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What is cash flow and how to calculate it
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Updated 25 March 2024

What are cash flows and how to calculate them

If you want to start, control and successfully manage a startup, the concept of “cash flow” must be absolutely clear to you. If you do not know what we are talking about, you would do well to read very carefully this guide dedicated, precisely, to the so-called cash flow. Here you will discover how to ensure liquidity and support your company’s growth by implementing some precise and very effective strategies. To avoid making mistakes, however, first of all, you need to clarify what cash flow is.

 

What is cash flow? Meaning

Jeffrey Fry once said:

“Profits are like food for a startup, but cash flow is water: without it, the company cannot survive.”

These words explain the importance of cash flows very well, but they do not fully clarify what it is really about. Out of metaphor, you should know that the meaning of cash flows refers to any change in liquidity within a company and, more specifically, to the continuous movements of money (both inflows and outflows) affecting the company’s cash over a given period of time.

 

What is cash flow

What is cash flow

 

It is also important for you to know that cash flow analysis is what allows you to make strategic decisions in relation to business cash management, that is, in the area of payments to your employees, your suppliers, the IRS etc.

While liquidity ratios give you a static picture of your company’s financial management, cash flows investigate the changes that occur over time, showing how much money is in cash and thus giving you an understanding of whether or not the monetary movements in cash are able to cover working capital needs.

 

Difference between cash flow and operating income

To fully clarify the definition of cash flow, the difference between cash flow and operating income should now be clarified.

To do this, you need to take a sales invoice as an example: when you issue the invoice you record revenue in the income statement, and when the customer pays you record a cash inflow. Keep in mind, however, that these two transactions can also occur months apart and even straddle two different years.

Although payment deferrals are a well-established practice in business-to-business relationships, for an entrepreneur (especially a novice one) this can be a huge problem because several business expenses require, instead, immediate payment (just think of personnel costs). This mix of factors can create liquidity problems even when there is a positive operating result (revenues minus expenses).

Thus, in order to keep corporate liquidity under control, it is necessary to identify all transactions that have a time gap between the time when an economic effect occurs (accrual principle) and the time when the corresponding financial effect is determined (cash principle).

 

Difference between cash flow and operating income

Difference between cash flow and operating income

 

Types of cash flow

We have just explained what is meant by cash flow, but it is important now to point out that there are different types of cash flows, which differ from each other according to the specific business activity with which they are associated. Let us discover them together now.

 

Operating cash flow

Operating cash flow, also known as free cash flow, refers to the money flowing in and out of the company’s coffers through transactions that are directly related to the operation of the business itself, without taking into account financing costs.

 

Cash flow from investment

Cash flow from investments, on the other hand, describes the money injected or spent in connection with the company’s investments, whether they are financial products that can be easily converted into cash or purchases of property and fixed assets (both tangible and intangible).

 

Financial cash flow

Last, but certainly not least, there is financial cash flow: this refers to cash movements related to the company’s financial investments, such as the payment of receivables or money received from the issuance of shares.

 

How to calculate cash flows

There is often confusion between cash flow management and cash budget management: while the former concept, as mentioned, refers to changes in a company’s liquidity over a given period of time, the cash budget (also known as the financial budget) is the financial planning tool that has as its object precisely cash flow management.

 

Schedules for cash flow analysis

Schedules for cash flow analysis

 

To plan, of course, it is essential to know, first, how to calculate cash flow. In this regard, you must keep in mind that the formula for calculating cash flow takes into account different data depending on the type of flow you intend to analyze. That said, it is time now to find out how to calculate cash flow.

 

Flow monitoring and analysis

If you want to keep track of and analyze your startup’s cash flow, you need to take as your reference point the cash flow statement, which is that accounting document that is prepared at the end of the fiscal year and includes within it everything about the company’s cash and cash equivalents during that particular period.

Analyzing cash flow, mind you, means that the numbers should not simply be observed, but rather interpreted in relation to the strategies adopted by the company and its financial policy. Cash flow analysis, in fact, gives the possibility to understand whether the financial management pursued by the company is correct or not and, more concretely, allows to evaluate the sources of resources and their destinations.

 

Alignment between inputs and outputs

Speaking generally, for the calculation of cash flow, one has to analyze the cash receipts and cash outflows in the company’s cash, that is, the money the company earns and the money it spends. The difference between monetary income and monetary expenditure is cash flow.

Pay close attention to this value because if it is negative, it means that the company has spent more than it has collected and will certainly run into problems.

 

Financial forecasting and planning

If one considers the change in liquidity over time, another way to calculate cash flow is to consider the company’s final liquidity in relation to its initial liquidity: a simple subtraction between these two factors returns a particularly meaningful figure because it describes the company’s performance over a given period.

The change in liquidity over time becomes even more valuable from a future and strategic perspective, since the prerequisite for being able to prepare accurate forecast statements is precisely to analyze what has happened in the past and what is happening in the present. In more practical terms, in order to have an accurate idea of future financial needs, it is essential to understand what factors have determined (or are determining) cash flows.

 

Example of cash flow calculation

A practical example will help you understand even better how cash flow calculations work and what factors affect them.

Luca is the owner of a small startup. His business is doing very well and his turnover has grown but this has necessitated the purchase of new machinery and the hiring of new employees. His prices provide him with good margins but, despite a positive operating profit and growing turnover, his account may be in the red and the lack of cash could bring his business to a halt, even if business is going well.

The reason for this is related precisely to cash flows. Remember, in fact, that income and expenses are related to costs and revenues, but these factors travel with different time frames.

Costs and revenues are purchase and sales invoices, personnel costs, depreciation, taxes etc. related to a given period. Income and expenses, on the other hand, are, for example, payments and receipts, which time-wise can occur with different due dates and thus can be a problem.

Receivables from customers who purchase products (the invoices issued and recorded) are collected by Luca at 90 days. Keep in mind that, at the beginning of the year, Luca collected the previous year’s invoices. In fact, the cash flow is the difference. Accounts payable works similarly but the effects are opposite because suppliers are usually paid immediately and few payments can be deferred to the following year.

Another factor to consider is inventory: increased customer demand has prompted Luca to increase inventory, but this choice represents additional cash outflow, with money leaving the account to end up on the shelves. When Luca succeeds in decreasing inventory, he will have a positive flow because the calculation is the change between ending and beginning inventory.

Self-financing is calculated from the income statement values by adding depreciation of equipment, machinery and other tools to the operating result. Luca, in past years, purchased some machinery, paying for it immediately, and now there is depreciation in his balance sheet, which does not result in cash outflows.

Chapter banks: although not in the income statement, existing mortgage payments and new disbursements generate cash flow. Not requiring new mortgages to finance growth, Luca must meet the repayment of previous mortgages, which results in an outflow.

Severance pay is calculated as an expense each year but the outflow of money occurs when the employee is paid off.

Transactions by partners and owners of the firm, such as contributions, withdrawals, and dividend distributions, are also cash flows. Let’s say that Luca has never withdrawn profit from the firm and, just this year, he put some of his personal savings into the firm’s account. This certainly provided a momentary liquidity benefit, but, as mentioned earlier, it may not have been enough.

In fact, all of these factors (plus other lesser technical ones) affect cash flow either positively or negatively. The means by which to keep them under control is the aforementioned cash flow statement (mandatory for all companies except micro-enterprises and those that prepare condensed financial statements).

 

Factors affecting cash flow

Factors affecting cash flow

 

Useful tools and software for calculating cash flow

By now it must be clear to you: monitoring and analyzing cash flow allows you to understand whether your business is healthy or not.

Given the importance of this indicator, it is essential to avoid any error, even the smallest, in calculation. To avert this risk, it is possible to use treasury software, which makes it possible to automate monitoring and eliminate manual calculation (and all the risks associated with it). Not only that: such a tool also gives the possibility to observe cash changes updated in real time. That’s not all: with such a tool it is also easier, based on the recorded data, to create forecast scenarios and plan a winning strategy for the future.

 

Cash flow: next steps

At the beginning of this guide, cash flow was probably an almost obscure subject for you; now, however, you have all the theoretical tools to carefully handle this critically important indicator for your startup. The next step is to move from theory to practice, surrounding yourself with experts and choosing the software most useful for your specific needs.

Nicola Zanetti

Founder B-PlanNow® | Startup mentor | Startup consulting & marketing strategist | Leading startup to scaleup | Private angel investor | Ecommerce Manager | Professional trainer | Book writer

info@b-plannow.com

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