How do you know if your small business is financially healthy? One clear sign is it’s making more money than it’s spending. This accounting metric is most commonly referred to as cash flow.
According to a recent Facebook study, 33% of small businesses cited cash flow constraints as one of the greatest near-term challenges they face—second only to lack of demand (35%).
To calculate cash flow accurately, first, you need to keep excellent track of the money that’s moving into and out of your business. We happen to know a great accounting tool that can help you with that (wink wink).
Second, you need to understand how to calculate cash flow. We can help you with that as well.
What is net cash flow?
Net cash flow is the difference between your cash inflow (the money going into a business) and cash outflow (the money leaving it).
If the number you get is positive after subtracting cash outflow from cash inflow, you have positive cash flow. If your outflow is greater than your inflow, you have negative cash flow.
Cash outflow is really a fancy way to say expenses—operating costs, debts, any money that’s leaving your business. Cash inflow includes the amount of cash you’re making from the sale of products or services and positive returns on investments (like stocks), for example.
There are three business activities that result in cash inflow and outflow:
- Operating: Cash flow from operating activities (CFO) is the money that’s coming in and out of your business as a result of your regular business activities. Whatever your business is getting paid for is your CFO. That could be manufacturing products, selling goods, or providing services. It also includes payments you’re making to suppliers or manufacturers, rent payments, and any other operating expenses you have (like utilities).
- Financing: Cash flow from financing activities (CFF) is the money that moves between a business’s owners, investors, and lenders. Your CFF is how you fund your business activities. That could be debt from a loan, equity, or dividends, for example. Both the money you’ve received from the bank and the regular payments you’re making on the loan are CFF.
- Investment: Cash flow from investing activities (CFI) is the money that’s generated from or spent on investments. Common investing activities for small businesses include investments in securities, the sale of securities or assets, and buying physical assets like equipment and property.
These three business activities should be on your cash flow statement (CFS), which is a financial document that summarizes the movement of money in and out of your company. If you’re doing a good job of keeping track of your CFO, CFF, and CFI, then net cash flow calculation should be a breeze.
Net cash flow vs. net income
Net income and net cash flow are not the same. The biggest difference is that net cash flow is determined through cash accounting (records transactions only when payment is exchanged), while net income is determined by accrual accounting (revenue or expenses are recorded when a transaction occurs, not when the payment is received).
Say your software company sells an annual license that’s worth $120. However, your customer is paying in monthly installments of $10. Your net income from this sale would be $120 even though you’re being paid in installments over a defined period of time. However, your cash inflow from the sale would be $10.
Net income is the amount of revenue you have earned, calculated using the following formula:
Net Income = Total Revenue – Cost of Goods Sold (COGS) – Operating Expenses – Interest Expenses – Tax
Besides having different formulas, they also serve different purposes. Net cash flow helps you determine the solvency, working capital, and management efficiency of your business, while net income determines only your end profits.
How to calculate the net cash flow formula
In the simplest terms, this is the net cash flow formula:
Net cash flow = cash inflow – cash outflow
If you’re still uncertain what transactions are cash inflow and outflow, here’s a high-level list of some of the most common examples of both for small businesses:
- Customer payments of any kind
- Sale of goods or services
- Insurance claims
- Interest earned on a fixed deposit/savings account
- Equipment and property sales
- Cash dividends
- Funding received from investors or banks
- Fixed asset sales
- Lawsuit settlements
- Transportation costs
- Insurance premiums
- Payments to suppliers/vendors
- Marketing/advertising spend
- Debt payments
- Shareholder payout
- Equipment and property purchases
If you want to be more specific, this is what the extended formula would look like:
Net cash flow = operating activity cash flow (CFO) + financing activity cash flow (CFF) + investment activity cash flow (CFI)
By grouping your cash inflow and outflow by types of business activities, you’ll be able to get a more accurate picture of your overall cash flow. It also helps you to get a better understanding of which areas of your business are having the most negative and positive effects on your net cash flow.
Net cash flow example
Let’s use a small business example to break down the formula piece by piece:
Say you’re running a food truck, and you’ve determined this is what your cash flow looked like in your first month of business:
CFO: $30,000 inflow, $17,000 outflow
CFF: $15,000 inflow, $8,000 outflow
CFI: $1,000 inflow, $9,000 outflow
Here’s how to calculate the net cash flow formula:
Step 1: Net cash flow = CFO ($30,000 – $17,000) + CFF ($15,000 – $8,000) + CFI ($1,000 – $9,000)
Step 2: Net cash flow = $13,000 + $7,000 + -$8,000
Final calculation: Net cash flow = $12,000
In this example, it’s clear your business investments put a dent in your company’s cash flow. However, that’s absolutely expected when you’re opening a new business. Your food truck needed new equipment (refrigerators, stoves, mixers, etc.), and these are long-term investments you expect will significantly boost your CFO in the coming months.
Why is net cash flow important?
Net cash flow shows you how much capital you currently have on hand and whether you have enough to cover the costs of your day-to-day business operations. It’s one of the best indicators of your business’s sustainability, viability, and overall financial health, so it’s a critical metric for you and anyone entering any type of business agreement with you.
Banks and investors want to see it
Financial institutions are much more interested in your net cash flow than your net income because the former provides a wider and more nuanced picture of your business’s overall financial health. Positive net cash flow trends offer assurance they could see a return on their investment sooner than later.
Negative cash flow isn’t necessarily bad. It’s not uncommon to have negative cash flow in the early days of your small business. You need to invest in new equipment, an office, marketing, new hires, and more. Banks and investors understand this, which is why they want to see your financials and analyze your cash flow trends before loaning you their money.
It guides your growth strategy
Businesses that track and analyze their net cash flow gain a clear understanding of their operations. They can identify fluctuations in cash flow and work to discover why they occur and what they can do to avoid them.
When companies keep detailed cash inflow and outflow records, it’s easier for them to see what’s working and what isn’t. The more data that’s available to you, the easier it will be for you to create financial projects and create a growth strategy for your business that’s healthy and sustainable.
Net cash flow doesn’t always tell the entire story
Net cash flow is a good barometer of financial health, and it’s easy to calculate. However, it doesn’t always show an accurate picture of your company’s financial status.
You can have a positive net cash flow not because you made a lot of sales, but because you’ve recently taken out a large loan. You could also have a negative net cash flow because you’ve made large investments in research and development that should pay off in the long term.
To get a more complete picture of your business’s financial health and liquidity, use other well-known and effective accounting formulas in conjunction with the net cash flow formula. Most importantly, keep accurate records of all your financial statements. Formulas are worthless if your data is bad.
To decrease the chances of making accounting errors, we recommend ditching handwritten ledgers and folders full of receipts and moving your cash flow records to the cloud.
If you’re looking for a simple and easy accounting and bookkeeping solution that’s customer-built for small businesses, start your free Neat trial today.