Editor’s note: At Lantern, we strive to help you make financial decisions with confidence. To do this, we occasionally feature content that includes information about our partners and their products or services. We do not provide, endorse, or guarantee any third-party product, service, information or recommendations—and our opinions are our own.
Determining cash flow is an important step in understanding how much operating expenses impact your business’s bottom line. While the process may vary depending on the complexity of your company, it’s still good sense to comprehend the cash flow formula. Many companies use accounting software to do the job, but it’s just as easy to utilize a spreadsheet and some basic math skills. Keep reading to learn how to calculate cash flows and why it’s a crucial part of managing your business.
Cash Flow ExplainedFiguring out how to calculate cash flow lets you see how your business’s expenses stack up to your income. In order to succeed, a business generally needs to be cash flow positive, meaning your monthly revenue exceeds your operating expenses. Tracking your cash flow reveals a lot of important information about your business and can help you make decisions as well. For instance, it helps you stay on track of invoices owed by customers. If you don’t pay attention to cash coming into your account, you could end up running out simply because of poor invoice management.Understanding your cash flow cycle helps you make financial projections, which can inform your decision making process as a business. By tracking your sales, you can anticipate when it’s time to manage inventory. You’ll also know whether or not you’ll be able to pay for it with cash, or if you’ll need to identify a financing source. If you sell a service rather than a product, understanding your cash flow lets you know how well your pricing is structured. When you’re cash flow positive, you know you’re offering the right services at the right price. But if your revenue isn’t covering your operating expenses, it may be time to rethink your business structure.Calculating your cash flow is also helpful for seasonal businesses. Obviously, your cash flow will vary throughout the year, so it’s smart to make a projection of your fixed expenses versus when you expect to earn revenue. Established businesses can look at historical data while new businesses could research competitors and create a conservative forecast. Your cash flow projections can help you figure out how you’re going to finance the lean months while being fully prepared for your busy months. No matter what type of business you operate, your cash flow is one of the most critical financial components to understand. Not only does it help you manage your business’s accounts, it will also be reviewed by lenders and investors whenever you apply for any type of financing.
How is Cash Flow Calculated?On a simple level, the cash flow equation involves subtracting your monthly expenses from your monthly balance and income sources. The money you have left over to transfer to the next month’s balance is your cash flow. Start by adding up your monthly income to your starting balance. This includes any revenue your company has brought in through sales, as well as from interest earned on investments or savings accounts. Collectively, this number is called your “cash in.”Next it’s time to calculate your cash out. Add up all of your expenses for the month, such as rent, loan or credit card payments, taxes, salaries, and manufacturing. When you subtract that total from your cash in, you’re left with a balance. Hopefully, the number is positive. That means you not only made a profit, but you’re also managing your money well enough that you have a balance to start with the next month. A negative number doesn’t necessarily mean your business is failing. After all, perhaps you had an emergency expense pop up, such as a machine repair. But that does mean you’re starting off the next month with a negative balance and you should carefully review your projections for the near term to make sure it’s not a long-term trend.This is referred to as operating cash flow and can be determined using the following formula:Revenue - Cost of Sales - Taxes = Operating Cash FlowThe formula can include other things for more complex businesses, such as adding in depreciation or accounting for other changes in cash flow.Let’s take a look at an example of a hypothetical company. In July, XYZ Retail grossed $500,000 in sales. But the cost of goods and marketing totalled $250,000 and taxes on the profit amounted to $62,500. $500,000 - $250,000 - $62,500 = $187,500In this simplified example, XYZ Retail has $187,500 of cash flow to roll over into the next month.Depending on the size of your business, you may pay for an accounting software that automatically calculates your cash flow for you. As you add more data, it may be able to predict upcoming forecasts using historical information so that it’s much more accurate. It may also automatically generate a cash flow statement so you can quickly see a breakdown of your income and expenses. More complex businesses can identify separate categories for cash flow from operations, investing, and financing. New businesses can use a spreadsheet to discover the same information, it’s just a little more time consuming. Also remember to carefully enter your numbers when manually preparing your cash flow statement to avoid mistakes from human error.
Solutions for Cash Flow ProblemsWhen you learn how to calculate cash flow and realize you consistently have a negative balance each month, it’s time to identify the issues and find viable solutions to keep your business afloat. A common problem for small businesses is managing invoices and collecting payments from customers.
Using Accounting SoftwareThere are two popular potential solutions for these issues. The first is to invest in an accounting software that can automate much of your bookkeeping. For instance, it can create invoices and track those that are outstanding. It also automatically breaks down your expenses compared to actual cash brought in each month.
Hiring a BookkeeperAlternatively, it may be beneficial to hire a bookkeeper. Small companies may not want to (or be able to) invest in a full-time staff member to take care of the accounting. But you may be able to afford a part-time contractor to manage the invoice process as well as both accounts receivable and accounts payable. They may even be able to help you identify areas in which you can improve your business’s cash flow.
Applying for a Line of CreditDepending on the nature of your cash flow issues and how long you expect them to last, applying for a line of credit may be an option for getting an injection of capital. Whether you’re a seasonal business or experiencing a temporary challenge, a line of credit, like a small business loan, can help ease cash flow bumps. However, just like with any type of financing, make sure you have a solid plan to repay your balance. It can be tempting to charge up a balance beyond what you need. It could also blind you from the fact that your business isn’t operating as it should. But it is an option if you know exactly what the problem and solution are for your cash flow—you just need a temporary bridge between the two.All businesses are likely to have cash flow hiccups at some point. Regularly tracking and analyzing your accounts payable and receivable each and every month can help you anticipate these challenges and create a proactive solution.
Refining Your BudgetDuring times of negative cash flow, it may be helpful to review your operating budget and cut any unnecessary expenses. Even in times of surplus, it can be helpful to have an effective operating budget in place. This can help businesses weather potential or anticipated downturns in business.
Increasing RevenueThis may seem like an obvious suggestion, but increasing revenue during a period of negative cash flow may require thinking outside of the box. This might include things like running an alternative marketing campaign, expanding employee training so that the sales team is better prepared and equipped with sales techniques and product knowledge, and working to turn over inventory that isn’t selling well.
Other Important FinancialsYour business’s cash flow statement is one of many important financial snapshots reflecting the health of your company. Here are some other factors to think about when making financial decisions.
Balance sheetYour company’s balance sheet also holds a lot of valuable information. Most notably, it lists out the business’s assets and liabilities. It also includes any relevant details on shareholders who have equity in the company. Assets include cash, inventory, and property. Liabilities, on the other hand, include debt, expenses owed, and shareholder’s equity (particularly if they’re paid retained earnings rather than having all earnings go towards debt or reinvesting in the business).Regularly creating a balance sheet, such as on a quarterly basis, is helpful in understanding part of the big financial picture. It reveals important metrics such as the debt-to-equity ratio and the amount of working capital your business has to work with. You’ll typically need to provide a copy of your balance sheet anytime you apply for financing or pitch new investors, along with other documents such as your business plan.
Income statement Another financial snapshot you need to regularly look at is your income statement. While your cash flow includes data from the business’s financing and investments, the income statement focuses solely on revenue and expenses over a set period of time. It can reveal trends in sales, production costs, and operating expenses. Depending on the type of accounting used, the income statement may or may not be based on cash accounting. For example, cash flow measures funds as they enter and leave your business accounts. But using an accrual accounting method, your income statement would reflect when orders are placed rather than when they are paid for. There are pros and cons to both methods, so explore your options to see what breakdown of financial information makes the most sense.
Final ThoughtsLearning how to calculate cash flow is a vital first step in understanding your finances. When joined by other documents such as your balance sheet and income statement, you can keep track of your true profitability. This information can also help you identify your most profitable ventures and where you might be over-spending. Regardless of what stage your business is in, you should regularly review your cash flow statement to ensure invoices are being paid and expenses aren’t stunting your growth. Knowledge is power when it comes to running your business, so use all of the information at your disposal to anticipate trends and act accordingly.
About the Author
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.