pet Portraits could look like. Assume Patty is interested in making a $24,500 investment in state-of-the-art photography equipment. Will the investment be worthwhile for the business? The company has the following information available:

Cash flow in period = $450,000
Discount rate = 15%
Period number = 3 years

Now, use the discounted cash flow formula:

Sum of cash flow in period ÷ (1 + discount rate)^{period number} = Discounted cash flow

$450,000 ÷ (1 + .15)³ = $295,882.30

In this calculation, Patty will pay less than the discounted cash flow value for the piece of photography equipment ($24,500). The calculation allows her to project that the rate of return is likely to be higher than the discount rate. 

Understanding your business's cash flow gives you the insights you need to make decisions that can move your business ahead and keep it resilient. By regularly reviewing income and expenses and using any of the 5 calculations presented here, you can have a better handle on when to conserve cash, get an infusion of funds or spend to enhance your output or expand your business.