What is Cash Flow? Calculation Methods and Real-World Examples

BURKHARD BERGER

13 min

·

January 22, 2024

Whether you are just starting a business or trying to keep one afloat, the answer to “What is cash flow?” is critical to boosting your company. 

Why? Cash flow (CF) affects every aspect of your business, from paying employees to investing in growth. When you understand what it is, you can make sure your cash position stays robust to support your business activities.

In this article, we will explore what business cash flow is and its benefits. Then, we will focus on its 2 calculation methods and a few cash flow statement examples. 

By the end of this read, you will have a firm grasp of the cash flow concept and its best practices to help you manage your cash. Get ready to empower yourself and make better financial decisions.

What Is Cash Flow?

Cash flow means tracking the cash coming in and out of your business. It offers critical insights into your finances and money management. 

Additionally, it provides you with a snapshot of 3 specific content:

types of cash flow

(Source: financestrategists.com)

Together, these 3 components paint a clear picture of your financial narrative to help you track every dollar and cent in and out of your enterprise. 

So, who is responsible for cash flow management?

Hire accounting professionals, financial officers, and treasurers who know and are skilled in accounting frameworks. However, you should also know finance or accounting fundamentals to keep up and audit their work.

You now have an overview of what cash flow is and the components that fall under it, but how do you calculate it? To know how your cash moves, there are 2 methods to calculate your cash flow. In the next section, we will discuss those 2 and show you what a cash flow statement should look like for each method. 

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Direct & Indirect: How To Calculate Cash Flow Using 2 Methods

The direct and indirect cash flow methods offer a unique view of your financial activities. Their processes, although different from each other, will help you compute and get numbers that accurately reflect your company’s financial health.

With these methods, you can make sure you maintain cash at an optimum level for business growth. Keep an eye out for examples that illustrate how the cash flow statement would look for each method.

1. Direct Method

The direct cash flow method employs a cash accounting technique. It specifically focuses on your business’s cash movement to give you a clear view of accurate cash outflows and inflows. It shows every cash transaction across financing, investment, and operating activities, presenting them without modifications.

What are the specific items included when using this method?

  • Investments: This covers larger cash movements, including asset purchases and upgrades to long-term assets.
  • Financing activities: These can involve debt obligations, dividend payments, and business loan repayment.
  • Business expenses: These are the everyday costs to keep your business running, including employee salaries, supplier payments, rent, and utility bills.
  • Proceeds from sales: This is the frontline of your business’s cash flow from operating activities.

Organize and take all your cash receipts into account to make your calculations and financial reports accurate. This will help you make informed decisions since you will have a precise view of your cash level.

Here is what your cash flow statements will look like using this method:

Statement of Cash flows direct method

(Soruce: principlesofaccounting.com)

As you can see, the statement is divided into 3 main components:

1.1. Cash Flow From Operating Activities

The cash received from customers represents the cash inflow, while inventory, wages, interests, operating expenses, and income taxes are the company’s cash outflows.

So, from the $3 million sales (inflow), all the outflows were deducted from it. Thus, the operating cash flow for the reporting period is $800,000.

1.2. Cash Flow From Investing Activities

This shows how the business is allocating resources for long-term use and growth. It shows the $750,000 sale of land resulting in a cash inflow that increases its cash reserves.

Additionally, the company purchased equipment (outflow). Overall, the company’s cash inflows from its investing activities (selling assets) exceeded its outflows (purchasing assets) for the year, resulting in $600,000 net cash for this section.

1.3. Cash Flow From Financing Activities

Within this section, you can see how the company’s cash is sourced and used to finance the business. The $80,000 proceeds from issued stock (inflow) show new equity being introduced to the business, a common way to finance growth without incurring debt.

The company also paid out dividends (outflow) worth $50,000 to its shareholders. However, its largest cash outflow is the repayment of loans worth $900,000. It indicates a decisive action to reduce its long-term financial obligations.

Tip: Accurate financial projections are essential for anticipating cash flow trends, enabling businesses to strategize and prepare for future financial challenges and opportunities.

To further leverage the cash flow statement, here is a more in-depth look at how to analyze the cash flow statement above:

2. Indirect Method

The indirect method leverages accrual accounting principles, contrasting the direct method’s cash accounting. Thus, this method offers a unique way of understanding your business finances.

To do the indirect method, start with your net income statement. Then, adjust it for any non-cash expenses like depreciation and changes in working capital, as shown in your balance sheet statement.

When making these adjustments, make sure the time period matches to help you accurately transform income into cash from operating activities. With this, you will see how your non-cash items and account changes affect your cash flow.

Additionally, the indirect method provides actionable insights as it aligns more closely with how your earnings are reported. It lets you look beyond your cash transactions and receipts. 

It helps you understand how your day-to-day and overall business operations, earnings, and expenses translate into cash flow. An indirect cash flow statement gives you a comprehensive view of your financial health to fuel your business decisions.

Here is what your indirect cash flow statement would look like:

Statement of cash flows indirect method

(Source: pressbooks.pub)

As you can see from the image, the net income and adjustments are under the cash flow from operating activities. This contrasts how operations activities’ cash flow is calculated in the direct method. 

However, both methods’ cash flow from investing and financing activities remains the same.

Here is a brief breakdown:

2.1. Cash Flow From Operating Activities

This section starts with the net income of $4,340 and shows the adjustment made on non-cash transactions to reconcile the net income to the net cash flow. 

Here are the adjustments:

Depreciation

This is the allocation of the cost of a tangible asset over its useful life. It is a non-cash expense of $14,400 added back to net income but it does not affect actual cash flow.

Gain On Sale Of Plant Assets

It is the profit realized from selling long-term assets for more than their book value. $4,800 is deducted from the net income because it is a profit that did not result from the company’s primary business operations.

Accounts Receivable Decrease

This shows the company converted more of its credit sales into cash over the period. The cash flow statement shows the company received $4,500.

Prepaid Insurance Increase

This is a cash outflow worth $700 that reflects a payment made in advance for insurance coverage.

Inventory Increase

The $2,500 deduction reflects that the company has invested more cash into stocking up on goods.

Accounts Payable Decrease

The $1,800 is a deduction representing the debts paid by the company to suppliers or creditors.

Salaries Payable Increase

The $400 addition to the net income adjusts for the fact that although the company has incurred these salary expenses (thereby reducing net income), it hasn’t disbursed the cash yet.

2.2. Cash Flow From Investing Activities

The company’s cash inflow from investments comes from a land sale worth $14,800. However, the company spent $40,000 to purchase new equipment. 

Thus, the cash flow from investing activities resulted in a negative $25,200. It shows the company decided to strategically spend more to boost its long-term assets.

2.3. Cash Flow From Financing Activities

In this section, the payment of notes payable (principal) is a cash outflow worth $10,000. This means the company paid that amount towards its debt obligations. Another outflow is its $400 dividend payments to investors. 

Despite the cash outflows, the company arrived at a positive figure ($34,560) for financing because it generated a $45,000 inflow by issuing common stock.

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3. Which Is Best For You?

To help you decide, here is a quick comparison overview of the 2 methods:

Direct vs indirect cash flow statement

If you have a small business with more manageable and trackable cash transactions, the direct method is ideal for you. It provides a more in-depth cash balance analysis. However, if you have many cash proceeds and other cash activities, it can be expensive since it will require time and manpower. 

In contrast, the indirect method is for you if you have a bigger business that goes through more audits since it is faster to prepare than the direct CF. However, it can be less accurate since adjustments occur throughout the process. It also gives you less insight into operational cash inflows and outflows.

While having an overview of these 2 methods gives you a boost, you can better enhance your cash flow knowledge through real companies. Their cash flow statements can give you inspiration on how to do yours or how to analyze them.

2 Real-World Cash Flow Statements Examples

These examples are from 2 major brands. We will provide a basic cash flow analysis of each to offer insights on how you can interpret these figures for your own business cash flow statements.

I. Apple Inc.

consolidated statements of cash flows - apple inc

(Source: educba.com)

As you can see, Apple Inc. practices the indirect cash flow method. Please note, that this is not the company’s comprehensive cash flow statement, but rather a targeted look at the operating activities section.

Here is a brief breakdown:

  • The company’s cash at the beginning of the year shows an increase year-over-year, indicating a growing cash reserve.
  • Apple’s reported net income shows the company’s high profitability since it is a positive figure and an increase from 2016.
  • The overall cash generated by the company from operating activities exhibits strong operating conditions. Despite being lower than in previous years, it still shows that the company is consistently generating cash.

II. Microsoft Corporation

consolidated statements of cash flow - microsoft

Like the previous example, this is not the full cash flow report and only focuses on operations. However, if you want to conduct a deeper analysis, a more comprehensive cash flow statement is available. 

Here is a brief breakdown:

  • Microsoft’s net income shows a strong upward trend from 2018 to June 2023. With this, the company shows growing profitability. 
  • As for the company’s net cash from operations, the increasing numbers indicate that Microsoft’s business operations are generating more cash over time.

Use these examples as a starting point to study how major companies are computing their cash flow. However, you will need to dig deeper into the investment and financing activities to get a full picture of a company’s financial position.

To help you analyze those activities, here is an in-depth look at how you can read your cash flow statements involving all components:

Is that enough? Well, you can always do better when you know the best cash flow management practices. These tactics will help you manage your cash flow and produce accurate statements that can help you make better business decisions.

5 Best Cash Flow Management Practices

While knowing the calculation methods, what cash flow statements should look like, and how to analyze those numbers are vital, the actions you take to manage your cash flow are what will truly drive your business’s sustainability.

What you do will dictate the numbers on those financial statements, so you should know the best practices to help you navigate tight spots and capitalize on opportunities that pop up. 

Look out for actionable insights to help you with cash flow management and sharpen your venture’s agility to stay profitable.

1. Monitor Your Cash Flow Regularly

Regular monitoring lets you spot trends and see exactly when and where your cash peaks and dips. This means you are less likely to be caught off guard by sudden cash shortages or by persistent debt collectors. 

More than that, regular cash flow monitoring sharpens your decision-making.  For instance, you will know when it is safe to invest in new assets, hire more staff, or boost marketing efforts. 

Additionally, helps you identify idle cash. You can make that idle cash work hard for you if you invest it in short-term bonds to earn interest.

To monitor your cash flow, set a routine schedule like weekly or monthly. Make sure to also leverage accounting software to get real-time insights or instant reports into your cash flow activities. 

Additionally, incorporating invoicing software can streamline your billing process, ensuring timely payments and thus contributing to a more predictable and stable cash flow.

Moreover, use the dashboard analytics to get a snapshot of your specific cash flow activities, including accounts payables and receivables. This will let you determine if you need to pay something or when you can expect some cash inflow. 

If you spot turbulence? You can quickly implement changes to improve cash inflow or reduce cash outflow

2. Control Staff Costs

Labor is often one of the biggest expenses for any business, so getting a handle on these costs helps you maintain a healthy cash flow. However, this does not mean cutting corners and hiring the cheapest labor you can find even if they do not have the skills you need for your enterprise.

How do you do this? Build a high-performing team. Remember, a smaller team of top-notch players can often outperform a larger group of average ones. 

When you invest in a few highly skilled individuals, you get more bang for your buck. They will be more effective, productive, and efficient. Thus, you can achieve more with less to help you stabilize your cash flow.

Moreover, balance your team’s needs with your business’s financial realities. For example, if you are struggling to maintain a positive cash flow, you should consider flexible hiring. Hire part-time or contract workers during peak season, instead of full-time staff all year round.

3. Be Proactive In Invoicing

Send invoices as soon as the job is done, instead of letting them sit on your desks. With timely invoices, you get paid quicker and keep the cash flowing in. This practice will help you keep everything from operations to investments running smoothly.

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Additionally, be clear about your payment terms and deadlines to set expectations and reduce confusion. You should also follow up on your invoices. A friendly reminder email can nudge a client into action.

4. Understand Basic Accounting

You do not have to be a certified accountant to run an enterprise. However, knowing the basics will go a long way when managing your cash flow. It will help you accurately track income and expenses, as well as analyze cash flow statements. 

How do you hone these skills?

Assess your knowledge to find your strengths and weaknesses when it comes to accounting or financial literacy. Then, based on the results, join an online course of workshops. 

For example, let’s say the assessment shows you are great at basic bookkeeping but lacking in cash flow analysis and balance sheets. You can enroll in courses focused on these specific areas.

Additionally, you should learn how to use accounting software to have first-hand experience in managing your cash flow. All of these will equip you to make informed financial decisions.

5. Have A Contingency Fund

The only thing constant in this world is change. That rings true for companies since the business world can be as unpredictable as the weather. 

Today, sales are flowing in, but tomorrow can be different. A contingency or emergency fund is your safety net under your business strategy. It is there to catch you when the unexpected happens.

Let’s say your client delays a payment, your equipment breaks down, the market experiences a downturn, or the world shuts down due to a pandemic. A stash of accessible assets can help you cover costs without closing down or resorting to high-interest loans at the first sign of trouble.

How do you create this fund?

It requires discipline and in-depth financial analysis since you have to determine how much your company can keep for the fund. Once you have the figure, start setting aside that agreed-upon percentage of your profits for the emergency fund. Over time, this grows into a substantial amount.

Moreover, keep this fund separate to avoid accidentally using it for other expenses. However, make sure the account is easily accessible to guarantee it is there when you need it. With this, your business can remain resilient and agile despite events outside your control.

With the best cash flow management practices, you can elevate your potential and boost your cash liquidity. But it does more than that. It has many other benefits that show how cash flow truly makes your business sustainable. 

How Taking Cash Flow Seriously Unlocks Growth

Cash flow is not simply numbers on a paper or your financial document. It provides numerous benefits that will increase your business and competitiveness in your niche. 

So, look for ways to leverage your cash flow numbers. 

A. Facilitate Timely Payments

With accurate and well-managed cash flows, you can guarantee you will have enough liquid cash to handle business transactions on time

How does this affect you? When you pay on time, you build trust. Plus, no late fees or interest charges. Thus, timely payments mean strong relationships with suppliers and a good reputation in the market.

Also, do not forget this includes paying your employees on time. Give them timely wages and you will boost their morale and trust in your management. This gives them a reason to be more productive and effective

B. Enables Growth & Expansion

Positive cash flow indicates robust financial health and that lets you channel funds into investing activities

Whether you are opening a new branch or tapping into new markets, each accounting period with solid cash flow empowers you to make crucial decisions confidently. It will also help you identify the right time to expand your business. 

For instance, let’s say you own a logo-making platform and have had a great year that ends with a positive cash flow of $65,000. This is your green light to grab an opportunity to expand and grow your company. 

You can spend $15,000 to invest in state-of-the-art design software and hire additional top-tier designers. With this, you can tap into a larger market and get more clients to boost your business operations.

C. Increases Business Valuation

Is your business cash flow strong and consistent? This paints a picture of your company’s secured financial position. Thus, it can significantly boost your business valuation.

How?

When inventors do a detailed analysis of your financial reports, a healthy cash flow suggests you are thriving. It shows your business can generate profits and manage expenses effectively

This makes them strongly consider investing in your company as they see your real economic value. If you get more investors, you can expand your company, upgrade your equipment, or hire more employees.

D. Helps In Managing Seasonal Fluctuations

Not all companies earn well all year round. However, you can lessen your worries if you have a well-managed and accurately calculated cash flow to help you navigate variable income, especially if you have a seasonal business.

Consider that you have an eCommerce store specializing in fitness gear. When January rolls in,  along with the New Year’s resolutions, your sales pump as fast as a high-speed treadmill. 

However, the spring season is not as profitable as the rush slows down and the weather changes. With savvy cash flow management, you can save sufficient cash to sail through the slower seasons. 

This cushion lets you continue regular business activities and pay operating expenses without going under. Additionally, this gives you the time and budget to scout new products or refine your marketing to make more money throughout the year.

Conclusion

Understanding what cash flow is goes beyond simply reading the definition. You have to master its calculation methods to help you decide how you are going to compute your cash flow activities (operation, investment, and financing) and arrive at accurate numbers.

Additionally, be familiar with its profound impact on your business to help you strategize on how to leverage your cash flow and financial statements to boost your business. Every piece of knowledge adds to your financial acumen.

More than that, know how to manage your cash flow effectively. Seize growth opportunities, avoid potential pitfalls, and strengthen your business’s financial position. It is also critical to continuously enhance your knowledge in these areas to make sure you are always one step ahead in your financial strategy.

So, are you ready to take the next step?

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