Cash flow statements play a vital role in understanding the liquidity status of an organisation. A cash flow helps investors understand the volume of revenues an organisation has earned over a said period of time. A positive cash flow statement affirms the healthy financial position of an organisation to investors. It serves as a blueprint informing investors about the money being spent, earned, and invested. It reflects the amount of cash owed to creditors and how much and when debts are repaid, all of which detail the organisation's financial standing. These details impact the expansion and growth objectives of every organisation. This helps in futuristic planning, setting new goals, and helps the organisations make strategic decisions in mergers and acquisitions. It also gives an organisation an understanding of the requirement of working capital and the various expenses made by an organisation. Unlike income statements, cash flow statements do not include non-cash expenditures. A cash flow statement clarifies whether an organisation is earning enough and more revenues that help it tide over its expenses.
Understanding the Calculations of Cash Flow
The primary constituents of a cash flow include three distinct areas. These are listed below:
- Investment activities
- Operation activities
- Finance activities.
The 3 important cash flow formulas include:
- Free cash flow formula
- Cash flow forecast
- Operating cash flow formula
Free cash flow formula: Operating cash flow – Capital expenditure
Another simple way of looking at it = Net operating profit (after taxes) – Net investment in operating capital
Operating cash flow formula: Involves the sum of revenues earned by regular business operations. Formula = Operating income (Y) Depreciation – Taxes change in the working capital
Cash flow forecast = The anticipated amount of cash in receivables - the volume of cash intended for expenses (for a distinct time frame)
Also Read: Know All About Cost Accounting
Workings of the Free Cash Flow Formulas:
This is one of the most simple calculations to understand how much excess cash your business enterprise has after it completes payments towards purchases of fixed assets as well as its operations. Let us look at a typical example of this formula:
Good Health is a homegrown wellness organisation desirous of expansion and diversification. It is keen on attracting new investments. The company’s income statement indicates a net profit of ₹ 100,000 after payment of taxes in the earlier year. To calculate the free cash flow, you have to add the non-cash expenditures incurred, if any, that lowered the net income. These could be amortisation or even depreciation. You also have to make profit adjustments to establish the changes in the working capital.
Amount of depreciation - ₹10,000
Amount involving amortisation - ₹5,000
Current assets of Good Health - ₹100,000
Current liabilities of Good Health - ₹80,000
Purchases of fixed assets - ₹50,000
Free cash flow formula = ₹100,000 – (₹100,000 - ₹80,000) ₹10,000 + ₹5,000 = ₹95,000
Free cash flow = ₹ 45,000 (₹95,000 - ₹50,000)
A company that reflects excess revenues is not necessarily a positive sign of its overall performance. Such a company may not have upgraded its technology or machinery. In the event of a breakdown, the company will cease functioning, which will impact its sales and revenues. The brand may also get negatively impacted. Similarly, a negative cash flow does not necessarily mean a company is experiencing losses. The company may have decided to invest in the latest technology and upgrade its machinery, which may have involved using the extra cash available on hand.
Operating cash flow, in simple words, signifies the volume of revenue earned by your company from regular business activities. The company does not take recourse to sources of income like interest. The inflow of cash always has to exceed the outflow of cash. This enables the company to earn profits and make timely payments without any hindrances.
Operating Cash Flow Formula:
Desi Hats is a company which manufactures headgear unique to every Indian state. It has only one market competitor, namely Phirangi Hats and wants to expand its business beyond boundaries. Its financial statement includes:
Net revenue earned - ₹100,000
Depreciation amount - ₹10,000
Changes in accounts receivables - ₹50,000
Inventory change - ₹20,000
Accounts payable change - ₹25,000
Therefore the operating cash flow :
₹55,000 = ₹100,000 - ₹50,000 + ₹20, 000 - ₹25, 000 + ₹10, 000
Desi Hats has ₹55,000 cash flow from its business operations at the end of the financial year. It can re-invest this to enhance creative and quality products to defeat the one existing competitor.
Cash Flow Forecast:
Every business should monitor its cash flow at regular intervals. This will enable them to understand various issues like the requirement for more cash. It also helps an organisation not experience an unnecessary outflow of cash. It aids in understanding trends and the right timing to make necessary investments in the larger interests of the organisation to function more effectively. In addition to revenue earned from regular operations, cash receivables can also include money that has come from previous invoices whose payments were due. Cash that is spent could be towards payment of income taxes, salaries, wages or even interests.
Net cash flow – Total cash received – total cash spent
Once you are familiar with the calculation of cash flow, it becomes very easy to make a projection of cash flow.
Given below are the steps to create a forecast for cash flow:
- One of the first steps is to consider a time frame – this could be a quarter of a year, 3 months or even six months
- Once you have defined a time frame, you should calculate the total value of your anticipated commercial transactions during that time period.
- Detail the number of cash receivables – you can start with things you are confident about, e.g., recurring invoices.
- To this above amount, you should add the sum of other cash inflows like sales of assets, tax rebates, if any, likely grants, and investments.
- Now pin down details of the amount of cash you anticipate spending across the forecasted time frame. This could include rent of the commercial premises, taxes, salaries, computer hardware, and the latest or upgraded computer software.
- Now you will have to resort to the net cash flow formula. If your cash flow forecast indicates a negative amount, it implies proper measures to be implemented at once in order to eliminate cash outflows. A positive cash flow forecast is always welcome but should not make you complacent. There can be unforeseen contingencies which may arise – like geopolitical issues which may disrupt the economy and the operations of businesses.
There are various ways in which you can prevent cash outflows and judiciously manage your cash. Some of these include:
- Monitor all your cash spends and try to curb the unnecessary ones
- Become a good negotiator for all your business deals
- Create regular forecasts for sales
- Incorporate meaningful procedures to monitor and control credit
- Keep checks on all spending activities and implement controls wherever required
- Incorporate firm policies on stock control
- Read financial reports
Also Read: What are Consolidated Financial Statements?
One of the most common reasons for the failure of small businesses is their inability to maintain requisite cash reserves. Every business needs a constant supply of cash to meet its numerous obligations of payments, investments, as well as growth plans. A dearth of funds disrupts the entire commercial operations leading to unpleasant business conditions. Monitoring your business operations and activities is imperative to all businesses. This article helps you understand the meaning of cash flow, the various methods of calculating it and its relevance to a business enterprise. Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.