In previous posts, we've covered how to read a cash flow statement and how to create a cash flow statement. Now, we're going to cover how to calculate net cash flow. As your franchise expands, you will want to keep your eye on cash flow. All businesses that are well run compute this number consistently over a period of time, usually monthly, and having the statement handy is essential to making sound business decisions.
The statement of cash flows is normally the third financial statement that is produced, after the balance sheet and the income statement.
Why is Net Cash Flow Important?
Consistent, long-term cash inflow signals sustainable growth and financial health within a business. Note that it is possible for any of the three sections to show cash outflows or the final number to show cash outflows. Negative cash flows need to be investigated, so the business can meet its working capital requirements and obligations to employees, creditors, and other key stakeholders.
The statement of cash flows consists of three sections: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. The cash flows from each of these sections determine net cash flow.
Breaking Down Net Cash Flow
Let’s take a closer look at each section of the cash flow statement and see how we get to the final net cash flow number.
Cash Flows from Operating Expenses
The first of the three sections is the cash flows from operating activities.
For the first numbers needed, look at the income statement. Net income should be added to all non-cash expenses. The most common non-cash items include depreciation and amortization, stock-based compensation, and unrealized gains or losses on securities. Operating expenses are those which a business incurs through its core operations.
If net income is negative, or working capital is not well-managed, it is possible for operating cash flows to be negative. In this case, the business manager would want to take a look at the company’s expenses, as well as if sales are where they should be (remember, net income = revenues – expenses).
Next, look to the balance sheet to locate current assets and current liabilities. These are needed for the next computation.
Any decreases in current assets (such as accounts receivable, inventory, and any others) should be added back in. To illustrate, if accounts receivable is paid off, that means cash has been collected from customers. If inventory decreases, goods have been sold, and cash has been collected. Vice-versa, if there are increases in current assets, those represent cash outflows.
Any increases in current liabilities (such as accounts payable, notes payable, and salaries payable) are recorded as cash inflows. To illustrate, if accounts payable increases, that means payments to suppliers are being delayed. If accounts payable decreases, that means cash has been paid to suppliers. Decreases in current liabilities are recorded as cash outflows.
Once non-cash expenses are added back to net income, add in the cash inflows and outflows resulting from changes in net working capital (current assets minus current liabilities) to find the final number for cash flows from operating activities.
Cash Flows from Investing Activities
The next section, cash flows from investing[EH1] activities, requires much less computation. Cash flows from investing activities can be found by adding the proceeds from the sales of fixed assets and marketable securities (cash inflows) and subtracting purchases of fixed assets and purchases of marketable securities. Once these four items are accounted for, total cash flow from financing activities has been calculated.
Cash Flows from Financing Activities
Cash flow from financing activities is also rather simple. First, add proceeds from equity issuances to proceeds from debt issuances. Next, subtract equity repurchases, debt payments, and dividend issuances.
Net Cash Flow
By adding the final number for each section, we calculate net cash flow, which could be an inflow or an outflow. That number is added to the beginning cash balance (which can be found on the previous statement of cash flows, or the balance sheet). This final number is the ending cash balance, which should be entered at the bottom of the cash flow statement.
As an aside, you also want to make sure you know how to calculate free cash flow. This is different from net cash flow and is more limited in scope. This number is important in discounted cash flow analysis, which is calculated by subtracting capital expenditures (CapEx) from operating cash flow. CapEx is calculated by adding the depreciation expense for the current period (found on the income statement) back to changes in PP&E (property, plant, and equipment, found on the balance sheet).
Keeping Your Business in Top Shape
Now that we’ve broken down how to calculate net cash flow, let’s look at some ways to increase your cash flow generation.
Given that we start with net income, selling more goods and services is a sure way to generate top-line growth. More revenue means more money to invest in income-generating activities. The other part of net income is made up of expenses, and although cutting costs can be a painful experience, all line items on the income statement should be subject to a thorough cost-benefit analysis.
Make sure it’s easy for your customers to pay and that the method of billing is standardized. This could mean offering more than one method of payment. This also means sending invoices out on time and keeping due dates consistent. This will help manage prompt collection of accounts receivable and help with monthly planning.
When possible, use electronic payments to save time and send invoices out promptly. Early payment incentives can help you collect cash more quickly as well.
Being realistic about inventory is important. Make sure that you are paying a good rate for the inventory you buy. Secondly, being realistic about what is selling and what isn’t is important. Selling inventory that customers aren’t buying at a loss is better than letting it go to waste.
Now that you know about cash flow, get out there and start making the big bucks!
