5 September 2023 | Metrics & Reporting

Cash Flow Formula Explained (3 Ways to Calculate Cash Flow)

Once you’ve decided to start tracking your cash flow, you’re faced with an important question: how do you actually calculate it? The complicated answer is—it depends.

There are multiple cash flow formulas, each best suited for specific purposes.

To help you understand what cash flow formulas are out there and what their intended purposes are, we’ve compiled three options commonly used by businesses both big and small.

We’ll break down what the formula is, the numbers you’ll need, and when you should be using it.

3 Cash Flow Formulas

The three options we’ve chosen to break down are:

As you read through the list, the formulas go from least to most complicated (but not difficult).

The first question you should ask yourself is how in-depth you want the calculation to be.

A good rule of thumb is the simpler the process, the simpler the conclusion. This means the more information you include, the more precise the findings, the more you can learn.

For now, let’s start simple and work our way up.

Net Cash Flow Formula

What is it: The net cash flow formula looks to answer one basic question—what was the net change in cash balance? Simply calculate it by summing up changes in any accounts that hold cash like bank accounts.

Use it for: Seeing the net effect of your cash inflows and outflows over a given period of time. If you’re looking to understand your cash flow as simply as possible, this is for you.

What’s included:

The formula:

Net Cash Flow = Total Cash Inflow – Total Cash Outflow

Example:

A graphic designer has two checking accounts and a savings account. One checking account collects payments and covers operational expenses while the other is used to hire contractors that help on projects.

Their income statement shows a net income of $3,000 for the month, but since they have uncollected invoices and paid some bills from the previous month, they want to know what their cash flow was.

At the start of the month, the balance sheet showed:

By the end of the month, the balances show:

From this, we know:

One checking account and the savings account had cash inflows totalling $2,500 ($2,000 + $500). Only one account had a cash outflow of -$1,500. Using the net cash flow formula, we find that the net cash flow is $1,000.

$2,500 – $1,500 = $1,000

Operating Cash Flow Formula

What is it: Operating cash flow looks specifically at the cash flow from core operations. It starts with looking at a business’s net income and then removes any changes that are from investing and non-cash activity.

Use it for: Isolating the effects of your day-to-day business operations on your cash flow. It’s especially useful for businesses that have a high amount of investment activity that makes cash flow difficult to understand.

What’s included:

The formula:

There are two different methods of calculating cash flow: direct and indirect. Which one you use is most likely determined by your accounting method.

Direct cash flow only includes activity where money has changed hands. For businesses using the cash basis accounting method, where transactions are recorded when cash moves, this can be easily done by looking at the income statement. The only adjustments you’d need to make would be for non-cash activity like depreciation or amortization.

(Direct) Operating Cash Flow = Cash Revenues – Cash Expenses

Indirect cash flow starts with net income (containing all financial activity) and then adjusts for any non-cash activity (similar to EBITDA). For businesses using the accrual basis accounting method, where non-cash activity like accounts receivable and payable are included, this is the methodology most commonly used.

(Indirect) Operating Cash Flow = Net Income – Change in Non-Cash Working Capital + Amortization/Depreciation Expense

Example:

Let’s look at a SaaS company that sells a $120 monthly subscription and a $1,200 annual subscription.

Since they use the accrual basis, the company records a $1,200 annual subscription differently. They record $100 sales revenue in the month they make the sale and record the remaining $1,100 as a liability called unearned revenue (money a company receives for a service that hasn’t yet been delivered).

Every month, they move $100 from their unearned income to their sales revenue. The reason they take this approach is to spread out the sales revenue over the life of the subscription to show how they “earn” what the customer already paid for each month.

One month, they see they recorded $5,000 in net income, but are still feeling cash strapped. In that month, they recorded $500 in amortization expense and their unearned revenue decreased by $7,000. Putting these numbers into the indirect operating cash flow equation we get:

Operating Cash Flow = $5,000 – $7,000 +$500
Operating Cash Flow = -$1,500

It’s easy to see how using unearned revenue with annual subscriptions can give the business the wrong idea about their cash flow. Their bottom line looks great, but it may not be the best representation of how cash is actually entering the business.

Free Cash Flow Formula

What is it: A way of calculating how much cash flow over a period of time is “free” to use after all expenses and capital expenditures have been covered.

Use it for: Seeing if you have enough cash flow to cover upcoming or prospective expenses like due invoices, bills, or big purchases.

What’s included:

The formula:

Free Cash Flow = Operating Cash Flow – Capital Expenditures
(which can be expanded into)
Free Cash Flow = (Net Income – Change in Non-Cash Working Capital + Amortization/Depreciation Expense) – Capital Expenditures

Example:

A real estate management company is looking to add another property to their portfolio. They’re currently looking at a condo priced at $500,000

They already looked at their operating cash flow and calculated it to be $700,000. Over the last period, they spent $100,000 on capital expenditures such as renovations to properties and installing air conditioning.

Putting their numbers into the free cash flow formula:

Free Cash Flow = $700,000 – $100,000
Free Cash Flow = $600,000

They see they have $600,000 in positive cash flow that was not committed to operating expenses or other capital expenditures. This means enough cash entered the business over that period of time to cover the condo purchase.

Choosing a Cash Flow Formula

Calculating cash flow is an easy way to improve your cash flow management. Which formula you choose doesn’t just depend on your business, but what you’re trying to learn.

The net cash flow formula is a quick and easy way to find out whether more cash entered or left your business. For someone who wants to get into cash flow beyond the income statement without getting deep in the details, this formula is for you.

The operating cash flow formula is a great way of isolating whether your operations are cash flow positive. Investors favor this metric because if a business is generating positive cash flow from operations, it’s more likely to be scalable and worth getting involved in.

The free cash flow formula is the most purposeful of the options covered here. It’s perfect for understanding just how much cash flow was generated that’s free to use or reinvest in the business.

If you’re new to understanding cash flow, try using each formula (and a cash flow statement) to see how the differences impact the result. This helps you understand the value and potential uses you might have for each.

Understanding Cash Flow Without the Calculation

In one survey, business owners reported working nearly 50 hours per week with only 32% of this time spent working on the business outside of operations. That’s merely 15 available hours for administrative tasks, marketing, expansion, and understanding their finances.

Understanding cash flow is key to financial success, but it’s hard to dedicate yourself to the task when you’re a time-strapped business owner.

With Finmark from BILL, you get a full suite of financial tools with reports and dashboards that can be completely automated. That means less time crunching the numbers and more time learning from them.

Completely customizable and easily integrated with Quickbooks, Xero, Wave, and more, Finmark turns your accounting into valuable insights and forecasts. Open up a world of proactive decision making and solving cash flow problems before they happen.

Get started with a free 30-day trial.

Brendan Tuytel
Brendan Tuytel
Contributor

This content is presented “as is,” and is not intended to provide tax, legal or financial advice. Please consult your advisor with any questions.

Subscribe to the Finmark Blog

Historically financial modeling has been hard, complicated, and inaccurate. But financials are the lifeblood of any company. They’re too important to be ignored or outsourced. They should be a core part of every founder’s job. This doesn’t have to be scary. And you don’t have to do it alone. The Finmark Blog is here to educate founders on key financial metrics, startup best practices, and everything else to give you the confidence to drive your business forward.

Get all the latest Finmark news directly to your inbox.

You can unsubscribe at any time.

By continuing, you agree to Finmark Terms of Service and Privacy Notice.

Other articles you might be interested in...

21 CFO KPIs To Build Your Dream Metric Dashboard

Modern CFOs are charged with more than simply reporting on previous financial performance. They’re involved in formulating the strategic direction of the…
Josh Krissansen
Contributor
3 April 2023 | Metrics & Reporting

How to Create Cash Flow Projections: Step-by-Step Guide

Ask any experienced business owner what the most important factor is in staying afloat as an early-stage company, and nine times out…
Brendan Tuytel
Contributor
25 September 2023 | Financial Planning & Analysis

Cash Flow vs. Free Cash Flow: What’s The Difference?

Cash flow is one of the most important metrics to track for small businesses. However, did you know there are a few…
Bailey Schramm
Contributor
16 August 2023 | Metrics & Reporting