Companies use cash flow formulas to calculate various variables related to cash flow. Here we give you an overview of the most important formulas and methods.
The cash flow formula according to the direct method is one way of calculating the cash flow balance so that other cash flow ratios can be determined later.
The direct method compares expenditure and income within a certain period of time. The cash flow balance is determined directly from the incoming and outgoing cash flows. The cash flow balance is often determined on a monthly basis:
Monthly cash flow balance = Monthly incoming cash flows - Monthly outgoing cash flows
Incoming cash flows include, for example:
- Revenue from sales
- Cash on hand
- Funding and subsidies
- Tax refunds
Outgoing cash flows include:
- Staff salaries
- Cost of materials
- Administration costs
- Marketing and distribution costs
- Leasing fees
- Insurance premiums
- Fees for software licences
- Back tax payments
In the indirect method, the cash flow is calculated from the key figures in the income statement by deducting all non-cash expenses and income from the net profit after tax.
With the indirect method, the individual cash flows are not compared with each other as with the direct method. All non-cash items are eliminated from the annual result until only the cash flow remains.
Non-cash expenses include, for example:
- Increases in provisions
- Allocation of reserves
- Decreases in inventories of finished goods and work in progress
Non-period and extraordinary expenses Non-cash income includes:
- Reversal of provisions
- Withdrawals from reserves
- Income unrelated to the accounting period and extraordinary income
With the help of the indirect method, the operating cash flow can be calculated from the cash flow statement. The following formula is used for this purpose:
- Operation cash flow = Net income + depreciation and amortisation + accounts receivables + inventory + accounts payables
The operating cash flow only takes into account the cash portion that arises from or has to be spent on operating activities. Investment and financing activities are not included.
The cash used for investment activities or generated by investments is called investing cash flow:
Investing cash flow = Incoming investment cash flows - outgoing investment cash flows
The incoming cash flows (e.g. returns or dividends from investments) are deducted from the outgoing cash flows (e.g. purchase of a new machine).
The cash flow from financing activities can also be presented separately by subtracting the outgoing from the incoming cash flows:
Financing cash flow = Incoming financing cash flows - outgoing financing cash flows
If you add up all the above cash flows, you get the net cash flow:
Net cash flow = Operating cash flow + investing cash flow + financing cash flow
To obtain the net cash at the end of a period, the net cash flow is offset against the cash flow balance of the previous period:
Net cash at end of period = Net cash flow + cash balance at start of period
For example, if the cash balance at the beginning of the year is £50,000 and the net cash flow during the current year is £30,000, the net cash balance at the end of the year is £80,000.
The free cash flow indicates the amount of cash that remains after all costs incurred in the operational area have been covered. Thus, the free cash flow is composed of the operation cash flow and the investing cash flow:
Free cash flow = Operation cash flow + investing cash flow
The net present value (NPV) indicates the value of all future cash flows at the current time. Future interest is taken into account and related to the current point in time. In this way, it is possible, for example, to assess whether an investment at the present time will generate a positive cash flow in the future or not.
To calculate the NPV, one needs the future net cash flow. This can be estimated, for example, by preparing a cash flow forecast that takes into account all expected incoming and outgoing cash flows generated by the initial investment. The NPV can then be calculated using the following formula:
NPV = Net cash flow / (1+r)^t - initial investment
In this formula, r stands for the interest rate assumed for the future cash flows; t stands for the duration of the investment (usually in years) and initial investment is the amount invested.
Example A company wants to know whether an investment of £500,000 in a new machine is worthwhile or whether the money should rather be invested for 5 years in the capital market, where an annual interest rate of 10% is expected. By investing in the new machine, on the other hand, the company expects an annual cash flow of £50,000. The NPV of the machine is then calculated like this:
NPV = -£500,000 + £50,000/(1+0.1) + £50,000/(1+0.1)² + £50,000/(1+0.1)³ + £50,000/(1+0.1)^4 + £50,000/(1+0.1)^5 Capital value = -£310,461
Since the NPV is negative, the investment in the machine is not worthwhile and the investment in the capital market is the more interesting alternative.
Since there are many different cash flow formulas, you may be wondering which one is the most important. However, there is no general answer to this question, because it always depends on the aspect from which you want to view your cash flow.
If you want to have detailed information about your monthly cash flows because you might want to calculate the cash burn rate, it is worthwhile to determine the individual cash flows using the direct method. This is more accurate than the indirect method.
If you are only interested in your annual cash flow, you can calculate it using your cash statement and the cash flow formulas for the indirect method. This method is less accurate, but it is easier and faster to calculate the individual cash flow figures.