Whether you are an entrepreneur or a manager of a company, you should be able to analyse balance sheets, and profits and loss accounts. Further, you should know how to interpret them, calculate them, and put them to work.
This is where cash flow comes into action. Cash flows are crucial for understanding your business’ success via your finances and cash position. That is why it is so important to know how to calculate cash flow and interpret it.
Cash Flow Definition
But just to be on the safe side, here is a quick overview:
When you have positive cash flow, you have more cash coming into your business than you have leaving it so you can pay your bills, and cover other expenses. When you have negative cash flow, you can’t afford to make those payments. We could say that it is an indicator that allows you to know the health of the company’s finances.
Now let us take a look at how to get under the hood of the data you see.
How to Understand Cash Flow?
Clunky spreadsheets on Excel or Sheets have become one of the most widely used tools when it comes to monitoring and controlling cash flow. To do this you’ll most likely have created up to three categories that will facilitate its management and interpretation:
- Operating cash flow: Cash that is generated by the company’s own activity.
- Investment cash flow: Disbursements resulting from the purchase of fixed assets.
- Financing cash flow: The expenses and income related to the financing of the company (i.e. payment of dividends, loans that are issued, amounts loaned to shareholders, etc).
Take into account these three different components, since they will all directly affect the economic status of your business. However, it is safe to say that your operating cash flow will better reflect your day to day activities, whereas, investment and financing cash flows may be conditioned by the determined period you are trying to calculate.
What if I Have a Positive Cash Flow?
It means that more money is coming into your business than is going out. There is a surplus of treasury so that you can face the debts you have, distribute dividends or perks among the shareholders and employees, or face new investments.
Essentially, if you are €30 positive, and an unexpected €10 cost creeps up, you will have enough cash in your pocket to cover it. Ideal, right?
What if I See a Negative Cash Flow?
Well, it is the opposite of a positive cash flow, it means that more money is leaving the business than entering. In this case, the company is in a deficit situation, so you will need to correct the cash flow through new capital inflows or review the excess spending.
If that unexpected €10 cost creeps up now and you are -€30 negative already, you would not have enough cash in your pocket to cover it.
Why Do I Need to Calculate My Cash Flow?
Well, it is easy to say that cash flow statements are the most effective tool for analysing your business cash flow. There are three main reasons that justify tracking your cash flow.
1. Long-term viability of the company.
Cash flow analysis allows you to anticipate future problems or needs. It not only gives you insight into the economic health of your company, but it will allow you to take the necessary measures needed to prevent said problems, and minimise the effect it has on your business. This should have a greater impact on the stability of your company in the medium to long term.
2. Optimise your expenses.
By identifying unnecessary, or duplicate expenses that are a significant financial burden, you can suppress them and move closer to a positive cash flow. This will also allow you to quantify and park a small cash reserve to deal with unexpected expenses.
3. Facilitate the relationship with banks and investors.
Looking for alternative investments or searching for finance from banks or credit lenders? You will have very accurate reports that will increase confidence in your company, meaning you will be in a more advantageous position when facing negotiations to postpone payments, request more investments, etc.
How Do I Calculate Operating Cash Flow?
If done manually, the easiest way is to calculate your cash flow is by using the indirect method, starting from the accounting statements. You can use this cash flow formula to calculate cash flow:
Firstly, you need to know the net profit of the company which can be negative or positive. This number is usually provided to you by your accountant from accounting software such as Xero, Quickbooks, or DATEV. Then you add the provisions for amortisation and provisions in the chosen period to be analysed to the net profit figure.
- Amortisations = the permanent depreciation of assets due to the passage of time and their use (machinery, company vehicles, etc).
- Provisions = occasional depreciation related to unforeseen events (insolvent customers, lost or deteriorated inventory).
If you want more accuracy, you use the direct method, starting from you actual in- and outflows on your accounts. To calculate cash flows using the direct method, follow these steps:
- Identify all sources of cash inflows and outflows from your bank statements, such as sales revenue, costs and expenses, investments, and financing activities.
- Determine the amount of cash received or paid for each source.
- Sum all cash inflows and outflows to calculate the total cash flow for the period.
- Report the calculated cash flow in the appropriate section of the cash flow statement, such as operating activities, investing activities, or financing activities. You will have to categorise your spending accordingly to reflect the cash flows in your company
- Repeat the calculation for each subsequent period to track the company's cash flow over time.
So there you have it, but if you still can’t quite wrap your head around all the figures and formulas needed for Sheets and Excel, there is a better alternative than paracetamol to your headaches…
Using a Finance Operations Platform
Try using a finance operations platform such as Friday Finance. Friday Finance is a unified financial management solution that marries your bank statements to generate your cash flow statements automatically. That way you don’t have to go through the messy process of waiting for your accounting statements, or transferring and categorising all your transactions yourself. You can get started for free and generate your direct cash flow statement in seconds — instead of using accounting data long after the expenses happened for an indirect cash flow statement.
Friday Finance allows you to connect your bank accounts, which auto-categorises all your historic transactions. In addition, you can also initiate new payments and have them categorised for your cash flow statements from the get-go as well. Friday Finance then produces your direct cash flow statement for you in real-time and even lets you input your cash flow forecast numbers in the spreadsheet based on your planned billings.