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What Is Cash Flow? Understanding the Role of Cash Flow in Business (2023)



Anyone with a personal checking account understands the challenge of keeping track of the money available to pay the bills. The point of watching a checkbook is to ensure the money coming in exceeds the money going out. The movement of money in and out of a checking account represents cash flow.

Businesses are like households in that respect. They must keep a close eye on their checkbook to maintain a positive cash flow, or to anticipate a possible negative cash balance by sourcing (or raising) money from other sources. Ahead, learn more about the different types of cash flow.

What is cash flow?

Cash flow is a record of both money received (cash inflow) and money paid (cash outflow) during a given time period. Effective cash flow management ensures there’s more inflow than outflow.

Accounts receivable, or money owed to a business, and accounts payable, money owed by a business, are ignored in cash flow. They are recorded in another financial statement, the balance sheet, of a business’s total assets and liabilities. Only once receivable amounts are collected, and payable amounts are paid, does a business record them as net cash flow.

What is a cash flow statement?

Your cash flow statement is a business financial statement that records the inflow and outflow of your business. It keeps a record of when cash was received and when cash was spent, covering operating activities, investing activities, and financing activities.

You can use cash flow statements to analyze your cash position, which is essential to your business’s financial health.

What is cash flow management?

Cash flow management is when a business monitors, analyzes, and optimizes its inflow and outflow of cash. This involves ensuring it has sufficient funds available to meet financial obligations, such as paying bills, salaries, and loan repayments, at all times.

3 types of cash flow to know

  1. Cash flow from operations
  2. Cash flow from investing
  3. Cash flow from financing

There are three main types of cash flow recognized in business accounting. US companies typically list them in quarterly financial reports in a statement of cash flows. The cash flows are:

Cash flow from operations

Operating cash flow tracks the flow of money that stems from the production and sale of a company’s goods and services. It includes cash received from the company’s business operations minus cash expenses, which includes the cost of goods sold and held, plus general and administrative expenses.

Cash from operations is the most important because it shows whether a company is viable and bringing in enough money on a regular basis to pay its bills without needing outside financing.

Cash flow from investing

This tracks money spent or received to buy or sell assets used in the business, such as property and equipment. It also includes money spent to buy stocks, bonds, or other securities, and money received from selling securities.

While cash from investing may show a negative balance, it’s not necessarily a red flag if the cash is invested in income-producing assets like inventory or in activities such as research and development that can bring about future sales and profit.

Cash flow from financing

Cash flow from financing accounts for money the business receives from outside sources to fund its operations, including proceeds from loans or bond sales, the sale of an equity stake to an investor, or a public offering of shares. It also accounts for money spent to repay loan or bond principal (the interest paid on loans and bonds comes out of cash from operations), repurchase shares or equity stakes, and pay any dividends.

Cash from financing shows how much a business is relying on outside sources of money, rather than internally generated cash from operations.

There are additional types of cash flow, which you can explore in these posts:

Cash flow vs. profit

A business’s profit and cash flow can be quite different, because of the differing methods of accounting. Income statements (also called profit-and-loss statements) use accrual accounting, which means sales, expenses, and profit are recorded as they’re incurred in a given period, regardless of when money is received or paid.

So for example, a company that sells $10 million in goods during a given period of time records the full amount on the income statement, even if all $10 million hasn’t yet been collected from customers.

Similarly, if expenses are $8 million, they’re fully recorded because they were incurred during that period, even if payment of some of the expenses was deferred. Cash accounting, in contrast, records only the portion of sales that were collected in the period, and the portion of expenses that were actually paid.

Example of profit vs. cash flow

Here’s a hypothetical example of how profit and cash flow can differ, based on accrual accounting versus cash accounting:

An entrepreneur with a business making sports apparel has seen the business grow to about $10 million in monthly sales. Expenses of $8 million yield a profit of $2 million.

But half of the sales, or $5 million, are on 30-day payment terms from customers, leaving $5 million in cash sales.

Meanwhile, the entrepreneur pays $4 million of the monthly expenses in cash, and the remaining $4 million will be paid on 30-day credit terms.

So while the business’s profit was $2 million, cash flow was half that amount:

$5 million cash sales – $4 million cash expenses = $1 million

Accrual accounting is guided by something called the matching principle: sales for a specific period are matched with expenses associated with the production of the sales. So in the example above, the $10 million in sales and $8 million in expenses are matched in the same period, rather than just the cash portion of each in cash accounting.

How to calculate cash flow

You can calculate cash flow in a few different ways, depending on what type of cash flow you’re focusing on. Three often-cited types are listed below, with the cash flow formulas for calculating each.

You don’t have to be a mathematician—you can also use online tools and calculators to help, like the Shopify cash flow calculator. Just plug in your numbers to get the results.

 

Screenshot of Shopify cash flow calculator
Use the free Shopify cash flow calculator to get a picture of your business’s financial health.

 

Operating cash flow

Companies can vary in their formulas, depending on the amount of details they provide. Many big companies provide a line item that accounts for their operating cash flow. But in the absence of a cash flow statement, you could use this basic formula to figure it out:

Net income + non-cash expenses – change in working capital – taxes = operating cash flow

Non-cash expenses from the income statement are added to cash flow. These expenses include depreciation of asset values and stock-based compensation to employees. Net change in working capital is subtracted—working capital is current assets minus current liabilities. Taxes are subtracted because they must be paid in cash.

Free cash flow

Free cash flow is simply how much cash you have to operate with, minus spending to maintain or upgrade the business’s assets, such as factories and offices. Such spending is called capital expenditure, or capex, and the free cash flow formula is:

Cash flow from operations – capex = free cash flow

Free cash flow, which is calculated by financial analysts and corporate managers, is a key measure of the strength of a business, because it shows how much money the business has at its disposal to use for expansion, acquisitions, pay dividends or buy back stock, or repay debt. It gauges how well a company can rely on its own resources without needing outside financing.

Cash flow forecast

Just as a business creates a budget and a seasonal forecast for sales growth and profitability, it might consider a forecast for cash flow. A simple formula could be:

Beginning cash balance + projected inflows – projected outflows = cash flow forecast

Projections may need to incorporate any expected price and cost changes during the forecast period—for example, if the business foresees a 10% increase in its product costs and overhead, and plans to raise its prices by 12%. Cash flow forecasts may need continual monitoring and adjusting, based on how money actually flows into and out of the business.

Cash flow is crucial to your business

You might not have pictured yourself fiddling in spreadsheets when you started your business, but some of these not-so-glamorous processes are actually critical to success. Without a handle on your cash flow, you could run out of money to keep the doors open. Luckily, there are calculators, templates, and formulas to help you get on top of your business’s cash flow and improve profitability.


Cash flow FAQ

What’s an example of a cash flow?

An example of a cash flow would be collection of money from a customer (an account receivable, cash inflow). Another would be payment to a supplier, or payment of rent for a warehouse (accounts payable, cash outflow).

What are the different types of cash flows?

Cash from operations, cash from investing, and cash from financing.

What’s an example of a positive cash flow?

A hypothetical sports-apparel business collected $5 million of its $10 million monthly sales in cash, and gave customers 30 days to pay the other $5 million. The business paid $4 million of its $8 million in monthly expenses in cash, deferring payment on the other $4 million. So the business’s positive cash flow for the month is: $5 million – $4 million = $1 million



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