Cash flow is one of the key metrics of a company’s financial health. Tracking cash flow gives you a clearer picture of your company’s spending, liquidity, flexibility, and performance. Below, we provide a comprehensive definition of cash flow in accounting.
What is Cash Flow?
Cash flow refers to the movement of cash in and out of a business within a given period of time. It is composed of the following parts:
- Inflows: The money going into a business through operating revenues, investments, and financing.
- Outflows: The money going out of a business through spending.
Your net cash flow is the difference between inflows and outflows. It reflects whether the business earns more than it spends. Positive cash flow denotes that inflows exceed outflows, while negative cash flow denotes the reverse.
How To Calculate Net Cash Flow
The formula for net cash flow is inflows minus outflows.
Net Cash Flow Example
Let’s say your company incurred $50,000 inflows from revenue and $4,000 outflows from expenses last November. Your net cash flow would be $46,000.
Types of Cash Flow
Companies derive their cash flow from three activity types: operations, investments, and financing. Below, we discuss the inflows and outflows each activity generates.
Cash from Operating Activities
Operating cash flow refers to all cash flow generated from core business activities.
- Inflows from operating activities include sales revenue, interest on bank deposits, and dividends.
- Outflows from operating activities include your typical business expenses, such as salaries, utilities, maintenance, and others.
Cash from Investing
Investing cash flow refers to the cash flow generated by investment-related activities.
- Inflows from investment activities include sales of investments like land, equipment, and securities and collection of loans and insurance proceeds.
- Outflows from investment activities include lending money and purchasing long-term assets, stocks, and securities.
Cash from Financing
Financing cash flow refers to the cash flow generated by funding activities, such as debt, equity, and dividends.
- Inflows from financing activities include borrowed money and issued equity.
- Outflows from financing activities include debt repayments and dividend payments to shareholders.
How to Analyze Cash Flow
There are multiple metrics you can use to analyze your cash flow information. These metrics can help you assess financial performance and aid short- or long-term planning.
| Metric | Description |
|---|---|
| Free Cash Flow | Operating cash flow minus capital expenditures. |
| Current Liability Coverage Ratio | The ratio of operating cash flow to average current liabilities. |
| Price-to-Cash Flow Ratio | The ratio of operating cash flow per share to price per stock. |
| Cash Flow to Net Income Ratio | Operating cash flow divided by net income. |
Free Cash Flow
Free cash flow (FCF) refers to the amount of cash left over after covering operating expenses and capital expenditures.
- Operating expenses are the ongoing costs of running a business. Examples include rent, utilities, salaries, inventory costs, and marketing costs.
- Capital expenditures are the costs of buying, maintaining, or improving fixed assets. Examples of fixed assets include land, buildings, vehicles, and equipment.
Alternatively, FCF can be written as the difference between operating cash flow and capital expenditures. FCF shows whether a company is efficient at generating cash past its necessities. Greater FCF implies a better ability to repay debt or invest in value-adding business activities. Investors look at FCF to determine a company’s capacity to roll out shareholder dividends or buybacks.
Example: In the fiscal year ending 2024, you generated a total revenue of $3,000,000. You also incurred operating expenses of $800,000 and capital expenditures of $1,000,000. Subtracting operating expenses from total revenue gives you $2,200,000. Then, deducting capital expenditures gives you an FCF of $1,200,000. This means you have $1,200,000 left to spend on debt, invest in growth, or pay dividends.
Current Liability Coverage Ratio
The current liability coverage ratio is the ratio of operating cash flow to average current liabilities. It measures liquidity and determines your current capacity to pay off existing debt. If the ratio is greater than one, the company has enough money to accommodate its liabilities.
Example: In the accounting period ending March 31, 2024, your company yielded an operating cash flow of $200,000. Your current liabilities amounted to $80,000. Dividing $200,000 by $80,000 gives you a current liability coverage ratio of 2.5, which means your operating cash flow can cover your debt 2.5 times over.
Price to Cash Flow Ratio
The price-to-cash flow (P/CF) ratio is the result of dividing the company’s stock price by its operating cash flow per share. It tells you how much money the company generates in relation to the cost of a single share. Investors look at P/CF to determine whether a company’s shares are worth buying.
Example: Your company has 500,000 shares and a share price of $120. In the fiscal year ending 2024, it had an operating cash flow of $15 million. Dividing $15 million by 500,000 gives you an operating cash flow per share of $30. To get the P/CF ratio, you divide the stock price of $120 by $30. This gives you a result of 4, which indicates that the company’s market share can cover operating cash flow 4 times over. It also means investors are willing to pay $4 per dollar of cash flow.
Cash Flow to Net Income Ratio
The cash flow to net income ratio is the result of dividing your operating cash flow by your net income. It measures the amount of cash that moves for every dollar the business generates on business activities. Higher ratios indicate that the company’s earnings translate to strong operating cash flow.
Example: Your company ended the fiscal year with a net income of $600,000 and an operating cash flow of $900,000. Dividing operating cash flow by net income gives you a result of 1.5, which implies that the company is efficient at converting its net earnings to cash.
What is a Cash Flow Statement?
The cash flow statement is one of the three fundamental financial statements in bookkeeping, complementing the balance sheet and the income statement. As its name implies, this statement displays how much cash a business spends and earns in a given period. The cash flow statement consists of four components:
- Cash flow from operating activities
- Cash flow from investment activities
- Cash flow from financing activities
- Disclosure of non-cash activities
The fourth component, which discloses non-cash activities, is occasionally required under generally accepted accounting principles (GAAP). Companies typically prepare cash flow statements on a monthly, quarterly, or yearly basis.
Cash Flow Statement Example
| Cash Flow from Operating Activities | |
| Net Income | $3,000,000 |
| Additions to cash | |
| Depreciation | $5,000 |
| Decrease in Accounts Receivable | $20,000 |
| Increase in Taxes Payable | $10,000 |
| Subtractions from cash | |
| Increase in Inventory | ($25,000) |
| Net Cash Flow from Operations | $3,010,000 |
| Cash Flow From Investing | |
| Purchase of Equipment | ($600,000) |
| Purchase of Securities | ($70,000) |
| Net Cash Flow from Investing | ($670,000) |
| Cash Flow From Financing | |
| Notes Payable | $10,000 |
| Net Cash Flow from Financing | $10,000 |
| Cash Flow for FY Ended December 31, 2024 | $2,350,000 |
In the above statement, the company started by listing its income from operating activities ($3,000,000), then all cash additions net income had not covered (depreciation, decreases in accounts receivable, and increases in taxes payable), then subtractions to cash (an increase in inventory, shown in parentheses to indicate negative value). The total net cash flow from operating activities was $3,010,000. Investing activities included the purchase of equipment worth $600,000 and securities worth $70,000, for a net of negative $670,000. Financing activities included only notes payable worth $10,000. The total cash flow for the fiscal year was $2,350,000.
What is a Cash Flow Forecast?
A cash flow forecast uses historical data to estimate upcoming cash inflows and outflows over a given period of time. It helps companies plan for any anticipated cash shortages or surpluses. For example, when a company projects an insufficiency of inflows to outflows, it can keep operations smooth by requesting funding from banks or shareholders. Alternatively, a company that projects excess inflows can plan to invest the money in business-growing activities.
Benefits of Tracking Cash Flow
As a financial health metric, cash flow can help you evaluate the effectiveness of your business decisions, optimize plans, and attract investors. Below are a few of the main benefits of calculating cash flow.
Helps Assess Financial Health
Tracking cash flow at the right time helps you assess whether your business is taking the right actions. Recording inflows shows whether you’re earning efficiently, while recording outflows shows whether you’re spending strategically. Comparing your inflows against your spending shows whether your business efficiently generates the usable revenue necessary for operations and growth. Additionally, consistent expense tracking is essential for effective financial management.
Improves Financial Preparation
Tracking cash flow consistently will eventually illuminate your company’s income and spending patterns. You can use these patterns to create cash flow forecasts and plan for projected income and expenses. For example, you run a laundromat near a student housing building. Naturally, your laundromat’s cash inflows decrease when students leave for winter and summer holidays. You can use cash flow data to pinpoint when income starts to drop, then lower utilities spending according to demand. Alternatively, cash flow forecasting can help you plan for excesses in cash flow.
Strengthens Relationships with Vendors
Cash flow forecasting helps you estimate when cash will be available. This prevents late payments and ensures strong relationships with vendors and suppliers. Additionally, you can use the information to negotiate payment terms that align with your cash flow timeline.
Attracts Investors
Evaluating financial performance helps more than just your business management plans. Tracking financial metrics like cash flow gives investors solid evidence that your business is worth backing. Attracting investors gives you extra funds to grow your business. Free cash flow proves that your business can pay its expenses and investments. The current liability coverage ratio shows its ability to pay back debt. One of the most relevant metrics is the price-to-cash flow ratio, which shows investors how much cash the business can generate per dollar that they invest.
Track Your Cash Flow With EpicBooks
Cash flow is one of the most useful financial health metrics. It can be used to assess your capacity to pay expenses and debt, your efficiency at generating revenue, and your ability to provide favorable returns for investors. Additionally, tracking cash flow through cash flow statements helps you forecast future revenues and expenses for smarter planning.
However, tracking cash flow can be a tedious process. If you want to benefit from insight-generating financial information without the time-consuming burden of financial management, consider outsourcing bookkeeping services. EpicBooks can help you track and analyze cash flow, build better budgets, and craft financial strategies for optimal performance and growth. We’ll track the metrics so you can focus on profits. Read the EpicBooks pricing page for more information.
FAQs
What is the difference between cash flow and revenue?
Revenue refers to the money the business generates through its activities. Meanwhile, cash flow describes the net amount of cash that moves in and out of the business over a given time period. Unlike cash flow, revenue does not account for spending. Additionally, revenue does not automatically equate to cash inflows, as earnings are sometimes paid on credit.
What is the difference between cash flow and net income?
While cash flow and net income are both key financial health metrics, they serve different purposes. Cash flow measures a company’s liquidity, flexibility, and ability to cover expenses, debt, and other financial obligations. It represents the difference between cash inflows and outflows. Net income, on the other hand, reflects profitability, showing the revenue left after subtracting expenses, taxes, and the cost of goods sold. While revenues and expenses generally correspond to cash inflows and outflows, companies using accrual accounting may experience delays between the recognition of these items and actual cash movement. As a result, net income is a less reliable indicator of liquidity compared to cash flow.
How do you determine healthy cash flow?
Cash flow is typically considered healthy when inflows exceed outflows. Another metric is the current liability coverage ratio, which divides operating cash flow by current liabilities. Having a current liability coverage ratio that is greater than 1 indicates that you have enough cash inflows to cover all necessary expenses and debt in a timely manner.
Is negative cash flow bad?
Negative cash flow doesn’t always signal poor financial performance. It’s simply a snapshot of activity over a specific period. Occasional occurrences of negative cash flow is normal, especially for businesses offering credit, facing seasonal demand, or investing in growth. In these cases, negative cash flow is only temporary, with positive inflows arriving in future accounting periods. Negative cash flow is an issue when it becomes a consistent pattern. Failing to recover costs indicates that the company is either spending too much, earning too little, or overinvesting.
Echo Wang is an accomplished Canadian entrepreneur and the driving force behind EpicBooks, bringing a wealth of experience and a passion for excellence to the realm of bookkeeping.
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