Cash flow is the cash that comes in and goes out of your business in any given time frame.
Cash is actual money that has come into your business. For example, if you send an invoice to a client, the amount due is not considered cash until you are paid. Once you receive payment, that becomes part of your cash flow. Until then, it’s known as accounts receivable and not cash in hand…bummer, we know!
If more cash comes into your business than goes out in a time period, you have positive cash flow! If more money goes out than comes in during a certain period, you have negative cash flow.
So is cash flow the same as profit?
Cash flow and profit are not the same thing.
Profit is your business’ financial gain and is calculated by subtracting your cost and expenses from your revenue. What’s (hopefully) left is your profit.
Revenue — Cost of Goods Sold — Expenses = Profit
Unlike profit, cash flow is all the cash coming in and going out of your business. While this does include the cost of goods and expenses, cash flow also includes transactions like credit card payments, loan payments, payroll and sales tax liabilities, and owner’s draws.
So it’s possible to be profitable and have negative cash flow at the same time.
Here’s an example. Let’s say you calculate your profit, and your numbers are:
$10,000 — $ 2,000 — $ 3,000 = $5,000
(Revenue) (Cost of Goods sold) (Expenses) (Profit)
Woohoo! You have profit, but what if you also have to pay your loans, file sales tax, and pay yourself?
$5,000 — $2,000 — $1,500 — $3,000 = —$1500
(Profit) (Loan payment) (Sales tax payment) (Owner’s draw) (Cash flow)
Uh oh. Even though you’re profitable, you don’t have enough cash flow to make all your other payments.
Why is cash flow important?
Everyone gets excited about having a profit, but having positive cash flow is just as important. Without healthy cash flow, your business can be severely impacted.
Having positive cash flow ensures that you have the money available to cover the costs of keeping your business operational. It also means you have the cash to manage debt, sustain financial hardships, and invest in tools, equipment, and inventory to grow your business.
Without positive cash flow, it’s far more difficult for the owners and investors of your business to receive dividend payments or a return on their investment. Even if you’re profitable, you would eventually run out of cash and not have money available to pay dividends to the owners if you have negative cash flow.
Okay, break down the types of cash flow for me.
There are two components to cash flow: inflow and outflow.
Inflow is the cash that comes into your business, and outflow is the cash that goes out of your business.
Every source of inflow and outflow can be categorized into one of the three types of cash flow:
- Operating cash flow
- Investing cash flow
- Financing cash flow
Here are some examples of the different types of inflow and outflow:
|Inflow||Type of Cash Flow|
|Cash from the sales of goods or services||Operating|
|Interest and dividends received||Operating|
|Cash sales of property, equipment, and other assets||Investing|
|Collection of loans made to others||Investing|
|Cash from the sale of capital stock||Financing|
|Owner or shareholder contribution to business||Financing|
|Outflow||Type of Cash Flow|
|Payments to suppliers use to produce goods||Operating|
|Expenses related to daily operations||Operating|
|Purchase of property, buildings, vehicles or equipment||Investing|
|Lending money to others||Investing|
|Dividend payments to owners||Financing|
|Repayment of loans||Financing|
Why do I need to know each type of cash flow?
Operating cash flow is money the comes in and out of your business through your day-to-day operations. This includes:
- Sales of good or services
- Purchasing inventory
- Paying salaries
- The costs of overhead expenses
If it relates to your daily business activities, it’s operating cash flow.
Operating cash flow is important because it indicates if a company can maintain and grow its operations without secondary revenue sources from investing and financing. Essentially, it tells you if your business model is sustainable or not.
Investing cash flow is money that comes in and out of your business related to investments you make in your business. Investing activities include:
- The purchase and sale of long-term assets (like property, vehicles, buildings, and equipment)
- The purchase and sale of securities like stocks and bonds.
Investing cash flow helps you understand how much money you’re putting into your future growth.
Since investing activities have to do with long-term assets, companies that spend a lot in investing activities are generally considered to be growing companies who are securing their ability to generate revenue.
Financing cash flow is money that comes in and out of your business related to financing transactions from creditors or owners. In other words, how your business raises money and pays it back.
Financing activities include:
- Loans obtained
- Issuing or repurchasing stock
- Cash contributions from owners
- Repayment of loans
- Dividend payments
Financing cash flow is important because it helps you see how much money comes into your business from acquiring loans or from your investors. Eventually, you want more money coming in from operating cash flow than financing cash flow because it means that your business model works.
Financing cash flow also shows you how much money is going out to pay your loans, which is helpful when creating budgets.
How do I calculate my cash flow?
Phew, that was a lot!
But if you’re worried about doing a bunch of lengthy formulas to calculate your cash flow, fear not! There’s a super quick and easy way to understand your cash flow.
It’s a handy-dandy report called a statement of cash flows. If you use a bookkeeping program like Xero, you can easily run a Statement of Cash Flows in the Reports section. If you work with a bookkeeper or an accountant, they can prepare the report for you.
A statement of cash flows, also known as a cash flow statement, shows you the total cash that has come in and gone out of your business in a given period, for each type of cash flow. It also shows how much cash you have available.
Running a statement of cash flows on a regular basis helps you identify trends in your cash flow and anticipate and prepare for financial peaks and valleys.
How do I read a statement of cash flows?
The statement of cash flows is broken up into three sections:
- Operating Activities
- Investing Activities
- Financing Activities
Under each section, the statement of cash flows shows the increases or decrease for various sources of cash flow. Then, it totals the net cash provided to your business by each type of cash flow.
In the example above, the business
- Generated $1,896.02 in cash from its daily activities (operating cash flow)
- Invested money back into itself by purchasing a vehicle (investing cash flow)
- Generated $15,662.50 in cash through financing activities, which included a $25,000 loan (financing cash flow)
At the very bottom of the report, you see the net increase for the reporting period.
- If it’s a positive number, you had an increase in cash—or positive cash flow.
- If it’s a negative number, you had a decrease in cash—or negative cash flow.
You’ll also see the cash at the beginning of the period (how much cash you started with) and the cash at the end of the period (how much cash you ended with). The net cash increase is the difference between these two numbers.
In this example, the business started with more cash than it ended with. That means it had negative cash flow for the reporting period.
What is free cash flow?
Okay, just one more term to go over, promise. Say hello to free cash flow.
In the cash flow world, free cash flow is the step-sibling of operating, investing, and financing cash flow. It’s related, but not quite the same thing.
Free cash flow is the cash left in your business after you’ve paid your operating and required ongoing capital expenses.
Required capital expenses are investments you need to make to keep your business operational, like replacing machinery and equipment, purchasing inventory, and investing in research and development.
Free cash flow is what you have available to allocate to things such as additional investments or payments to the owners of your business. You get to choose what you do with your free cash flow!
The formula for free cash flow is:
Operating cash flow — Required capital expenses = Free cash flow
You can find your operating cash flow on your statement of cash flows at the end of the Operating Activities section. It’s the line called “Net cash from operating activities.” To find your capital expenses, run a Balance Sheet report in your bookkeeping program and look for the Fixed Assets section. Those will be your capital expenses.
Here’s an example:
Donna runs a bakery. At the end of the year, she runs a statement of cash flow and has $50,000 in operating cash flow. She then runs a Balance Sheet and determines that her capital expenses, which include a new stove and display coolers, are $30,000.
$50,000 — $30,000 = $20,000
(Operating cash flow) (Capital expenditures) (Free cash flow)
Donna has $20,000 in free cash flow. She can now decide if she wants to use that money to make additional investments in her business, take out as an owner’s draw, or spend it on something else.
There you have it! With a good understanding of how to maintain positive cash flow and stay out of debt, your business has a greater chance of success.
Rather have someone else manage all this cash flow statement work for you? Find an accountant or bookkeeper who can help you with your business needs.Updated December 28, 2018
This article provides general information and shouldn’t be construed as tax advice. Since tax rules may change over time and can vary by location and industry, please consult a CPA or tax advisor for advice specific to your business.