Last Updated on July 24, 2023
If you’re a first-time small business owner, you’re probably getting hit with financial terms like “net cash flow” that would make the average person want to run for the hills. However, it is important to stay informed to help your business remain afloat. Understanding bankruptcy, profit and loss and everything in between – financial literacy is the key to keeping the doors open.
Net cash flow is one of those many terms you’ll become familiar with as you begin your small business journey. So, while you’re sitting there trying to get your business’s financial house in order, let’s talk about the importance of net cash flow and how you’ll use it.
What Is Net Cash Flow?
Even if you’ve never taken a business course or gotten acquainted with your accountant, calculating your net cash flow is going to let you know if your business is on the right track.
Net cash flow is a simple way to measure if your business is profitable. Want to know if last month was a good month or a bad one? Net cash flow is going to help you answer the question.
Grab a sticky note and write this equation down:
Total Cash Inflows – Total Cash Outflows = Net Cash Flow
We’ll go further in-depth shortly, but let’s nail down the foundation of this business calculation. A cash inflow is money you have coming into your business – whether that be from sales, financing, or investments. A cash outflow is money coming out as operating expenses like rent, equipment, and salaries to your employees.
Doing this calculation, even on a napkin or in the Calculator app on your phone, will give you an idea of your business’s health. If your net cash flow is positive over several months, then your business is in fantastic shape. A negative net cash flow is a sign that things are not going well.
Do The Math
Let’s break it down further and bring some math into this equation. Say your business took in $10,000 last month in cash inflows. Your business disbursed $8,000 in cash outflows. Using the formula above, we’ll see the company operated with a positive net cash flow of $2,000 last month.
$10,000 (total cash inflow) – $8,000 (total cash outflow) = $2,000 (net cash flow)
Conversely, let’s say last month your business took in $8,000 and disbursed $10,000. With our net cash flow formula, you’ll see that we’re dealing with a negative net cash flow of $2,000.
$8,000 (total cash inflow) – $10,000 (total cash outflow) = -$2,000 (net cash flow)
Now that we’ve got the basics covered, we can move on to a more in-depth way to calculate net cash flow.
Net Cash Flow Can Be a Complicated Equation
We touched on the idea earlier that net cash flow can be a simple equation. But there is another side to the equation that breaks your business’s finances down even further. Our friends at Wave Accounting have the breakdown. Still, have that sticky note from earlier? Good. This equation goes below the other.
Operating Activity Cash Flow + Investment Activity Cash Flow + Financing Activity Cash Flow = Net Cash Flow
That can be intimidating to look at if you’ve never seen those terms before. That’s why you’re reaching out for help, though. To get us on track to understanding these new terms, we’ll explain metric by metric.
Operating Activity Cash Flow, or CFO, is the money your business brings in from typical business activities like sales of goods or services. The CFO also includes operating expenses like employee salaries, rent, or website hosting, to name a few.
Investment Activity Cash Flow, or CFI, is the money gained or lost from business investments. These might be things like assets or stock purchases. It can also be investments in the business itself, such as property, equipment, or research and development.
Financing Activity Cash Flow, or CFF, is a type of funding generated by a business. For example, a business can issue equity or debt to raise the funding necessary to invest further into the company.
With all those financial terms out of the way, we can put some numbers to help bring this into focus.
- Last month, your business had $10,000 as CFO.
- Of that, $12,000 came in and $2,000 went out.
- Your CFI was -$1,000 because $4,000 came in but $5,000 went out.
- Finally, your CFF was $15,000 after $20,000 came in and $5,000 went out.
Using our formula above, we’ll plug in our numbers:
$10,000 (CFO) + -$1,000 (CFI) + $15,000 (CFF) = $24,000
A positive net cash flow of $24,000 last month is acceptable in this case. However, that would be a different story if this number came back negative.
Benefits and Limitations of Net Cash Flow Calculations
Knowing that a simple equation can tell you plenty about the health of your business can put many people at ease. After all, a positive is a positive and a negative is a negative.
Understanding this calculation allows you to control the business finances better to mitigate the risks when you grow your enterprise. Being able to track your net cash flow over several months/quarters will give you greater insight in your company’s financial health and allow you to stay on top of your expenses.
However, net cash flow can also have its limitations. Reducing a company’s health down to a single metric rarely tells the full story. Having a full-scale accounting system in place is the only way to ensure that your net cash flow is calculated accurately.
Net Cash Flow vs. Free Cash Flow
Free cash flow is yet another metric that can show if your business is profiting. While you calculate the generated net cash flow by adding CFO, CFI, and CFF, you calculate free cash flow by subtracting CFO from capital expenditures, according to Investopedia.
Capital expenditures may include buying a new building or renovating the one you’re currently using. Back to that sticky note from earlier – let’s make one more addition:
CFO – Capital Expenditures = Free Cash Flow
Financial analysts and other business types often use free cash flow to help measure a business’s value.
A sound accounting system is the best way to know the financial health of your business. With all these business accounting terms a little more demystified, you can now understand what it takes to keep a business going.