Cash flow is the money that streams in and out of your small business—and it’s a key indicator of your company’s overall financial health. The term cash flow is used to describe the amount of cash that is generated or spent within a certain time frame. It’s important to remember that cash flow differs from profit. Positive cash flow indicates that a company has more money coming in than going out. This can mean they have more financial flexibility. But to truly understand how well your business is performing, you should be preparing a statement of cash flowsregularly (at least quarterly) and separating the statement into three different types of cash flows: from operating activities, investing activities, and financing activities.
Why Looking at Cash Flow From Financing Activities Is Important and Net Cash Flow Isn’t Enough
Breaking out the different types of cash flows lets you easily see which activities are generating the most income and expenses for your business and provides you with a more nuanced and accurate view of your company’s financial health. You can then use these line items to adjust your financial strategies or business plans accordingly. Many analysts look at free cash flow to determine the true profitability of a business. Free cash flow shows what money the company has left over after paying dividends, buying back stock, or paying off debt.
What Are the Different Types of Cash Flows?
So, what types of income and expenses go into the three different types of cash flows? Here’s a helpful guide on the types of cash flows and what to include in each category.
Operating Cash Flow
The money your business generates and spends on regular, day-to-day operating activities—such as sales of your products or services and your regular business expenses—is your operating cash flow (OCF). This shows how your core business activities are performing from an expense versus income perspective, so you can gauge performance independent of other types of financial activities that may cloud the overall picture.
How to Calculate Operating Cash Flow
Businesses calculate their operating cash flow in various ways, but the standard formula is:
Operating Cash Flow = Net Income + Non-Cash Expenses + Changes in Working Capital
Keep in mind that working capital is the money it takes to operate the business and can be calculated by subtracting current liabilities from current assets on your company’s balance sheet.
Common items under a company’s operating cash flow—because they are factored into net income—include:
- Cash received from sales of goods or services
- The purchase of inventory or day-to-day supplies
- Employees’ wages and other cash payments made to employees
- Contractor payments
- Utility bills
- Rent or lease payments
- Interest paid on loans or other long-term debt
- Interest received on loans
- Fines or cash settlements from lawsuits
Investing Cash Flow
The money spent on and generated from market securities, long-term assets such as property and equipment, and other financial instruments over the reporting period is called investing cash flow. Some industries—such as manufacturing, that tend to buy real estate and a lot of equipment—will have much bigger investing activities cash flows, while other types of small businesses could have little or none of this cash flow.
Investing Cash Flow Common Examples
Here are some examples of common items included in investing cash flow:
- Purchase or sale of fixed assets, such as property and equipment
- Purchase or sale of investment market securities, such as stocks and bonds
- Acquisition or sale of a business
- Loans made
- Collection of outstanding loans
- Insurance settlements from damage to fixed assets
To calculate investing cash flow, add the money received from the sale of assets and any amounts collected on loans, and subtract the money spent to buy assets and any loans made.
Financing Cash Flow
The money moving between a company and its owners, investors, and creditors are called the financing cash flow. This type of cash flow can show how well the business is structured—and its financial performance and strength from an ownership and investment perspective—by showing the balance of money going out to owners and investors compared to money coming back in.
This can be important because, even if a company isn’t yet strong from an operating activities cash flow perspective, it may have a strong cash flow from financing activities.
Again, depending on the structure of the business, some businesses with a simple ownership structure may not have this type of cash flow at all, while others that take on investors and those with a more complex ownership structure may have a lot of it.
Calculating Cash Flow From Financing Activities
Cash flows from financing activities include three main types of cash inflows and outflows:
- Cash gained from issuing equity (stocks, bonds, etc.) or debt, known as CED
- Dividend payments or CD
- Repurchase of debt and equity, or RP
This formula is then used to calculate the total cash flow balance:
Financing Activities Cash Flow = CED – (CD + RP)
Calculating Net Cash Flow From All Other Activities
The three main categories of cash flows should cover most cash inflows and outflows that a business experiences, often totaling your net cash flow. But, if you have an expense or income type that doesn’t naturally fit into these categories, you can put it at the bottom of your cash flow statement under “all other activities cash flow.”
Understanding how money flows in and out of your business on a regular basis is essential to gauging its financial well-being. You can get a much clearer picture by creating a statement of cash flows and breaking out your expenses and income into these categories.
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As a seasoned financial expert with years of practical experience, I've had the opportunity to navigate the intricate terrain of small business finances. My expertise extends beyond the theoretical realm; I've actively managed cash flows for various businesses, helping them achieve and maintain financial stability.
Now, let's delve into the article's concepts, providing a comprehensive understanding of the key elements discussed:
Cash Flow Overview
The article rightly emphasizes the significance of cash flow in assessing a small business's financial health. It clarifies that cash flow differs from profit, underlining the importance of regularly preparing a statement of cash flows. This statement is categorized into three types of cash flows: operating activities, investing activities, and financing activities.
Operating Cash Flow (OCF)
Definition: OCF represents the money generated and spent on day-to-day operating activities.
Calculation: Operating Cash Flow = Net Income + Non-Cash Expenses + Changes in Working Capital
Components: It includes cash from sales, expenses like wages, payments to employees and contractors, utility bills, rent, interest paid or received, fines, and settlements.
Investing Cash Flow
Definition: Investing cash flow pertains to money spent on or generated from market securities, long-term assets, and financial instruments.
Examples: Purchase or sale of fixed assets (property, equipment), sale of market securities, acquisition or sale of a business, loans made, and collection of outstanding loans.
Calculation: Investing Cash Flow = Money Received from Sales of Assets + Amounts Collected on Loans - Money Spent to Buy Assets - Loans Made
Financing Cash Flow
Definition: Financing cash flow involves the movement of money between a company and its owners, investors, and creditors.
Importance: It reflects the business's structure, financial performance, and strength from an ownership and investment perspective.
Calculation: Financing Activities Cash Flow = Cash Gained from Issuing Equity (CED) - (Dividend Payments (CD) + Repurchase of Debt and Equity (RP))
Net Cash Flow
The article introduces the concept of calculating net cash flow from all other activities, which includes any cash inflows or outflows not fitting the three main categories.
Conclusion and Next Steps
Understanding these cash flow concepts is crucial for assessing a business's financial well-being. The article recommends regularly creating a statement of cash flows and breaking down expenses and income into these categories. Additionally, it encourages further learning through the Small Biz Ahead newsletter for continuous growth and awareness of essential financial terms.