Why do some profitable businesses still fail? The answer may surprise you.
Over 60% of business failures aren't due to lack of profit, but a more silent issue: running out of cash.
That's right! A staggering 82% of these business failures are due to poor cash flow management or simply a fundamental misunderstanding of what cash flow really means.
Consider this: one-third of small to medium-sized businesses have had to resort to overdrafts because of delayed payments impacting their cash reserves.
The consequence? Poor cash flow forecasting and financial management are fundamental reasons behind the root of 80% of business failures.
With these figures in mind, it's clear that understanding how to calculate and manage
cash flow is absolutely crucial for the survival and success of a business. So, let's dive deep into this essential aspect of business and find out how to calculate cash flow.
Cash flow is the net amount of cash transferred into and out of a business,and it serves as a vital indicator of financial health and operational efficiency.
Positive cash flow occurs when the cash inflow from sales, investments, and other sources exceeds the outflows for expenses and taxes. This is a sign of a robust financial foundation.
Conversely, negative cash flow suggests that a business is spending more than it is earning, potentially leading to financial difficulties.
Here's the formula to calculate net cash flow:
Cash Flow = Cash Inflows − Cash Outflows
This formula can be broken down further to assess specific areas of your business:
- Cash Inflows: Include cash received from sales, investment returns, loans, and other sources.
- Cash Outflows: Comprise cash spent on operating costs, taxes, debt repayments, and investments.
So, how does Cash Flow differ from Profit?
While profitability is often seen as the yardstick for business success, it doesn't provide the full picture. Profits, calculated as revenue minus expenses, reflect theoretical earnings and don’t account for the actual cash available to you.
Cash flow, however, offers a more tangible assessment of your financial status.
It shows the liquidity available to meet debts, fund operations, and grow your business.
Therefore, even a business that appears profitable can face operational hurdles if its cash flow is negative, lacking the liquid assets necessary to cover immediate expenses.
Suggested Reading: How to Leverage Key AR Metrics to Drive Business Decisions
Cash flow is essential to business operations, and it can be categorized into different types based on the activities that generate or consume cash. These types reflect how a business earns and spends cash, crucial for strategic planning and management.
Here’s an in-depth look at each type and how they are calculated:
What It Is: Operating cash flow (OCF) is the cash generated from the normal business operations. It's a direct reflection of how well a company can produce cash from its core business activities.
How to Calculate:
OCF = Net Income + Non-Cash Expenses + Changes in Working Capital
Example: Suppose a company has a net income of $100,000, non-cash expenses (depreciation and amortization) of $20,000, and an increase in working capital of $10,000 (indicating more cash tied up in inventory and receivables).
The operating cash flow would be:
$100,000 + $20,000 − $10,000 = $110,000
This positive OCF indicates that the company is generating sufficient cash from its core business operations.
What It Is: Investing cash flow includes cash used for or generated from investment activities, such as purchasing or selling fixed assets like machinery or buildings, or acquiring stakes in other businesses.
How to Calculate:
CFI = Cash Received from Sales of Assets − Cash Used to Purchase Assets
Example: If a company sells old equipment for $15,000 and buys new equipment for $50,000, the investing cash flow would be:
$15,000 − $50,000 = − $35,000
A negative CFI indicates that the company is investing in its future growth by acquiring new assets.
What It Is: Financing Cash Flow includes the cash exchanges between a company and its stakeholders and lenders. This involves issuing or buying back company shares, dividend payments, and borrowing or repaying loans.
How to Calculate:
CFF = Cash Inflows from Financing − Cash Outflows from Financing
Example: If a business issues new shares worth $40,000 and repays loans worth $25,000, the financing cash flow would be:
$40,000 − $25,000 = $15,000
Positive financing cash flow suggests inflows from financial activities, possibly from taking on new debt or selling equity.
To determine a company's net cash flow, add the cash flows from operating, investing, and financing activities.
Net Cash Flow = OCF + CFI + CFF
Total Cash Flow = $110,000 + (−$35,000) + $15,000 = $90,000
This approach to categorizing and calculating cash flow helps businesses manage their finances effectively, ensuring they have the necessary cash to meet obligations and invest in growth opportunities.
Free Cash Flow (FCF) represents the amount of cash a company generates after it has paid out the cash required to maintain or expand its asset base.
FCF = Operating Cash Flow (OCF) − Capital Expenditures (CapEx)
To calculate Free Cash Flow (FCF), follow these steps:
- Calculate Operating Cash Flow (OCF), which represents the cash generated from the business's regular operations, as found in the cash flow statement.
- Determine Capital Expenditures (CapEx), which includes the funds a company uses to purchase, upgrade, or maintain physical assets such as equipment, property, or industrial buildings.
Suppose a company’s annual operating cash flow is $120,000, and its investments in capital expenditures are $30,000 for the year.
The FCF would be calculated as follows:
FCF = $120,000 − $30,000 =$90,000
This $90,000 represents the cash available to the company for expanding operations, paying dividends, or reducing debt, after maintaining its capital assets.
Why FCF Matters?
Free Cash Flow is an essential measure for stakeholders to assess how well a company generates cash that can be allocated to pay dividends, invest in expansion, or reduce debt.
It offers a deeper understanding of the actual cash generated by the company, which is a vital indicator of its financial health and future growth potential.
The cash flow statement is an indispensable financial report that tracks the flow of cash in and out of a business over a specified period.
Here are the insights include:
- The cash flow statement directly measures the amount of cash a company has on hand to pay bills and make investments, which is crucial for maintaining daily operations without financial stress.
- The statement is divided into three parts—cash flows from operating activities, investing activities, and financing activities. This separation helps stakeholders understand where the cash is coming from and how it is being used, whether it's for maintaining operations, investing in the business, or financing debts.
- Unlike the income statement, the cash flow statement does not include future incoming and outgoing cash that has been recorded on credit. Therefore, it provides a more accurate picture of a company's cash on hand.
Wrapping up, it's evident that mastering cash flow management is crucial for any business aiming to sustain and expand, particularly in uncertain economic climates.
However, manual efforts of these processes can be tedious, time-consuming, and prone to errors.
Constant, a financial automation platform, integrates seamlessly with your existing financial tools and provides real-time insights into cash flow, allowing businesses to continuously monitor their financial status and make swift, informed decisions.
This platform facilitates the automation of repetitive tasks and offers detailed forecasts and reports, which helps businesses understand their financial health and strategize for future growth.
Constant simplifies financial management by consolidating various AR operations within a single platform, from invoice processing to payment executions.
Plus, Constant's AI-powered tools deliver predictive analytics on cash flow trends, supporting precise forecasting and strategic planning.
To explore how Constant can benefit your business operations and financial management, consider booking a demo today.
