Financial planning has never been as important for companies as it is today. But what exactly does cash flow exactly? In this article, you will learn everything about cash flows - simply explained and immediately understandable.

You don't have to be a business graduate or trained tax consultant to be able to calculate cash flow. On the contrary: it is the simplest system of key figures that can be used internally in a company, especially if you use the direct method. But we'll get to that later! To emphasize the importance of cash flow you have to recognize its impact on day-to-day management.

Regardless of whether you want to forecast the liquidity situation, financial strength or the potential for profit distributions - with the help of cash flow indicators, entrepreneurs, business economists, banks and investors have a quick insight into the health of a company.

What is cash flow?

Cash flow explained simplyCash flow means "flow of money" or "flow of payments". It is an important value for assessing the financial strength of companies and provides information on the effectiveness of liquidity management. liquidity management and the cash flow (incoming and outgoing payments) that has taken place or will take place in a particular accounting period.

In a narrower definition, cash flow merely means the inflow or outflow of liquid funds from the so-called ordinary activities of a company (operating cash flow). Non-cash inflows and outflows or non-cash transactions (e.g. depreciation and provisions) are not taken into account. In a broader sense, cash flow also includes cash inflows and outflows from investments and financing.

Conclusion: Cash position is a point-in-time view. The cash flow as a cash flow statement is a view of the change over a period of time. This shows how much money flows in or out of a company during a defined period of time (usually month, quarter, year) - hence the term cash flow or payment flow.

Loss despite positive cash flow result?

What does cash flow mean? You are probably familiar with the following or a similar statement: "The company has a positive cash flow, you should invest here!". At first glance, this makes sense. More inflows than outflows mean more profit, right?

From the perspective of a tax consultant or accountant, however, this is not correct, as different systems are mixed together. Profit is recognized through a profit and loss account (P&L) on the basis of bookkeeping, while inflows and outflows are determined using the cash flow calculation (cash flow plan).

A closer look at the calculation methods shows why the formula "more inflows than outflows" does not automatically lead to a profit and why this can also be significantly lower. However, this does not mean that a positive cash flow should not be attributed any significance!

What is the difference between direct and indirect cash flow calculation?

To emphasize the fully understand the meaning of cash flow it is important to know that two basic calculation methods can be used, depending on the situation.

Both cash flow or cash flow statements are common and lead to the same result. However, when to use which method depends on needs and available information.

Indirect method:

• It is used when there is no internal information on inputs and outputs or when you are dependent on public sources.
• The indirect calculation is based on the existing annual financial statements (balance sheet and income statement) and is mainly used to assess the liquidity situation.

Direct method:

• Due to its simplicity, the direct method can be used internally at any time within the company itself as a key performance indicator system.
• Here, the actual cash inflows and outflows are considered, which enables the cash flow to be determined directly.

Let's take a look at the two calculation models in comparison.

Direct cash flow calculation vs. indirect cash flow calculation

Direct cash flow calculation

The direct calculation of the cash flow has the advantage of simplicity and the speed with which you arrive at a result. The method is particularly advantageous when it comes to getting a quick overview of the financial situation. However, one disadvantage of this approach is that it is often not verifiable, as internal and unaudited information is generally used.

Once again: The cash flow or cash flow is a snapshot time-limited snapshot of the cash flows. This means: what result do I have in the self-defined period (about one month) if I subtract the outflows from the inflows?

Cash flow formula of the direct calculation:

Incoming payments minus outgoing payments = cash flow

All income affecting payments is recorded as receipts. For example:

• Proceeds from sales / receivables
• Other incoming payments such as equity contributions
• Borrowing
• Etc.

All cash expenses are recorded as outgoings. For example:

• Payments for personnel and liabilities
• Expenses for materials and goods
• Other expenses
• Loan repayment
• Etc.

What is cash flow? Simply explained using practical examples:

For private individuals: direct cash flow - (example student)

If, as a student, I spend €300 on rent, €300 on food and €400 on other interests, but only earn €800 in my part-time job, my cash flow is negative by €200.

The specific cash flow statement reads:

(INPUTS: 800 - OUTPUTS: 1,000) = -200 euros cash flow.

Direct cash flow of a company - (example agency)

In the case of a net office rent of € 4,000, wage costs of € 12,000 and advertising costs of € 7,500, the expenses amount to € 23,500. The net income from the agency service is € 35,000. The cash flow is therefore positive at € 11,500.

The specific cash flow statement reads:

(INPUTS: 35,000 - OUTPUTS: 23,500) = € 11,500 cash flow.

Indirect cash flow calculation

This calculation method is tax and business consultants and experienced business economists and is often the only possible method. The prerequisite for this is a properly prepared set of financial statements, usually an available annual financial statements. However, one disadvantage of this method is the complexity of the required data collection.

Cash flow formula of the indirect calculation:

PROFIT plus non-cash expenses minus non-cash revenues = Cash flow

The indirect calculation of the cash flow is complex to calculate and usually only possible independently to a limited extent due to the data required. Above all, a closed (accounting) period is required, usually a closed financial year. However, with the support of a tax consultant or accountant, the indirect cash flow calculation can also be calculated independently. A defined period also applies here - in this case usually a financial year.

Non-cash expenses (non-cash expenses) are defined as:

• Depreciation
• Creation of provisions
• Accruals and deferrals
• Amortization of losses on receivables
• Etc.

Non-cash income (non-cash revenue) is defined as:

• Reversal of provisions
• Valuation gains (on real estate)
• Inventory increases
• Own work capitalized
• Etc.

Specifically: profit plus non-cash expenses - often also referred to as non-cash expenses - (depreciation and amortization, losses on receivables and reserves) minus non-cash income (write-ups due to higher valuations, for example) = cash flow.

Practical example:

Indirect cash flow of a company - (example craft business)

A craft business generates a profit of € 60,000 in this financial year. According to the annual financial statements, provisions and depreciation amount to € 20,000. In addition, provisions for legal costs amounting to € 15,000 were reported in the financial statements. According to the indirect cash flow calculation, the business therefore generated a cash flow of € 95,000.

The indirect cash flow statement reads:

Profit: € 60,000 + non-cash expenses: € 35,000 = € 95,000 cash flow.

Conclusion on direct and indirect cash flow calculation

The examples given above show that the variables profit, provision and amortization may well lead to the financial year being positive, but the actually generated Cash position can be significantly higher. The problem is that the exact opposite can also be the case.

The cash flow calculation can be used to reveal leeway in the preparation of annual financial statements (often referred to as balance sheet tricks) and to show the company's actual liquidity situation.

By the way: once the individual cash flows have been calculated for each period (monthly, quarterly, annually), they can be summarized into another important key figure. The cumulative cash flow is calculated as the sum of the cash flows over the periods under consideration.

Assume that a company has the following results in the following years:

• Year 1: +€10,000
• Year 2: -5,000 €
• Year 3: +15,000 €

The cumulative value is calculated as follows:

• At the end of the first year: € 10,000
• At the end of the second year: €10,000 + (-€5,000) = €5,000
• At the end of the third year: € 5,000 + € 15,000 = € 20,000

The cumulative value at the end of the third year is therefore € 20,000.

Above all, cumulative cash flow is important in the long-term view of the company. It is of central importance for investors, creditors, company managers and financial analysts, as it helps to make well-founded decisions and monitor financial performance over several financial years.

The cash flow formulas (as a reminder)

With the two cash flow formulas you can easily calculate the cash flows. The direct calculation provides a quick insight into the financial situation, while the indirect method is more detailed and therefore offers a more precise insight into the financial situation of a company. Cash position of a company. At the end, the individual results can be cumulated.

• Formula for direct calculation:
  INPUTS minus OUTPUTS = cash flow
• indirect method:
  PROFIT plus non-cash expenses minus non-cash income = cash flow
• Formula of the cumulative cash flow:
  ADDING the individual results from several cash flows

Interpretation of the cash flow: Significance in relation to the Cash position

The result of the cash flow statement, the current cash flow, allows conclusions to be drawn about Cash position :

Positive cash flow = Cash position (surplus)

If the cash flow is positive, this means that there is a surplus in the period under review, e.g. one month.

Ausgaben < Einnahmen = positiver Cashflow = Überschuss

A positive cash flow meansthat the outflows are lower than the inflows in the period in question and there is a surplus. The Cash position is therefore available and payments can be made, debts repaid or investments made. Conversely, what does a negative cash flow mean for a company?

Negative cash flow = liquidity bottleneck or gap

If the cash flow is negative in a period, there is a liquidity gap. liquidity gap in this period.

Expenses > income = negative cash flow = deficit

If the cash flow is negative, the expenses are higher than income and a liquidity deficit arises. If there was no cash balance at the beginning of the analysis, the solvency is therefore not given and temporary - i.e. for the period of the liquidity bottleneck - payments can be made. liquidity shortfall - no payments can be made, debts repaid or investments made. In this case, the question arises as to whether other available funds, such as unused overdraft facilities, are available.

The scheme for determining direct cash flow: meaning in detail

COMMITLY uses the so-called direct cash flow calculation as a framework (template) for the Cash flow planning the cash flow statement. In financial jargon, this means that cash income is netted against expenses. In plain language, this means that we calculate the available cash flow or free cash flow as the difference between incoming and outgoing payments on all (linked) accounts. To achieve this, we take advantage of the advantages of practical bank and ERP integrations.

In the calculation, the inputs and outputs are divided into three groups. To understand these, the following basic information is important:

1. What is operating cash flow?
2. Significance of cash flow from investing and financing activities

A - The operating cash flow

The operating cash flow indicates whether your company is in a position to finance itself. If current income (incoming payments) is higher than expenditure (outgoing payments) in a given period, everything is in the green. Keep it up! A long-term positive cash flow is important for the continued existence of the company. The importance of the operating cash flow is particularly evident in the fact that it reflects the financial health and sustainability of the company.

B - Cash flow from investing activities

This area indicates whether you have made investments or purchased assets. If the cash flow from operating activities is positive, i.e. money is available or has been left over, it is possible to make investments, e.g. to buy a new workstation including a PC.

C - Cash flow from financing activities 

This area shows whether the company has taken out or repaid loans, made payments to shareholders (dividends) or received payments from shareholders. Withdrawals in excess of the entrepreneur's salary also fall into this category. If operating activities do not generate enough cash flow, investments can also be made from this area, e.g. with a corporate loanbe financed from this area. The importance of the cash flow from financing activities is that it shows how the company uses external sources of financing to secure its Cash position and investments.

Why are these three areas so important for the significance of cash flow optimization?

Because together they perfectly reflect the financial strength of the company. This means that all levers are transparent in order to optimize cash flow cash flow. In our example, we have presented the best case: business is going so well that a surplus is generated from current income, which can be invested and there is even a residual amount. If there is something left over, this means free cash flow and therefore opportunities to invest in other areas.

Positive free cash flow: meaning and possibilities

The positive (free) free cash flow is, as the name suggests, freely available. This means that all current expenses are covered, investments have been made and there is still something left over. Congratulations!

What is the best thing to do with free cash flow?

• Build up a liquidity buffer as a precaution
• Invest in new projects or new employees
• Repaying loans early
• Remove profits

What can a negative free cash flow mean?

But what happens if the operating cash flow is negative, i.e. if the expenses (outgoing payments) are higher than the income (incoming payments)?

Firstly: Don't despair! Secondly, keep in mind that this problem is not uncommon! Almost every entrepreneur is familiar with this situation: incoming payments are late one month and not all expenses can be paid smoothly.

Lucky are those who have built up liquidity reserves from previous periods. Then it is only a temporary bottleneck. If not, the only thing that can help is cash flow from financing - i.e. reaching into your own pockets or going to the investor and the bank. The importance of operating cash flows in the negative range can therefore be something completely normal, but also a clear warning signal that should be examined more closely. In this way, problems can be detected at an early stage and avoided in the coming months.

Optimizing cash flow / managing cash flow - what measures can be taken?

• Create a cash flow planCreate a detailed cash flow plan.
• Check investmentsConsider whether investments can be postponed and what impact this will have on planning.
• Dispose of fixed assetsCheck whether realizable fixed assets can be sold (divestment).
• Check financing optionsIs there access to loans, subsidies or fresh equity?
• Waiver of withdrawalsThe waiver of withdrawals also falls within the scope of financing.

All measures should be mapped in the cash flow plan to make discussions with potential financing partners much easier.

Does this mean that cash flow planning is aimed exclusively at bank accounts?

The short answer is: Yes!

But what about the accounting data? The main task of this area is the legally correct representation of the past. Planning concerns the future, has no legal requirements and nothing can be "broken". This is an important aspect that is also cited by our customers. The well-known investor Fred Wilson has also described another very important aspect in his blog - different types. The finance function: looking back and looking forward

"In my experience, the people who are strong in the look-back role are often not strong in the forward role. You may need different people to take on these roles. In a large company, there are very different departments that perform these functions. There's an accounting department and a financial planning department (often called FP&A)."

Does this mean that direct cash flow planning only makes sense for those with a surplus of income?

No! Companies with double-entry bookkeeping have to accounting often only have a limited insight into their cash flow. This often leads to the indirect method being used to calculate it. The starting point is the result for the period and so-called non-cash items, i.e. non-cash income and expenses such as depreciation and amortization, are deducted. There are also issues with accruals and deferrals. However, the indirect derivation is so complicated that this is usually done by the tax consultant, which leads to delays.

Isn't indirect determination better for larger companies after all?

To emphasize the importance of cash flow it should be noted, however, that the directly calculated plan, as used by COMMITLY, is super simple and covers all scenarios, accounting forms and company sizes. The "connecting piece", if you will, is the cash balance or bank account balance. In practice, we have rarely (actually never) seen liquidity planning and cash flow reports in Excel that were reconciled 1:1 with accounting. Our tool ensures this reconciliation thanks to intelligent functions.

Why? Because at the end of a period, the most important basis for a tax consultant (regardless of whether it is EÜR or double-entry bookkeeping) is the reconciliation with the bank account. And this is automatically guaranteed in COMMITLY.

Credits: Photo from pixabay, by Stevepb