Introduction To Cash Flow Calculation
Based on my experience working with small business owners in the UK, I will share comprehensive information about cash flow calculation with you in this guide.
I’m an expert in cash flow and a chartered certified accountant.
First, I will share with you the complete cash flow calculation areas to cover.
Then, I’ll share the benefits of each area. I’ll use a specific example from some of the clients I have worked with as their cash flow coach. I’ll also use examples from clients I currently work with.
I have used these cash flow calculations to identify business future growth opportunities. I also use them to figure out debt servicing requirements and capital spending. This ensures the business maintains positive cash flow.
These are cash flow calculations. They affect all aspects of financial statements (income statements, balance sheets, and statements of cash flows).
These calculation tools cover the basics to ensure financial stability.
They also cover advanced topics to help you to scale a business faster.
Also whether you are buying or selling a business, these cash flow caluluations come in handy too
I have witnessed business owners reviewing profit and loss statements as cash flow statements.
Here’s why it does not work.
Because it doesn’t include non-cash items, don’t make this mistake and follow the guide below. Understanding the nuances of debits and credits and their impact on your financial statements is crucial.
Look, I don’t know what is your current cash flow situation.
- Maybe you have a debt obligation to cover. Or you’re a credit-conscious business owner, always looking to balance your books.
- Perhaps you are looking to make investments for long-term strategic growth or
- Potentially want to take out money from your business as dividend payments.
- Possibly you want to be certain of future cash balance to maintain working capital.
Whatever your situation, you need to perform cash flow calculations to ensure you have a clearer picture to make financial decisions based on facts.
Why would you trust me as a guide on this?
I have been a cash flow specialist for the last two decades. I have helped hundreds of clients calculate their cash flow. I have been featured on this topic in major sites like QuickBooks Online, Independent, Zoho, and Floatapp. Many of these clients are significant companies. They have unique cash flow challenges.
I review my clients’ financial statements. Then, I devise a plan of action to fuel long-term growth. I do this all day, every day, for a living. So, don’t worry. You are in safe hands.
Key Takeaways
- Understanding Cash Flow is Critical: Know where your money comes from and where it’s going.
- Make informed decisions. Use the insights from cash flow calculations to guide your business strategies.
- Prepare for the Future: Anticipate and adapt to changes in the economic landscape.
Let’s dive in.
Before we do that, I want to share a cash flow story of one of my clients, Brenda.
Brenda’s book publishing Agency Cash Flow Journey
Brenda runs a book publishing agency based in Portsmouth. She thought she was on top of her game. Revenue was rolling in, and clients were happy. But somehow, at the end of the month, the numbers weren’t adding up.
What Was The Problem?
Brenda was stuck in a cash flow rollercoaster and couldn’t figure out why.
What We Worked On Together?
We sat down together and reviewed the monthly cash flow statement. We went through actual cash inflow and outflows.
We also reviewed Quickbooks online accounting software. We checked debtors’ and creditors’ reports.
We discovered that Brenda’s payment terms with clients did not match her outgoing cash flow. A critical part of this process was performing a detailed bank reconciliation. It provided insights into Brenda’s cash handling.
By adjusting her invoicing cycle and payment terms, we turned erratic cash flow into a smooth, reliable cash flow. This included managing overheads more effectively. It also involved understanding the balance between debits and credits.
What Were The Results?
Furthermore, by just reviewing the debtor’s report, we discovered she had £15,275 unpaid invoices that were not followed up on. This is a classic example of turning credit into actual cash flow. She collected the cash in the space of a few weeks.
The Bottom Line
Understanding how to calculate cash flow is crucial. It helps identify leakage to stop unnecessary outgoing cash flows. It also helps figure out excess cash to fuel business growth. Cash flow management involves strategic problem solving. It’s about identifying gaps and creating solutions.
You can only achieve this by implementing one or more cash flow calculation areas. I will share these ten areas with you next.
These are specific areas. When you learn how to calculate cash flow, you will have a clearer picture. This will help you make financial decisions based on financial facts, not gut instincts. Remember, every successful business owner is part investor, thinking beyond the immediate numbers.
Comprehensive Areas of Cash Flow Calculation
Now that you know the ‘why‘ of cash flow calculations, let’s delve into the ‘what.’
I’m about to walk you through ten comprehensive areas of cash flow calculation. These areas are absolute game-changers.
Let’s start with the first one.
1. Understanding Operational Cash Flow
At its core, operational cash flow is about understanding the cash generated and used in your business’s operations. It’s the money you earn from selling your products or services minus the cash you spend to keep the business running.
Why It is significant?
Think of operational cash flow as fuel to the vehicle.
Just as your vehicle needs fuel to get moving, your business needs a consistent cash flow to operate smoothly. Your core business operations tell you if your business is self-sustaining. They also show if it’s relying on external funding to keep going.
In essence, it’s a reality check on your business’s ability to generate cash flow to fund the business operations. Understanding financial accounting principles plays a key role here, ensuring you’re accurately tracking every item that affects your operational cash flow.
At the heart of it is cash management.
According to a U.S. Bank study, 82% of businesses fail due to poor cash flow management, highlighting the critical nature of understanding operational cash flow.
It reminds me of one of my clients, Tim.
Tim runs a small craft brewery that was gasping for cash.
Sales were decent. Yet, they were always scrambling to pay bills and suppliers.
After analysing the operational cash flow, the problem was clear.
Tim had generous payment terms for his customers but was on the hook for quick payments to his suppliers.
This mismatch created a monthly negative cash flow, primarily due to the liability of quick payments against slower receivables. Managing liabilities effectively is crucial in cash flow management.
What did we do together?
We looked at specific calculations like Operational Cash Flow (CFO) and Operating Cash Flow Margin.
It revealed that, although his operating cash flow margin was pretty decent, cash flow from operating activities was poor.
This was because his average cash collection days were 45 days, and his average cash payment days were 30 days. It had 15 15-day cash flow gap, which resulted in negative cash flow month after month.
Together, we worked on renegotiating payment terms with both customers and suppliers and streamlined his inventory management to free up cash.
The Results?
Tim’s Brewery went from a cash-eating monster to a cash-making machine. This is a classic example of how effectively managing liabilities and overheads can transform a business’s cash flow.
[This is a prime example of how effective management of a Fixed Asset can play a pivotal role in a business’s growth strategy
He’s now expanding, and yes, he’s doing it with the cash generated from his operations.
If you want to do cash calculations using a simple tool I have created, you can use this cash flow calculator
2. Investing Activities: Planting Seeds for Growth
Investing activities are all about planting seeds for growth and watching them bear fruit over time.
It encompasses the cash you use for purchasing assets like new technology, property, or even other businesses. When we consider investing activities, particularly in fixed assets, it’s important to account for depreciation.
Depreciation is a significant non-cash expense that affects the value of assets over time and has a substantial impact on cash flow planning.
It also includes the proceeds from selling off assets you no longer need.
Why Investing Smart is Non-Negotiable?
Think about it: every asset you purchase or sell directly impacts your cash flow and your ability to grow.
Get it right, and you’ve set yourself up for expansion and innovation.
Get it wrong, and you could be tying up precious cash in unproductive assets or missing out on lucrative opportunities.
It reminds me of Mark, who owns a café business based in Southwest London, England.
He wanted to invest in building an accommodation business and wanted to extract cash from the café business.
I analysed specific calculations –Cash Flow from Investing (CFI) and Capital Expenditure (CapEx).
I assessed the potential cash flow impact of the new accommodation business and calculated the expected return on investment.
In addition, I helped Mark calculate current working capital needs for the existing business and work out excess cash to -reinvest.
The results?
Mark’s cafe business continued to thrive while he invested in a new accommodation venture, which generated a good return on his investment.
He now employs two additional people and can continue growing thanks to his accommodation business’s proceeds.
3. Financing Activities: Fuelling Your Business Ambitions
After looking into day-to-day business operations and strategic investments, it’s time to look at the fuel that powers your business’s engine: cash flow from financing activities.
This is where you secure the funds to drive your business forward faster.
Why Getting It Right Matters?
Get your financing cash flow right, and you’ll have the resources to seize opportunities and fund for rainy days.
Get it wrong, and you could be facing a crippling debt load or giving away too much control of your business.
It reminds me of one of my clients – Davina’s jewellery business based in Bond Street, London.
She was concerned about increasing the overdraft facility. She had to pay 2.75% over the base rate, which at the time was 4.5%. So the cost to her was 7.25% on top of £120,000 arrangement fee for the £10.5m overdraft facility.
What do we work on?
We worked on specific cash flow ratios – Cash Flow from Financing (CFF) and Debt Service Coverage Ratio (DSCR) to establish her financing cash flow needs as well as her ability to make debt payments.
One of the covenants was stock assets had to be more than three times of debt amount. DSCR provided the info needed to convince the bank that the business could repay the debts on time.
The Results?
Davina managed to acquire high-value jewellery items at auction houses from Sotheby’s Bonham’s at lower prices and sold them to the buyers at huge margins covering overdraft interest and arrangement fees.
Since then, the business has scaled profitably from £2.3m to £7.3m in sales revenue in four years.
During these financial periods, she continuously monitored her financial activities every quarter. She submitted quarterly management accounts to the bank, highlighting key figures such as monthly cash flow balance, cash surplus, operating expenses and overall current financial position.
This resulted in a solid mutual understanding between the bank and Davina. As a result, she could renegotiate better terms from 7.25% to 6.5%.
4. Understanding and Monitoring Business Health: Net Cash Flow Calculation
Now that we’ve covered the helicopter view of cash flow, let’s zoom in on the first of the specific calculations -the Net Cash Flow Calculation.
Net Cash Flow: Your Financial Health Indicator
Net Cash Flow is an important indicator of a business’s financial health.
While most people focus on net profit, I prioritise net cash flow as a reliable measure of a business’s overall health – Shishir Khadka
Why?
Because simply no cash = no business.
We only have to look at so many businesses shutting down in the UK because they ran out of money, not because they were not profitable.
Did you know?
Twenty-nine percent of small businesses fail because they run out of money.
It’s a straightforward yet powerful calculation that tells you the total amount of cash being transferred in and out of your business over a certain period of time.
It answers the crucial question: “Is my business generating more cash than it’s spending?”
Why It’s Crucial?
It’s the lifeline indicating whether your business is on a growth path or is time to hit the brakes and reassess.
Positive net cash flow means you can invest, expand, and even weather unexpected storms.
Negative?
It’s a red flag that calls for immediate attention and strategy adjustments.
A Cash Flow Case Study: Debbie’s Seasonal Boutique
Debbie owns a boutique with a high seasonal variance in sales.
Her first year was a struggle, with significant off-season dips affecting her ability to restock and market effectively.
She started using a net cash flow calculator, a tool I created and started monitoring her monthly net cash flow. I mainly asked her to see the net cash pattern over the last three months. I asked her to compare it with the last three months of profit. I asked her which is bigger.
She started strategically ordering stock based on the identified patterns. She also negotiated better terms with suppliers and planned targeted off-season promotions.
By her second year, Debbie’s boutique was surviving the off-season and thriving. It had enough cash reserve to explore new opportunities.
Debbie’s case study highlights the importance of being aware of net cash flow as it allowed her to:
- make informed cash flow decisions
- assess the liquidity of her business at all times
5. Operational Efficiency and Performance
Once you have assessed your net cash flow, focus on your operational efficiency and performance. These factors drive your business daily.
Operational Cash Flow (CFO): A Key Factor for Efficiency
Operational Cash Flow, also known as CFO, is crucial for the day-to-day operations of your business.
It measures the cash generated from your core business activities. It shows how well your company turns its revenue generation operations into cash.
Why Operational Efficiency Matters
Here’s the thing.
Common Mistake: Focusing solely on revenue growth without considering the cash flow implications of operational decisions.
By dissecting your CFO, you can pinpoint areas where operational efficiency can be improved.
Most business owners focus on net income, aka profit. They get confused about why my business is profitable but there’s hardly any cash in the bank account.
While net income indicates the business is making money, it is only on paper. We cannot spend and meet our loan payments or pay salaries using net income. We need cash.
It reminds me of a luxury retail business based in London. I have changed the name of a person for reasons of confidentiality. Let’s call him Dave.
Dave’s business model was Made to Order- (MTO)- So he would sell the product first to the customer and collect payments, and then when the goods were made, he would pay the suppliers.
He noticed despite the increase in sales, the company’s cash position wasn’t improving.
He was confused and frustrated.
Once I started to work with him, I calculated his business’s operating cash flow margin to be 32%.
I also looked at other performance metrics like Cash Conversion Cycle (CCC). The current situation was taking 12 weeks to deliver the build the product. So, the client had to wait 12 weeks to collect the final balance.
We switched the supplier who could manufacture and deliver the goods in 8 weeks- saving 4 weeks of CCC.
The result?
After four weeks of saving, CCC added £119k on average cash inflow faster.
Furthermore, we increased the margin to 41% by implementing cash flow improvement strategies like early payment discounts and trade rebates. As a result, he had an additional £43k net cash flow from operations.
We achieved a significant increase in cash balance by looking at cash flow from operations, operating cash flow margin and cash conversion cycle calculations.
6. Free Cash Flow: The Key to Shareholder Satisfaction
Why FCF Matters?
- It ensures you’re providing returns to your investors. It also keeps enough cash to support your business’s growth and stability.
- It signals that your company is not just managing its current operations well. It also has the potential to generate growth and returns in the future.
Free Cash Flow (FCF) is a business’s cash generated after accounting for cash from operations and capital investment.
Essentially, it’s the cash you have free to:
- Pay back creditors
- payments to shareholders in the form of dividends and ensuring you’re providing returns to your investors while maintaining enough cash to support your business’s growth and stability
- reinvest in your business’s growth
I remember working with a client who runs an e-commerce business selling womenswear.
Her business was strapped for cash. It didn’t have enough money to fund the winter season knitwear after summer selling swimwear.
One of the first things I did was to calculate free cash flow. This was to identify existing excess cash to re-invest in buying the inventory. And then potentially top it up with funding from the bank.
Then, I also looked at cash from operating activities. This gave me the idea that the business was not generating positive operating cash flow.
This was because it was poor when I looked at the profit margins. Operating expenses were very high as compared to sales revenue. Due to slim operating profit, cash flow from operations was poor too.
She had to take additional debt personally to fund the winter season inventories.
7. Discounted Cash Flow (DCF): Your Business's Future in Today's Terms
Discounted Cash Flow is a cash flow formula. It estimates the value of an investment based on its expected future cash flows. The formula discounts the cash flows for time and risk. This is why it’s called discounted cash flow.
For example, the value of £100 today will not be the same as £100 in 3 years, right?
In the same way, when you intend to invest in a business -say £100k in three years’ time value will be much higher than £100k.
DCF is a cash flow formula to look into the financial future of your business. It helps you make decisions grounded in long-term value rather than just immediate returns.
Recently, I worked with a café business owner to value his business using the DCF method.
When doing so, I looked at the following steps:
- Selected the period and forecasted cash flow for the next five years
- Then, I estimated the terminal value of the investment
- Agree on a Discounted rate- using Weighted average costs of capital (WACC).
- Discounted the forecasted cash flow and terminal value to the present value
- We arrived at the sum of discounted future cash inflows – the business’s value.
8.Future-Proofing the Business with Forecasts and Projections
Cash flow forecasting is your business’s financial GPS. It estimates future cash inflows and outflows, giving you a glimpse into your cash balance.
It’s a bit like while driving; further, you look ahead and have more time to react to potential hazards.
A well-crafted forecast helps you anticipate cash shortfalls and surpluses. It also helps you plan investments and prepare for market volatility.
Unique Perspective: Forecasting is your financial GPS, guiding your business through future uncertainties with informed predictions.
If you want to go very deep on this topic, as you should, I cover this separately in great depth. I cover all aspects of forecasting and projection
9. Ensuring Liquidity and Solvency for Stability
Business is like a marathon, not a sprint.
Running the business and launching a marketing campaign and product takes longer than anticipated. It also requires more cash than expected. So, maintaining financial stability is crucial for survival and thriving long-term.
How do you do that?
There are two measures you want to be familiar with. A simple version of the cash flow formula for this is Current Asset/Current Liabilities. You can find both these figures in the balance sheet.
10. Liquidity: The Quick Measure of Financial Health
Quick Ratios (also known as the Acid-Test Ratio) and Current Ratios are liquidity formulas. They show how well your business can cover short-term debts with its cash and other easily converted assets. A simple version of the cash flow formula for this is Current Asset/Current Liabilities. You can find both these figures in the balance sheet.
But why does Liquidity Matter?
A study shows that improving liquidity ratios by just 10% can decrease the likelihood of financial distress by up to 20%.
Imagine being caught in a sudden cash crunch. You can’t pay suppliers or employees because all your funds are tied up in slow-moving inventory or outstanding receivables.
It happened to one of my clients recently when she didn’t have enough cash to pay salaries on the 22nd of the month, and she had to borrow from her Dad despite having outstanding receivables.
10.1 Solvency: The Long-Term Perspective
While liquidity focuses on the short term, solvency takes a longer view.
It’s about your business’s ability to meet its long-term obligations. It’s also about continuing to operate into the future. Solvency ratios, such as the debt-equity ratio, give you a broader perspective on your business’s financial viability. They also show its debt burden.
I have comprehensive content on business liquidity. I share examples, mistakes, misconceptions, steps, and case study stories. You can check it out here.
10.2 Mitigating Financial Risks for Security
In the business world, the only constant is change, and with change comes financial risk.
But savvy business owners do not fear risk. Instead, they understand and manage it. Mitigating financial risks isn’t about avoiding them. It’s about recognizing potential pitfalls. It’s about safeguarding your business’s financial future.
10.2.1 Post-Covid 19 Period in the UK
It reminds me of the post-Covid 19 period in the UK. In 11 months, base interest rates increased for the 14th time from .25% to 5.25%.
Imagine the impact on business loan rates. This impacts cash balance in the balance sheet and eats profit as loan interest charges.
To further add to the agony, inflation jumped to 9%. So it was costing the business more to run, which hurt profitability and bank balance.
There are tools you can use to manage and mitigate risk.
10.2.2 Cash Flow at Risk (CFaR)
This tool estimates the amount of future cash flows that could be at risk due to various factors.
It helps you understand the potential impact of market changes on your cash position. This enables you to develop strategies to mitigate these risks.
10.2.3 Sensitivity Analysis
Sensitivity analysis assesses how different values of an independent variable affect a particular dependent variable. It does this under a given set of assumptions.
It’s a way to test how market conditions, interest rates, or other factors could impact your business’s financial health.
A common mistake is not conducting risk assessments. Also, ignoring potential risks until they become imminent threats.
To tackle this, you can do the following:
- STEP 1– Prepare a cash flow statement. Consider your actual cash receipts and payments. You can do this by using a direct method or an indirect method. If you are not familiar with the differences or how to do this, you can follow the link here.
- STEP 2: Perform cash flow analysis to understand what’s going on with your cash flow
- STEP 3: Preparing three cash flow forecast types after a cash flow analysis. Best case, worst case and most likely scenarios.
By doing this, you are on the path to managing and mitigating financial risk.
Your Next Steps
You can get started by using my FREE cash flow calculator.
Following the cash flow calculator, now it’s your turn; which of the following ten areas would you like to tackle first?
Tag me on Linkedln and let me know how you get on.
