Cash flow: meaning, definition and calculation

Financial planning has never been as important for companies as it is today. But what does cash flow actually mean? In this article you will learn everything about the flows of money – explained simply and immediately understandable.

You do not have to be a business graduate or a qualified tax adviser 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 will come to that! To understand the meaning of cash flow, you have to recognise its effects on day-to-day business.

Whether you want to forecast the liquidity situation, financial strength or the potential for profit distributions – the key figures of the cash flow statement give entrepreneurs, business managers, banks and investors a quick insight into the state of health of a company.

What is cash flow?

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

In a narrower definition, cash flow means only the inflow or outflow of liquid funds from a company’s so-called ordinary activities (operating cash flow). Non-cash income and expenditure or non-cash transactions (such as depreciation and provisions) are not taken into account. In a broader sense, inflows and outflows of money from investing and financing activities are also assigned to cash flow.

In short: liquidity is a snapshot at a point in time. Cash flow, as a cash flow statement, looks at the change over a period. This shows how much money flows into or out of a company during a defined period (usually a month, quarter or year) – hence the term flow of money or flow of payments.

A loss despite a positive cash flow result?

What does cash flow tell you? You have surely heard something like this: “The company has a positive cash flow, this is where you should invest!”. At first glance that makes sense. More inflows than outflows must mean more profit, mustn’t it?

From the point of view of a tax adviser or accountant, however, this is not correct, because different systems are being mixed up. Profit is determined by a profit and loss account (P&L) on the basis of the accounting records, while inflows and outflows are terms belonging to 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 have to lead to a profit, or why that profit can be considerably lower. That does not mean at all that a positive cash flow should be regarded as unimportant!

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

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

Both cash flow statements are common and lead to the same result. Which method you use when, however, depends on your needs and on the information available.

Indirect method:

• It is used when no internal information about inflows and outflows is available or when you have to rely on public sources.
• The indirect calculation is based on the existing annual financial statements (balance sheet and P&L) and is mainly used to assess the liquidity situation.

Direct method:

• Because of its simplicity, the direct method can be used internally within the company as a system of key figures at any time.
• Here the actual incoming and outgoing payments are considered, which allows cash flow to be determined directly.

Let us look at the two calculation models side by side.

Direct cash flow calculation vs. indirect cash flow calculation

Direct cash flow calculation

The direct calculation of cash flow has the advantage of being simple and fast to arrive at a result. The method is particularly useful when you need a quick overview of your financial position. A disadvantage of this approach, however, is that it is often difficult to verify, since as a rule internal and unaudited information is used for it.

To repeat: cash flow is a snapshot limited in time of the flows of money or payments. In other words: what result do I get in the period I have defined myself (a month, say) if I subtract the outflows from the inflows?

Cash flow formula of the direct calculation:

Incoming payments minus outgoing payments = cash flow

All cash-effective income is recorded as inflows. For example:

• Payments received from revenue / receivables
• Other payments received, such as equity contributions
• Borrowing
• Etc.

All cash-effective expenses are recorded as outflows. For example:

• Payments for personnel and liabilities
• Expenses for materials and goods
• Other expenditure
• Loan repayments
• Etc.

What is cash flow? Explained simply with practical examples:

For private individuals: direct cash flow – (example: a student)

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

The specific cash flow statement reads:

(INFLOWS: 800 – OUTFLOWS: 1,000) = -200 euros cash flow.

Direct cash flow of a company – (example: an agency)

With net office rent of €4,000, wage costs of €12,000 and €7,500 of advertising costs, you are at €23,500 on the expenditure side. Income from the agency’s services comes to €35,000 net. Cash flow is therefore positive at €11,500.

The specific cash flow statement reads:

(INFLOWS: 35,000 – OUTFLOWS: 23,500) = €11,500 cash flow.

Indirect cash flow calculation

Among tax and business consultants and experienced business managers, this calculation method is the preferred and often the only possible one. It requires properly prepared accounts, usually available annual financial statements. A disadvantage of this method, however, is the complexity of the data collection required.

Cash flow formula of the indirect calculation:

PROFIT plus non-cash expenses minus non-cash income = cash flow

The indirect calculation of cash flow is complex to work out and, because of the data required, usually only possible on your own to a limited extent. Above all, a completed (accounting) period is required, usually a completed financial year. With the support of a tax adviser or accountant, however, the indirect cash flow calculation can be done independently as well. Here, too, a defined period applies – in this case usually a financial year.

Non-cash expenses are understood to be:

• Depreciation
• Setting up provisions
• Accruals and deferrals
• Write-downs of bad debts
• Etc.

Non-cash income is understood to be:

• Release of provisions
• Valuation gains (on real estate)
• Increases in inventories
• Own work capitalised
• Etc.

Specifically: profit plus non-cash expenses – often also referred to as non-cash items – (depreciation, bad debts and reserves) minus non-cash income (write-ups due to higher valuations, for example) = cash flow.

A practical example:

Indirect cash flow of a company – (example: a craft business)

A craft business generates a profit of €60,000 in the current financial year. According to the annual financial statements, provisions and depreciation come to €20,000. In addition, provisions for litigation costs of €15,000 were reported in the accounts. Using the indirect cash flow calculation, the business has 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 the direct and indirect cash flow calculation

The examples above show that the variables profit, provisions and depreciation can quite well lead to a financial year being positive while the liquidity actually generated is considerably higher. The problem is that exactly the opposite can also be the case.

The cash flow calculation can reveal the leeway used when preparing annual financial statements (often referred to as balance sheet tricks) and 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 combined into another important key figure. The cumulative cash flow is determined by adding up the cash flows across the periods considered.

Suppose a company has the following results in the following years:

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

The cumulative figure 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 added-up figure at the end of the third year is therefore €20,000.

Cumulative cash flow is significant above all when looking at the company over the long term. It is of central importance for investors, creditors, company managers and financial analysts, because it helps them take well-founded decisions and monitor financial performance across several financial years.

The cash flow formulas (as a reminder)

With the two cash flow formulas you can calculate cash flows quite easily. The direct calculation gives you rapid insight into your financial situation, while the indirect method is more detailed and therefore offers a more precise view of a company’s liquidity. At the end, the individual results can be added up.

• Formula of the direct calculation: INFLOWS minus OUTFLOWS = cash flow
• Indirect method: PROFIT plus non-cash expenses minus non-cash income = cash flow
• Formula of the cumulative cash flow: ADDING UP the individual results of several cash flows

Interpreting cash flow: what it means for liquidity

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

Positive cash flow = liquidity (surplus)

If cash flow is positive, this means that there is a surplus in the period considered, for example a month.

Expenditure < income = positive cash flow = surplus

A positive cash flow means that the outflows are lower than the inflows in the period concerned and that a surplus arises. Liquidity is therefore assured and payments can be made, debts repaid or investments carried out. So what does a negative cash flow mean for a company, conversely?

Negative cash flow = liquidity bottleneck or gap

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

Expenditure > income = negative cash flow = deficit

If cash flow is negative, expenditure is higher than income and a liquidity deficit arises. If there was no cash balance at the start of the period considered, solvency is therefore not assured, and temporarily – that is, for the duration of the liquidity bottleneck – no payments can be made, no debts repaid and no investments carried out. In this case the question arises whether other funds are available, such as unused overdraft facilities.

The scheme of the direct cash flow calculation: what it means in detail

COMMITLY uses the so-called direct cash flow calculation as the framework (template) for cash flow planning. In financial jargon this means that cash-effective income is netted against expenses. In plain language, we calculate the available cash flow, also known as free cash flow, as the difference between incoming and outgoing payments on all (connected) accounts. To achieve this, we make use of practical bank and ERP integrations.

In the calculation, inflows and outflows are divided into three groups. To understand them, the following basic information is important:

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

A – Operating cash flow

Operating cash flow indicates whether your company is able to finance itself. If ongoing income (incoming payments) in a given period is higher than expenditure (outgoing payments), everything is fine. Keep it up! A cash flow that is positive over the long term is important for the company’s continued existence. The meaning of operating cash flow shows itself above all 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 cash flow from operating activities is positive, that is, if money is available or left over, there is the option of making investments, for example buying 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 contributions from shareholders. Withdrawals beyond the entrepreneur’s salary also fall into this category. If operating activities deliver too little cash flow, investments can also be financed from this area, for example with a business loan. The significance of cash flow from financing activities lies in the fact that it shows how the company uses external sources of financing to secure its liquidity and investments.

Why are these three areas so important for cash flow optimisation?

Because together they give the best picture of the company’s financial strength. That also makes every lever transparent for optimising cash flow. In our example we have shown the best case: business is going so well that a surplus is generated from ongoing income, which can be invested, and there is even something left over. If something is left over, that means free cash flow and therefore opportunities to invest in other areas.

Positive free cash flow: what it means and what it makes possible

As the name suggests, positive (free) cash flow is freely available. That means all ongoing 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
• Repay loans early
• Withdraw profits

What can a negative free cash flow mean?

But what if operating cash flow is negative, that is, if expenditure (outgoing payments) is higher than income (incoming payments)?

First: do not despair! Second: keep in mind that this problem is not unusual! Almost every entrepreneur knows the situation: in one month incoming payments are late and not all expenses can be paid smoothly.

Anyone who has built up liquidity reserves in previous periods is fortunate. Then it is only a temporary bottleneck. If not, the only thing that helps is cash flow from financing – reaching into your own pockets, or going to your investor and your bank. Operating cash flow in negative territory can therefore be something completely normal, but it can also be a clear warning signal that should be examined more closely. That way problems can be spotted early and avoided in the coming months.

Optimising cash flow / managing cash flow – what measures can be taken?

• Draw up a cash flow plan: create a detailed cash flow plan.
• Review investments: consider whether investments can be postponed and what effects that has on the plan.
• Sell fixed assets: check whether realisable fixed assets can be sold (divestment).
• Check financing options: is there access to loans, subsidies or fresh equity?
• Forgo withdrawals: forgoing withdrawals also falls within the area of financing.

All measures should be reflected in the cash flow plan, so that discussions with potential financing partners become considerably easier.

Does cash flow planning therefore focus exclusively on the bank accounts?

The short answer is: yes!

But what about the data from accounting? The main task of that area is to represent the past in a legally correct way. Planning concerns the future, has no legal requirements and you cannot “break” anything either. That is an important aspect, and one our customers mention as well. The well-known investor Fred Wilson has also described another very important aspect in his blog – different types of people. The finance function: looking back and looking forward

“In my experience, the people who are strong in the looking-back function are often not strong in the looking-forward function. You may well need different people to take on these roles. In a large company there are quite different departments that handle these functions. There is an accounting department and a financial planning department (often called FP&A).”

Does that make direct cash flow planning useful only for cash-basis accounting?

No! Companies with double-entry bookkeeping often have only limited insight into their cash flow from their accounting. This frequently leads to the indirect method being used. The starting point is the result for the period, and so-called non-cash items – non-cash income and expenses such as depreciation – are removed from it. On top of that there are issues with accruals and deferrals. The indirect derivation is so complicated, however, that as a rule it is done by the tax adviser, which causes delays.

Isn’t the indirect calculation better for larger companies after all?

To grasp the meaning of cash flow, you should bear in mind that the directly calculated plan, as used by COMMITLY, is extremely simple and covers all scenarios as well as all forms of accounting and company sizes. The “connecting piece”, if you like, is the cash balance, that is, the bank account balance. In practice we have rarely (in fact never) seen cash flow plans and cash flow reports in Excel that reconciled one-to-one with the accounts. Our tool ensures that they can be reconciled, thanks to intelligent features.

Why? Because at the end of a period the most important basis for a tax adviser (whether cash-basis or double-entry accounting) is the reconciliation with the bank account. And COMMITLY ensures that automatically.

Credits: Photo from pixabay, by Stevepb