Cash Flow: definition, calculation, principle, all you need to know!

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Cash Flow: definition, calculation, principle, everything you need to know!

Many financial jargon terms frequently crop up in business and can sometimes be confusing. To get a clearer picture, here we focus on a term you will surely have heard already: "Cash Flow". This term actually refers to one of the most vital indicators for business people and one of the most scrutinised by analysts, bankers and investors. Together, let's find out what "cash flow" means and how it is calculated and interpreted. We also provide some extra tips to take away so you know everything you need about this topic!

Cash Flow Defined

Cash Flow is a term used frequently in everyday business English and you may also see it written as one word "cashflow". The definition of Cash Flow is actually quite straightforward: it is a measurement of the net flows of cash in a business (inflows and outflows). This is known as "Cash in" and "Cash out". They are often entered in a statement which is then used to develop a cash flow plan.

Understanding the content of Cash Flows

A carefully prepared cash flow statement distinguishes three precise categories of flows. This particularly facilitates "cash flow management", with the aim of listing and understanding these flows to better manage the company's cash. Before we look at the calculations, let's see what these three Cash Flow categories are:

Cash flow from operating activities means the surplus cash generated by the company's business, i.e. resulting from its sales

Cash flow from investing activities identifies inflows from asset disposals and outflows for acquisitions of fixed assets

Cash flow from financing activities lists all the inflows and outflows relating to financing choices, such as capital contributions, dividend payments, loans granted and repaid, and shareholder current accounts, etc.

Positive and Negative Cash Flow

As these flows may be cash in or cash out for a business, two main cases must be distinguished:

Positive cash flow (more cash in than out), meaning that the company has surplus cash and can therefore pay its debts, distribute dividends or invest the money for example.

Negative cash flow: (more cash out than in), meaning that the company is lacking cash. More money must therefore be brought in or the company must cut its costs.

Also read: What is cash burn and how is it managed?

Cash Flow: Avoid the confusion

Beware that, by misuse of language, Cash Flow is often mixed up with self-financing capacity, although it is not exactly the same thing. Self-financing capacity measures the ability of a business to self-finance its operating cycle and generate wealth. It is a potential flow, whereas cash flows are actual flows. In more concrete terms, self-financing capacity is a "potential" cash surplus which does not factor in the time differences between customer and supplier payments. Numerically, the change in working capital requirement (WCR) is used to go from a potential flow to an actual flow.

This difference is summed up in the calculation below:

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Cash flow from operating activities = Self-financing capacity +/- change in working capital requirement

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Why calculate Cash Flow?

Secure your business's long-term solvency

By calculating Cash Flow you can assess the economic health of your business and anticipate any potential difficulties that may arise. You will therefore be able to take preventive measures before the going gets tough. Good cash flow management therefore significantly reduces the risks you may face.

Make savings

Having a clear vision of your Cash Flow also allows you to detect and eliminate unnecessary expenses. Your cash flow statement will come in very handy to assess your cash surplus, and possibly invest it to earn interest over the long term. You can then build up a reserve to keep your business running even in difficult times (caused by late payments from customers for instance) and, above all, finance your future investments.

Manage bank and investor relations

Lastly, as Cash Flow reflects a company's ability to finance investments out of its operations and pay dividends to shareholders, it is essential to have precise, reliable reports to inspire confidence in your partners in negotiations.

Cash Flow Calculation Methods: Main Models

Operating Cash Flow

The first level of calculation concerns operating cash flow (also called cash flow from operating activities or cash flow from operations). These are variations stemming directly from the operating performances of your business. It is one of the indicators the most closely monitored by Chief Financial Officers, as it is the best way to measure the company's actual cash flow over a given period.

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Operating Cash flow = Self-financing capacity +/- change in working capital requirement

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Note that to do this calculation, you will need to assess your Self-Financing Capacity:

Self-Financing Capacity = net profit + depreciation + provisions – non-recurring items

And your Working Capital Requirement (WCR):

Working Capital Requirement (WCR) = Current Assets – Current Liabilities

So, by setting out the calculation in more detail, we get:

Operating Cash flow = net profit + depreciation + provisions – non-recurring items + current assets – current liabilities

Investment Cash flow (or cash flow from investing activities)

Investment cash flow concerns all the expenditure and income relating to acquisitions and disposals of fixed assets and equity interests. Therefore, to measure the amount, the calculation is as follows:

Investment cash flow = acquisitions of fixed assets (tangible and intangible) – acquisitions of entities (equity interests) + disposals of intangible and tangible fixed assets + disposals of entities (equity interests)

Financing Cash flow (cash flow from financing activities)

Financing cash flows concern income and expenses relating to equity and borrowings. To work out the value, simply do the calculation below:

Financing Cash Flow = Capital increase + Medium-and long-term borrowings – Repayment of medium- and long-term borrowings +/- variation in shareholder loans – dividends paid

Free Cash Flow

You may also want to assess your Free Cash Flow, i.e. the cash remaining after taking account of asset disposals, any investments, your WCR (working capital requirement) and tax on profits. Here is how it is calculated:

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Free Cash flow = Operating Cash Flow + Investment Cash Flow

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With more detail, you therefore obtain:

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Free Cash Flow = Gross Operating Surplus + asset disposals – investments +/- change in WCR – tax on profits

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However, note that to have even more precise information about your cash flow, you can use the distinction between two categories of Free Cash Flow, even if this is seldom done in real life:

Free Cash Flow to the Firm (FCFF) which corresponds to the amount available to all the investors, including holders of debt

Free Cash Flow to Equity (FCFE), which corresponds to the amount available solely to lenders. You may wish to calculate the free cash flow to equity, especially if you need to estimate the value of your company's equity when one or more investors acquire an interest.

In this case, the calculation is as follows:

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Cash flow to equity = free cash flow – financial expenses – financial income +/- change in bank and financial debt

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Découvrez notre dossier complet sur le Free Cash Flow : Qu’est-ce que le Free Cash Flow ? Définition, calcul et interprétation

Some useful Cash Flow Ratios

Calculating Cash Flows is particularly beneficial as it allows you to measure other important indicators for the company. Here are the main ratios you will need to calculate depending on the information you require:

● The Cash flow/revenues ratio shows the profitability of a company (the higher it is, the more the company is capable of turning its sales into cash flow)

● The Cash flow/debts ratio assesses a company's solvency (the higher this ratio is, the less the debts burden the company's cash flow)

● The Cash flow/market value of the company ratio measures the return on investment.

● The Cash Flow/Equity ratio indicates the net return on equity.

Cash Flow Management

While the cash flow statement is a vital tool for managing your business, you not only need to know how to build it, but also how to interpret the results you obtain. Before you set about analysing your Cash Flow, make sure you have identified the different types of cash flows we defined above in this article.

Analysing your Operating Cash Flow

Your operating cash flow corresponds to the surplus cash generated by the company's main business activities (in practice, it is your revenue, without including investment and financing activities). This surplus therefore expresses the value of the wealth that your company creates. It is a vital calculation for a company, in order to repay loans, self-finance certain investments, and pay dividends, etc. Remember to monitor these flows closely to anticipate any shortage of income you use to cover these expenses.

Analysing your Investment Cash Flow

Your investment cash flow reflects the investment effort over the period. Your interpretation here will differ depending on your company's sector of business: if you engage in a service activity requiring few investments, this flow will be lower than if you work in heavy industry for example.

Furthermore, investment expenditures are not always linear in a company. For instance, your business may invest when a new opportunity arises and it may incur the odd unexpected major expense. So, you should also keep an eye on this flow to anticipate your ability to deal with exceptional situations.

Analysing your Financing Cash Flow

Your financing cash flow traces the company's financing choices: flows with shareholders (capital increase and dividend payments, shareholder loans) and flows with lenders (loans issued and repaid).

What your Cash Flow Statement tells you

Your financial analysis of your cash flow statement should be done in several stages.

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  • It gives you a complete picture by reading through the flows recorded:
  • Your self-financing capacity shows the profitability of your company
  • Your operating cash flows help you manage your working capital requirement;
  • Your investment cash flows measure the extent of your investments in fixed assets;
  • Your repayments of medium/long-term loans guide your financing choices;
  • Your financing cash flows allow you to guarantee dividend payments to your shareholders;
  • Your net opening cash balance allows you to compare your situation over time and monitor your cash position.

What is Cash Flow forecasting?

Cash Flow Forecasting is vital to anticipate any difficulties, confidently plan the development of your business and reduce burdensome expenses that affect your profitability.

To do this, you must start by identifying your past inflows and outflows. You can organise your list in a table by distinguishing the different types of cash in and cash out. You may also like to distinguish those concerning customers, those concerning suppliers, as well as grants, loans and other forms of financing.

After listing the categories, you can then enter the amounts corresponding to each inflow and outflow of cash. To have a more complete picture, you can go back over all your past expenditures to obtain a summary of your monthly cash flows over the required period. In this step, make sure you pay close attention to payment times: the aim is to enter the amounts in the month you received (or paid out) the money, not at the time the receivable (or payable) was established.

After all this preparation, you can now draw up your cash flow plan. Start by listing all your recurring inflows and outflows, such as fixed costs. You can then estimate your variable cash flows based on past amounts adjusted to estimated changes. To do this, you will no doubt need to develop different scenarios.

À lire aussi : Comment faire un plan de trésorerie prévisionnel : 4 étapes à suivre

Automate your cash flow calculations for more accurate forecasting

All these tasks can obviously be done by hand using software such as Excel. However, to prepare reliable cash flow forecasts while saving valuable time, today a growing number of companies use cash management software. With this solution, cash management becomes smoother and especially more automated, saving you a lot of tedious and stressful work.

Agicap is a cash management software tool suitable for all small and medium-sized businesses. With Agicap, you have access to automated, real-time cash monitoring: the solution integrates with your banks, accounting tools and invoicing software and updates your cash position automatically.

With Agicap, you can also forecast your cash flows over 1, 3, 6 or 12 months or more, to make the right decisions and secure your financing requirements. You can easily simulate the impact of crisis scenarios on your cash position such as a drop in sales, short-time working, deferred loan repayments, etc.

Read the testimonial by Lucas Gros, CEO of Traction Productions, an optical frame wholesaler:

"In our wholesale trade, as our business is based on large purchase volumes compared to the sales figure, our WCR is an important issue." Lucas Gros, CEO of Traction Productions

The advantages of Agicap to improve your cash flow management:

● Simplicity : Agicap is extremely easy to use and does not require any expert accounting skills.

● Automation : by being connected to your banks and internal software, Agicap updates all your financial data in real time.

● Visualisation : with Agicap, you can see changes in your cash balance at a glance, and customise the displays to meet your needs.

● Forecasting: you can prepare your budget forecast directly in Agicap and have a view of your cash flow over several months or years. You can also develop more scenarios to see how certain events (recruitment, investments, crisis, etc.) could impact your cash flow.

Agicap is the ideal tool for closely monitoring your company's operating working capital requirement. Try it!

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