Cash flow calculation, simply explained!

Cash flow calculation, simply explained!

cash flow

Cash flow or cash flow planning has never been as important for companies as it is today. In this article you will learn everything about cash flow calculation in companies - simply explained and immediately comprehensible.

You don't have to be a business administration graduate or a trained tax consultant to be able to perform a cash flow calculation. On the contrary: the cash flow calculation is the simplest key figure system that can be used internally in a company. Especially if you use the direct method. But we will get to that!

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

What is cash flow (cash flow)?


Cash flow what is it? Cash flow is an important indicator of a company's financial strength (cash flow key figure). The cash flow provides information about the liquidity situation and the cash flow (inflows and outflows) that has taken place or will take place in a specific accounting period.

In a narrower definition, cash flow refers only to the inflow or outflow of liquid funds from the so-called ordinary activities of a company (operating cash flow). Non-cash receipts and payments or non-cash transactions (e.g. depreciation, amortization and accruals) are not included in cash flow. In the broader definition, inflows and outflows of cash from the areas of investments and financing are also allocated to cash flow.

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

Loss despite positive cash flow result?


Cash flow what does it say? Surely you know the following or a similar statement: "The company has a positive cash flow, here you should invest!"

At first glance, this makes sense. More inflows than outflows means more profit, right?

However, from the point of view of a tax advisor or accountant, this is not correct, because different systems are mixed. Profit is determined by a P&L based on accounting, inflows and outflows are terms of cash flow calculation (cash flow plan).

A closer look at the calculation methods shows why the formula does not automatically lead to a profit or why the profit can also be considerably lower.

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


How to calculate cash flow? Basically, there are two calculation methods for the cash flow calculation: the "direct calculation" and the "indirect calculation".

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.

If no internal information on receipts and payments is available or if one has to rely on public sources, the indirect method is used. The indirect method is therefore mainly used to assess the liquidity situation on the basis of an existing annual financial statement (balance sheet and income statement).

Due to its simplicity, the direct method can be used internally at any time within the company itself as a key performance indicator system.

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


Advantageous in the direct calculation cash flow is the simplicity and thus speed of this variant, with which you come to a result. A disadvantage of this calculation method is often the lack of verifiability, since internal and unaudited information is usually used for this purpose.

Mentioned again: the cash flow or the capital flow is a time-limited snapshot of the cash flow, the payment flows. That means: what result do I have in the self-defined period (for example one month) if I subtract the outflows from the inflows?

Cash flow formula of the direct calculation:

Incoming payments minus outgoing payments = cash flow

Cash flow calculation direct method

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

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

All cash expenses are recorded as outgoings. For example:

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

Direct cash flow of a private person - (example student)


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

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 an office net rent of 4,000 euro, wage costs of 12,000 euro, 7,500 euro advertising costs iegt one with 23,500 euro on the expenditure side. The incomes by the agency service result net 35,000 euro. The cash flow is therefore positive with 11,500 euros.

The specific cash flow statement reads:

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

Indirect cash flow calculation


This calculation method is the preferred or only possible one among tax and management consultants or experienced business economists, since the prerequisite for this is a properly prepared financial statement, usually an annual financial statement, and this is available. The complexity of the necessary data collection is often cited as a disadvantage.

Cash flow formula of the indirect calculation:

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

Cash flow method Indirect calculation

The indirect calculation is complex in the calculation and due to required data mostly only conditionally independently possible. Above all, a completed (accounting) period is required for the calculation, usually a completed financial year. However, with the support of a tax advisor or accountant, the indirect cash flow calculation can also be calculated independently. Here, too, a defined period applies - in the case of indirect calculation, mostly a fiscal year.

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

  • Depreciation
  • Creation of provisions
  • Accruals and deferrals
  • Write-off 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 - (write-downs of receivables as well as reserves) minus non-cash (non-cash) income (write-ups due to higher valuations, for example) = cash flow.

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


A craft business generates a profit of 60,000 euros in this fiscal year. According to the annual financial statements, provisions and depreciation amount to 20,000 euros this year. In addition, litigation cost provisions of 15,000 Euro were shown in the financial statements. According to the indirect cash flow calculation, the print shop has thus generated a cash flow of 95,000 Euro.

The indirect cash flow statement reads:

(PROFIT: 60,000 + N.T.W. EXPENSES: 35,000) = 95,000 euros cash flow.

Conclusion on direct and indirect cash flow calculation


The examples above show that the variables profit, provision and depreciation can certainly lead to the result changing in such a way that although the financial year is positive, the actual Cash position can be significantly higher. The problem is that the exact opposite can also be the case.

With the help of the cash flow calculation, leeway in the preparation of annual financial statements (often referred to as balance sheet tricks) can thus be revealed and the actual liquidity situation of the company can be presented.

The cash flow formulas (as a reminder)


With the two cash flow formulas, you can easily calculate any cash flow. The direct cash flow calculation formula provides quick insights into the financial situation, while the indirect cash flow calculation formula is more detailed and therefore offers a more precise insight into the Cash position of a company.

  • Cash flow formula of direct calculation:
    INPUTS minus OUTPUTS = Cash flow
  • Cash flow formula of the indirect calculation:
    PROFIT plus non-cash expenses minus non-cash revenues = Cash flow

What is the significance of cash flow in relation to 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 consideration, e.g. one month.

Ausgaben < Einnahmen = positiver Cashflow = Überschuss

Cash flow surplus

If the cash flow is positive, the outflows are lower than the inflows in the relevant period and there is a surplus. The Cash position is therefore available and payments can be made, debts repaid or investments made.

Negative cash flow = liquidity bottleneck or liquidity gap

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

Expenditure > income = negative cash flow = liquidity gap

Cash flow liquidity gap

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

3 Areas of direct cash flow calculation

The scheme of direct cash flow calculation in detail


COMMITLY uses as a framework (template) for the Cash flow planning the so-called direct cash flow calculation. In financial jargon, this means that cash income is netted against cash expenses. In plain English, this means that we calculate the available cash flow or free cash flow as the difference between the incoming and outgoing payments on all (linked) accounts.

In the calculation, the inputs and outputs are divided into 3 groups:

A - Cash flow from operating activities (operating cash flow)


The operating cash flow indicates whether your company is able to finance itself. If the current income (incoming payments) is higher than your current expenses (outgoing payments) in a certain period, everything is in the green. Keep it up. A long-term positive operating cash flow (operating cash flow) is essential for continuity. 

B - Cash flow from investing activities


This pot indicates whether you have made investments or purchased assets for your business. If your cash flow from current business activities is positive, i.e. money is available or left over, you have the possibility to make investments, e.g. to buy a new workplace including a PC.

C - Cash flow from financing activities (cash flow from financing activities)


This indicates whether your company has taken out or repaid loans or made payments to shareholders (dividends) or received payments from shareholders. A withdrawal in excess of the entrepreneur's salary also falls into this category. If operating activities do not provide enough cash flow, you can also make investments from this pot, e.g. with your business loan. (Cash flow financing activity)

Optimizing cash flow - but why are these three areas actually so important?


Because together, they represent the financial strength of your company in the best possible way. This means that all levers are transparent for optimizing cash flow. We have shown the best case in our example: Your business is running so well that you generate a surplus from your current income, can invest and even have something left over. By the way, what is left over is the "free cash flow".

A positive free cash flow / Free cash flow


The positive "free cash flow" is, as the name suggests, at your free disposal. This means that you have covered all current expenses, made investments and still have 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, for example, new employees
  • Repaying loans early
  • Remove profits
  • ...

What to do in case of negative operating cash flow / negative free cash flow?


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

First: Do not despair! Second: Keep in mind that you are not alone with this problem! Almost every entrepreneur knows this situation: In one month the incoming payments are late and not all expenses can be paid smoothly.

Lucky who has built up a liquidity buffer from the previous periods. Then it is only a temporary liquidity shortage. If not, only cash flow from financing helps - i.e. reaching into one's own pockets or going to the investor or the bank.

Optimize cash flow / manage cash flow - so what measures can be taken?

  • Create cash flow plan!
  • Check whether investments can be pushed back and what impact this has on the cash flow plan
  • If there are realisable fixed assets, a sale (divestment) can possibly also be examined.
  • Financing - is there access to loans, grants, fresh equity capital
  • The waiver of withdrawals also falls within the scope of the financial return.
  • Map all measures in the cash flow plan, which also makes discussions with potential financing partners much easier

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


The short answer is: Yes!

But what about the data from accounting? The main task of accounting is the legally correct representation of the past. Planning concerns the future, has no legal requirements AND you can not "break" anything. This is an important aspect, which is also cited by our clients. The well-known investor Fred Wilson has also described in his blog another very important aspect - different types. The financial 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 revenue surplus calculators?


No! Companies with double-entry bookkeeping have just limited insight into their cash flow from the bookkeeping. This often leads to the use of the indirect method to determine the cash flow. The starting point is then the result for the period and so-called non-cash items, i.e. non-cash revenues and expenses such as depreciation and amortization, are deducted. In addition, there are issues with accruals and deferrals. However, the indirect derivation is so complicated that this is usually done by the tax consultant, with a corresponding time delay. 

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


The directly determined cash flow plan, as used by COMMITLY, is super simple and covers all scenarios and also accounting forms AND also company sizes. The "connector" if you will, is the cash balance or bank account balance. In practice, we have rarely (actually never) seen liquidity planning (and also cash flow reports) in Excel that could be reconciled 1:1 with accounting. A tool like COMMITLY ensures the reconcilability.

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

Credits: Photo from pixabay, by Stevepb