Every small business owner knows that cash is king, but unfortunately many face problems at some point – 71% of those with cash flow issues have struggled to pay suppliers, while 64% have been charged late payment fees.
So, how can you keep track of the cash that flows in and out of your business every day? What tools can you use to help ensure your business has enough cash, not just to survive from month to month, but to grow and expand? And what metrics will lenders and investors want to see when deciding whether to provide your business with essential finance?
Here’s a run-down of all the formulae that small business owners can use to calculate cash flows.
How to Calculate a Cash Flow Forecast
Why is a cash flow forecast important? Looking up to 12 months ahead and scenario planning for best- and worst-case situations helps you avoid potential pitfalls. Likewise, having that long-term view of your cash flow also means you can take advantage of short term opportunities whenever they present themselves.
“Someone contacted us with a skillset we knew would add value in generating additional revenue," Chris Eccles, co-founder of Employment 4 Students, the UK's largest graduate and student jobs and internships website. "We plugged their expected salary into our cash flow (salaries fall under overheads in our cash flow forecast). This helped us work out the kind of return we’d need to get from that new hire to make it viable.”
Cash flow forecasts are simple to calculate. This is the basic formula that can be applied monthly, quarterly or yearly:
Closing cash balance = Opening cash balance + Projected inflows – Projected outflows
- Opening cash balance comes from the company’s cash flow statement
- Projected inflows include: current invoices falling due; invoices not yet issued that will fall due within the period; other expected income in the period
- Projected outflows include: overhead payments such as rent, utilities, wages due in the period; supplier invoices falling due in the period; debt service payments; other payments including one-off items
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How to Calculate Operating Cash Flow
Operating cash flow (OCF) gives a picture of the company’s ability to generate cash from its normal operations. Lenders and investors often want to see a business’s operating cash flow. The OCF formula is:
Operating cash flow = Net income + Non-cash expenses – Change in working capital
All the information needed for this formula can be obtained from the income statement.
- Net income is the bottom line
- Non-cash expenses include depreciation, amortisation and taxes
- Working capital is the difference between the company’s current assets and liabilities
How to Calculate Cash Flow from Investing Activities
Cash flow from investing (CFI) is the net cash inflow or outflow from capital expenditures, mergers & acquisitions, and purchase/sale of marketable securities. Here’s the CFI formula:
CFI = Purchase/sale of property and equipment + Purchase/sale of other businesses + Purchase/sale of marketable securities
These items are all listed in the cash flow statement. They can also be identified by comparing non-current assets on the balance sheet over two periods.
How to Calculate Cash Flow from Financing Activities
Cash flow from financing activities (CFF) is the net flow of cash between the company and its owners, creditors and investors. It reflects the company’s financing mix. This is the CFF formula:
Financing cash flow = Cash inflows from issuing equity or debt – (dividends paid + repurchase of debt and equity)
These can all be found in the cash flow statement.
How to Calculate Net Cash Flow
Net cash flow is the difference between all the company’s cash inflows and cash outflows in a given period. It’s a key metric for understanding the company’s financial health. Here’s the formula:
Net cash flow = Operating cash flow + CFI + CFF
See above for the formulae for the individual components.
How to Calculate Free Cash Flow
“Free cash” is the cash left over after the business has met all its obligations. “Knowing the business’s free cash flow is essential when planning future spending,” says author and finance expert Frances Coppola.
The basic FCF formula is:
Free cash flow = Operating Cash Flow – Capital Expenditure
Capital expenditure can be found on the cash flow statement. Basic FCF doesn’t include changes in debt, so when a company takes on new debt, basic free cash flow for that period can be misleadingly positive. Therefore, levered free cash flow, also known as free cash flow to equity (FCFE), can be more accurate.
FCFE = Free cash flow – (debt issued – debt repaid)
Debt issued and repaid in the period can be found on the cash flow statement.
Investors also use unlevered free cash flow, also known as free cash flow to the firm (FCFF), when estimating a company’s enterprise value. FCFF is a hypothetical measure of the free cash that the company would have available if it had no debt. It enables companies with very different capital structures to be directly compared for valuation purposes.
To calculate FCFF, first calculate earnings before interest and taxes (EBIT) using this formula:
EBIT = Net income – Interest – Taxes
Now recalculate the taxes line on the income statement to exclude the interest element (since interest on debt typically incurs tax relief). Then recalculate operating cash flow (see formula above) with the new tax figure. Finally, apply the FCF formula to give the FCFF figure.
How to Calculate Discounted Cash Flow
Discounted cash flow (DCF) estimates the net present value (NPV) of a company, project, security or asset by totalling its expected future cash flows and discounting them by a rate that reflects the time value of money. It indicates whether an investment is likely to be profitable.
The DCF formula is a time series:
DCF = CF1/(1 + r)1 + CF2/(1 + r)2 + … + CFn/)(1 + r)n
- CF = cash flow
- r = discount rate
- n = time in years before the future cash flow occurs (expanded to 1, 2, 3, etc.)
So, cash flows need to be estimated for the entire lifetime of the investment. The discount rate is the minimum rate of return that the investment must generate to meet profitability expectations. It’s sometimes called a 'hurdle rate'. You'll find software and tools to support DCF calculations available online, choose the right for you and your business.
Routinely calculating your cash flows using these formulae can ensure you don't encounter any cash flow problems and maintain an accurate picture of your business’s financial health.
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