Have you ever wondered why a seemingly profitable business fails? Statistics reveal a surprising truth: more than 60% of such failures occur not because these businesses aren't generating profits but because they simply run out of cash.
That's right! A staggering 82% of business failures can be attributed to insufficient management of cash flow or a lack of understanding of cash flow itself.
In fact, 34% of small to medium-sized businesses that receive late payments have been forced to use overdrafts to fulfill their responsibilities.
The importance of managing cash flow effectively can't be overstated. Poor cash flow forecasting and financial management are at 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 success and survival of a business. So, let's dive deep into this essential aspect of business and find out how to calculate cash flow.
Cash flow, a vital measure of a company's financial health and operational efficiency, refers to the movement of money into and out of a business.
Positive cash flow occurs when more money is entering the business through avenues like sales and investments, surpassing what is leaving through expenses and taxes. Conversely, negative cash flow suggests that a business is expending more cash than it is generating.
While profit remains an important measure of a business's success, it does not offer a holistic view. Unlike cash flow, profit is more of a theoretical concept, accounting for revenue and expenses regardless of actual monetary transactions.
On the other hand, cash flow signifies the tangible movement of money, painting a more practical picture of your business's financial status.
Hence, even a business that appears profitable on paper can encounter financial issues if it suffers from negative cash flow, as it might lack the immediate cash necessary to cover expenses.
A cash flow statement (CFS) provides a detailed breakdown of how a company receives and spends cash during a specific period, usually a quarter or a year. The statement offers an in-depth look at a company's ability to generate cash and uses it as a measure of financial strength.
The cash flow statement is generally classified into three key sections: Operating Cash Flow, Investing Cash Flow, and Financing Cash Flow.
Each section reveals different aspects of a company's financial activities and provides insights into how it manages its cash.
So why is a cash flow statement important?
A cash flow statement offers crucial insights into a company's liquidity and solvency. It helps businesses and investors understand where the company's money is coming from, how it's being spent, and whether the company can maintain and grow its operations.
Cash flow can be classified into three types based on the activities that generate the cash. These categories reflect the different ways your business can both earn and spend cash. They are as follows:
Cash flows from operating activities, or operating cash flow (OCF), signifies the cash produced from a company's essential business activities. This incorporates cash inflows from customers and cash outflows for expenses such as inventory, salaries, rent, and other daily operational costs. A positive OCF shows that a company can adequately generate cash from its primary operations, signifying robust financial health.
Investing cash flow refers to the cash used or generated from investment activities, such as purchasing or selling assets like machinery, buildings, or investments in other businesses. A negative cash flow from investing activities is typical for growing businesses as they often invest heavily in their growth. However, a positive cash flow in this category could indicate significant asset sales.
Financing cash flow reflects the exchange of cash between a business and its stakeholders and lenders. It includes activities like issuing or buying back company shares, paying out dividends, or borrowing and repaying loans.
Positive cash flow from financing activities often means that a company brings in cash by taking on debt or selling equity. In contrast, negative cash flow could indicate a company is paying down debt or issuing dividends.
Grasping the process of cash flow calculation enables you to make informed and strategic decisions that benefit your business.
First, start with your net income from the income statement. Then, adjust it for non-cash expenses (like depreciation and amortization), changes in working capital (like changes in accounts receivable, accounts payable and inventory, and other operating activities.
Cash Flow from Operating Activities (CFO) = Net Income + Non-Cash Expenses + Changes in Working Capital
Next, calculate the total cash used or provided by investing activities. This includes purchases and sales of long-term assets and other investments.
Cash Flow from Investing Activities (CFI) = Cash Received from Sales of Assets and Investments - Cash Paid for Purchase of Assets and Investments.
Finally, calculate the cash used or provided by financing activities. This includes cash transactions related to debt, equity, and dividends.
Cash Flow from Financing Activities (CFF) = Cash Received from Issuing Debt or Equity - Cash Paid for Debt Payments, Repurchasing of Equity, and Dividend Payments.
Add up cash flows from operating, investing, and financing activities to get your total cash flow:
Total Cash Flow = Cash Flow from Operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities.
Understanding these calculations and what they represent can help you identify trends, plan for the future, and navigate your business to financial success.
While understanding cash flow is crucial, it's also beneficial to dive deeper into specific areas of your financials. For instance, your Accounts Receivable (AR) metrics can offer valuable insights to inform your business strategies. To learn more about key AR metrics, check out our blog post on "Leveraging Key AR Metrics to Drive Business Strategies."
Analyzing your cash flow can give you valuable insights into financial health and sustainability. Here's how you can go about it:
A positive operating cash flow is typically a favorable indication, suggesting that your business is producing adequate cash from its principal operations to meet operating costs.
Persistent positive operating cash flow can show potential investors or lenders that your business is secure and generating profits. If this figure is negative, it's crucial to comprehend the reasons behind it and initiate measures to enhance it.
Investing cash flow can be a bit trickier to assess. Negative cash flow from investing activities indicates that your business is investing heavily in its future growth, which can be a positive sign.
However, if this negative cash flow continues over a long period without corresponding growth in income, it could indicate a problem.
Similarly, positive investing cash flow could mean your business is selling off assets, which might be a concern if it's due to a lack of operating cash flow.
Financing cash flow reflects how a business is funded. A company that frequently issues stock or takes on debt might show a positive financing cash flow.
Nevertheless, this isn't invariably advantageous, especially if it's not matched by proportional growth within the business.
Regular dividend payments or repayment of the debt would result in negative financing cash flow, which could be a positive sign of the company returning value to shareholders or reducing its debt load.
Comparing your net cash flow with net income (profit or loss) can provide valuable insights into your business's financial health. A company with high net income but low or negative business cash flow may signal problems with collecting payments or managing expenses.
Conversely, a company with low net income but high cash flow could be investing heavily in growth or dealing with significant non-cash expenses, such as depreciation.
Understanding, calculating, and analyzing cash flow is vital for businesses of all sizes. It provides a foundation for strategic decisions and future planning and guarantees the sustainability of your business.
However, manual management of these processes can be tedious, time-consuming, and prone to errors.
Constant, the financial operations automation platform, eases the burden of cash flow management by automating repetitive tasks, driving real-time visibility into transactions, and fostering a more collaborative finance function.
The platform takes the pain out of contract management by automatically extracting and storing important attributes from your Service Legal Agreements (SLAs). It further enhances operations with a searchable database and timely alerts for contract end dates and renewals.
And, to keep track of your business’s financial operations, Constant provides comprehensive financial dashboards for different areas such as Account Payable, Account Receivable, and Subscription metrics. The dashboard provides clear metrics to gauge performance and identify areas that need attention—a single all-in-one dashboard.
Understanding and managing cash flow is critical but doesn't have to be intricate or time-consuming.
With tools like Constant, you can automate and streamline your financial operations, allowing you to focus on your primary objective: business growth. Remember, cash flow is the lifeblood of your business, and with the right management, it can also be a powerful tool for success.
