Cash Flow Basics for Business Owners

Cash flow, in simple terms, refers to the movement of money coming in and going out of a business or individual’s finances. Learning your company’s cash flow is crucial for a business owner as it brings confidence. If you are here, you have the request for the knowledge, and we have the resources to share it. Below, you will learn the basics of cash flow; see definitions and explanations. Let’s start!

What is Cash Flow? 

Cash flow is the movement of money in and out of your business over a specific period (documented in a cash flow statement.) It sounds simple. However, it requires some actions in practice: analyzing the company’s income statement and balance sheet and considering factors such as revenue, expenses, changes in working capital, and investment activities. 

The fundamental factor that determines a company’s capacity to provide value to its shareholders is its ability to generate positive cash flows, specifically by maximizing long-term free cash flow (FCF), which represents the cash generated by the company from its regular business operations after deducting capital expenditures (CapEx).

Components  

Typically, a company’s cash flow is classified into three categories: 

• cash flows from operations 
• cash flows from investing activities
• cash flows from financing activities 

Various techniques can be employed to assess a company’s cash flow, such as evaluating the debt service coverage ratio, examining free cash flow, and analyzing unleveraged cash flow.

Note: Calculating cash requires understanding accounting principles and financial analysis techniques. So it is great when you engage someone with the appropriate expertise and credentials. For example, financial analysts, financial controllers, chief financial officers (CFOs), certified public accountants (CPAs), and accountants have financial statements and analysis expertise. Thus, you ensure accurate and reliable cash flow calculations.

Operating cash flow 

Operating cash flow refers to the cash generated or consumed by a company’s core operations, excluding investments and financing activities. It measures a company’s ability to generate money from its day-to-day operations.

Let’s consider two examples of small companies:

1. A small retail store: Its cash flow includes money received from sales minus the cash paid for inventory, employee wages, rent, utilities, and other operational expenses. A positive operating cash flow indicates that the store generates enough money to cover the costs.
2. A small consulting firm: The cash flow comprises cash received from client fees minus cash paid for salaries, office rent, professional services, and other operational costs. Positive operating cash flow demonstrates that the consulting firm can meet its financial obligations.

How to calculate the operating cash flow

To calculate operating cash flow using the indirect method, you start with net income, adjust it for non-cash expenses, consider changes in working capital, and account for taxes paid. This calculation helps determine the cash flow generated from the company’s core activities.0

1. Begin with the company’s net income, the profit reported on the income statement.
2. Adjust the net income by adding back non-cash expenses like depreciation and amortization. These expenses are included in the net income figure but don’t involve actual cash outflows.
3. Take into account changes in working capital, including accounts receivable and accounts payable. These changes affect the cash flow; thus, one should pay attention to them.
4. Calculate the change in working capital by comparing the current period’s operating worth to the previous period’s working value.
5. Add the change in working capital to the adjusted net income calculated in Step 2.
6. Deduct any taxes paid during the period from the result obtained in Step 5.

The resulting value is the operating cash flow, representing the cash generated or used by the company’s primary operations.

Please note that this explanation provides a simplified overview, and it’s advisable to refer to financial statements and seek professional advice for precise calculations.

Investing cash flow 

This type of cash flow represents the cash inflows and outflows related to a company’s investment activities. For example, a small manufacturing company may invest in new machinery to improve production efficiency—that cash outflow files as a negative investing cash flow. Conversely, if the company decides to sell an old piece of equipment, the cash inflow from the sale would be a positive investing cash flow.

Consequently, investing cash flow and operating cash flow are two distinct components of a company’s cash flow statement, but they are interrelated in several ways. Below, you can see the relationship between them:

1. Asset purchases: 

When a company invests in new equipment, machinery, or property, the cash outflow associated with these purchases is in the investing cash flow section. However, it indirectly impacts the operating cash flow as these assets can enhance productivity, reduce costs, or increase revenue generation.

2. Asset sales:

Suppose a company sells its assets, such as real estate or equipment. It files the cash inflow from these sales to the investing cash flow section. Then, while the operating cash flow is not directly affected, the proceeds from asset sales can contribute to increased liquidity. It can improve the company’s ability to fund its operations.

3. Dividends and investments: 

Financing or investing activities include cash outflows related to dividends paid to shareholders or investments in other companies. These outflows would not directly impact the operating cash flow. Still, they affect the company’s overall cash position and capital structure.

In summary, while operating cash flow focuses on the cash generated from core operations, investing cash flow accounts for the cash flows related to investments in long-term assets.

Note: every case is different. Sometimes, negative cash flow from investing activities is not a cause for concern. On the contrary, it can relate to substantial investments made in the long-term growth and sustainability of the company, for example, research and development (R&D). Thus, the lesson is to check the statement and learn the company activity.

Financing cash flow 

Cash flows from financing activities (CFF), aka financing cash flow, represent the overall inflows and outflows of cash used to support the company and its capital. These activities encompass transactions related to issuing debt, equity, and distributing dividends. For instance, a small company may generate cash inflow by issuing new shares of stock or borrowing funds through loans or bonds. Analyzing the cash flow from financing activities allows investors to assess a company’s financial robustness and the effectiveness of its capital structure management.

Is there a difference between Cash Flow and Profit?

Both metrics are crucial for comprehensively understanding a company’s financial performance. People may even wonder what is more crucial. However, cash flow and profit are two distinct financial metrics that provide different perspectives on a company’s economic performance. 

The key differences between cash flow and profit are as follows:

	Cash Flow	Profit
Definition	Cash flow refers to the actual movement of cash in and out of a company over a specific period.	Profit refers to the financial gain or excess of revenues over expenses during a specific period.
Focus	Cash flow focuses on the timing and amount of cash inflows and outflows, which are essential for assessing a company’s liquidity and ability to meet short-term obligations.	Profit focuses on the overall financial performance and profitability of a company.
Components	Cash flow includes operating cash flow (from core business operations), investing cash flow (from investments in assets), and financing cash flow (from financing activities).	Profit is derived from the revenue earned and expenses incurred, typically based on accrual accounting principles.
Cash vs. Accrual	Cash flow is based on actual cash transactions, irrespective of when revenue or expenses are recognized.
Timing		Profit may not align with the timing of cash flows since it considers revenue recognition and expense allocation principles.
Insights	Cash flow provides insights into a company’s ability to generate and manage cash, and whether it has sufficient cash reserves to cover expenses, investments, and debt obligations.	Profitability measures a company’s ability to generate earnings and increase shareholder value, but it doesn’t necessarily reflect its cash position or liquidity.

In summary, cash flow measures cash movement, while profit represents the excess of revenues over expenses. Cash flow provides insights into a company’s liquidity and cash management, whereas profit assesses overall profitability. 

Free Cash Flow (FCF) and Unlevered Free Cash Flow (UFCF) 

Here is one more thing to mention. 

1. Free Cash Flow (FCF) is a financial metric that measures the cash generated by a company’s operations after accounting for capital expenditures and working capital requirements. It represents the cash available to the company for discretionary purposes, such as reinvesting in the business, paying dividends, or reducing debt.
2. Unlevered Free Cash Flow (UFCF) is a variation of FCF that excludes the impact of debt and interest expenses. It focuses solely on the cash generated by a company’s operations without considering the effects of financing decisions. UFCF provides insights into the cash flow available to all capital providers, including debt and equity holders.
3. Both FCF and UFCF are important metrics investors and analysts use to evaluate a company’s financial performance and ability to generate cash. Positive and increasing FCF or UFCF figures are generally seen as positive signs, indicating a company’s ability to self-fund growth, repay debt, and potentially return value to shareholders.

Conclusion

Cash flow represents the movement of money in and out. A positive cash flow signifies a more significant inflow of money, while a negative cash flow suggests increased spending. However, a negative cash flow can be justified if it means an investment in growth. Yet, excessive spending can lead to insufficient funds for emergencies and difficulties meeting obligations to suppliers and lenders. Whether managing a business or personal finances, maintaining a vigilant approach to cash flow is crucial. Good luck, and make your business thrive!

About the Author:

Ben Adam is a dedicated in-house copywriter at Wittix, a leading money transfer services company. With a passion for crafting compelling content and respect for clients, Ben has been creating engaging and informative articles that captivate readers and provide valuable insights into finance, money transfer, and related topics.