Cash flow might be the most important number in your business that you’re not tracking closely enough. While profits get all the glory, cash flow determines whether your business survives day to day. I’ve seen brilliant businesses with amazing products fail simply because they ran out of cash. Let’s dive into what cash flow really is, why it matters so much, and exactly how to calculate it for your business.
What is Cash Flow, and Why is it Important?
Cash flow is simply the movement of money in and out of your business during a specific period. It’s like watching your business’s checking account – how much came in, how much went out, and what’s the net result?
Why does this matter so much? Because timing is everything in business. You might have $100,000 in customer orders, but if they won’t pay for 60 days and your suppliers want payment in 30 days, you could find yourself in a serious cash crunch despite being “profitable” on paper.
Here’s why cash flow is your business’s lifeblood:
- It keeps the lights on. You pay your bills with cash, not promises or paper profits.
- It gives you flexibility. With positive cash flow, you can take advantage of opportunities (like a discount for early payment) or handle emergencies without taking on debt.
- It attracts investors and lenders. Both want to see that your business generates enough cash to sustain itself and eventually provide returns.
- It reveals operational efficiency. Your cash flow patterns can highlight problems in your business model long before they show up in profit figures.
Cash flow problems kill small businesses at an alarming rate. The U.S. Bank once found that 82% of business failures were due to poor cash flow management or poor understanding of cash flow. That statistic alone should make you pay attention.
What Are the Different Types of Cash Flow?
Cash doesn’t just move in and out of your business in one uniform stream. For calculation and analysis purposes, we divide cash flow into three distinct categories that represent different aspects of your business activities:
1. Operating Cash Flow
This is cash generated from your core business operations—selling products or services. Think of it as your day-to-day business activities.
Examples include:
- Cash received from customers
- Cash paid to suppliers
- Employee salaries and wages
- Rent and utility payments
- Tax payments
2. Investing Cash Flow
This represents cash used for long-term asset investments or generated from selling those assets.
Examples include:
- Purchasing equipment, machinery, or property
- Buying or selling investments like stocks or bonds
- Acquiring another business
- Selling off business assets
3. Financing Cash Flow
This captures cash moving between a business and its owners, investors, and creditors.
Examples include:
- Taking out or repaying loans
- Receiving investments from venture capitalists
- Paying dividends to shareholders
- Buying back company stock
Understanding these three types is crucial because they tell very different stories about your business. A company might have negative total cash flow but be in excellent shape if that’s due to major investments (investing cash flow) rather than an inability to generate cash from regular operations.
How is Cash Flow from Operating Activities Calculated?
There are two methods for calculating operating cash flow: direct and indirect. Most small businesses use the indirect method because it’s easier to implement with standard accounting information.
Direct Method
The direct method tracks actual cash inflows and outflows:
Operating Cash Flow = Cash Receipts from Customers – Cash Paid to Suppliers and Employees – Cash Paid for Operating Expenses – Cash Paid for Taxes and Interest
While conceptually simple, this requires a cash-based accounting system and detailed records of every cash transaction.
Indirect Method
The indirect method starts with net income (from your income statement) and adjusts for non-cash items and changes in working capital:
Operating Cash Flow = Net Income + Non-Cash Expenses (like Depreciation and Amortization) + Changes in Working Capital
Working capital adjustments include:
- Increases in accounts receivable (subtract)
- Decreases in accounts receivable (add)
- Increases in inventory (subtract)
- Decreases in inventory (add)
- Increases in accounts payable (add)
- Decreases in accounts payable (subtract)
Let’s see an example:
Your business had:
- Net income: $50,000
- Depreciation expense: $10,000
- Accounts receivable increased by $8,000
- Inventory decreased by $5,000
- Accounts payable decreased by $4,000
Operating Cash Flow = $50,000 + $10,000 – $8,000 + $5,000 – $4,000 = $53,000
Why is operating cash flow higher than net income here? Because depreciation reduced your reported profit but didn’t actually consume cash, and you reduced inventory (converting it to cash). These positive factors outweighed the negative impacts of growing accounts receivable and reducing accounts payable.
How is Cash Flow from Investing Activities Calculated?
Calculating investing cash flow is straightforward. You simply track all cash spent on or received from long-term assets and investments:
Investing Cash Flow = Cash Received from Sale of Long-term Assets or Investments – Cash Spent on Purchase of Long-term Assets or Investments
For example:
- You purchased new equipment for $25,000
- You sold an old delivery van for $8,000
- You bought a competitor’s business for $50,000
Investing Cash Flow = $8,000 – $25,000 – $50,000 = -$67,000
The negative figure here is common, especially for growing businesses investing in their future. A consistently positive investing cash flow might actually be concerning, as it could indicate a company is selling off its assets rather than investing in growth.
How is Cash Flow from Financing Activities Calculated?
Financing cash flow tracks money moving between your business and its owners or creditors:
Financing Cash Flow = Cash from Issuing Equity or Debt – Cash Paid to Shareholders (Dividends) or for Debt Repayment
For example:
- You took out a business loan for $30,000
- You made loan payments totaling $12,000 (principal only, not interest)
- You took a $10,000 owner’s draw from the business
Financing Cash Flow = $30,000 – $12,000 – $10,000 = $8,000
For small businesses, financing cash flow often reflects the owner’s relationship with the business through draws or contributions, plus any formal loan arrangements.
How is Total Cash Flow (Net Cash Flow) Determined?
Once you’ve calculated each of the three components, determining total cash flow is simple addition:
Net Cash Flow = Operating Cash Flow + Investing Cash Flow + Financing Cash Flow
Using our examples above:
- Operating Cash Flow: $53,000
- Investing Cash Flow: -$67,000
- Financing Cash Flow: $8,000
Net Cash Flow = $53,000 + (-$67,000) + $8,000 = -$6,000
In this scenario, your business experienced a net cash decrease of $6,000 for the period. But is that bad? Not necessarily. You’re generating strong cash from operations, investing heavily in growth, and supplementing with some financing. This could be exactly the right strategy for your business phase.
The key is ensuring you have enough cash reserves to handle the temporary negative flow and that your investments will eventually generate enough additional operating cash flow to justify themselves.
What Financial Statements Are Used to Calculate Cash Flow?
The cash flow statement (also called the statement of cash flows) is dedicated to presenting cash flow information, but creating it requires data from two other key financial statements:
1. Income Statement
The income statement is the starting point for calculating operating cash flow using the indirect method. It provides:
- Net income
- Non-cash expenses like depreciation and amortization
2. Balance Sheet
Comparative balance sheets (current and previous period) reveal changes in working capital accounts needed for operating cash flow calculations, such as:
- Changes in accounts receivable
- Changes in inventory
- Changes in accounts payable
They also help identify investing and financing activities like changes in fixed assets, long-term debt, and equity accounts.
3. Cash Flow Statement
The cash flow statement itself organizes all this information into the three categories we’ve discussed:
- Operating activities
- Investing activities
- Financing activities
The statement shows both the individual cash flows within each category and the total net cash flow for the period, reconciling the change in cash between your beginning and ending cash balances.
How Does Cash Flow Differ from Profitability Metrics Like EBITDA and Net Income?
This is where many small business owners get confused, so let’s clarify the key differences:
Cash Flow vs. Net Income
Net income measures your accounting profit: revenues minus expenses for a period, regardless of when cash changes hands.
Cash flow measures actual cash movements in and out of the business during that period.
The difference comes from:
- Timing differences: When you recognize revenue or expenses versus when cash actually moves
- Non-cash items: Expenses like depreciation that reduce profit but don’t consume cash
- Balance sheet activities: Inventory purchases, loan payments, and equipment acquisitions that use cash but don’t immediately appear on the income statement
You can be profitable but cash-poor if, for example, your customers take too long to pay or you’re investing heavily in inventory.
Cash Flow vs. EBITDA
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is often used as a proxy for operating cash flow, but they’re not identical.
EBITDA removes major non-cash expenses (depreciation and amortization) from the profit calculation and ignores financing costs (interest) and taxes. This makes it closer to operating cash flow than net income, but it still misses crucial elements:
- It doesn’t account for working capital changes (receivables, inventory, payables)
- It doesn’t reflect actual tax payments
- It doesn’t capture capital expenditures
While EBITDA might give you a quick approximation of operational cash-generating ability, actual cash flow calculations are much more precise and useful for business decisions.
Practical Cash Flow Calculation for Small Business Owners
Let’s translate all this theory into practical steps you can take:
Step 1: Gather Your Financial Information
- Your income statement for the period
- Balance sheets from the beginning and end of the period
- Detailed records of any major asset purchases or sales
- Loan statements showing principal payments
- Information on owner contributions or distributions
Step 2: Calculate Operating Cash Flow
- Start with net income
- Add back non-cash expenses (depreciation, amortization)
- Adjust for changes in working capital:
- Subtract increases in current assets (receivables, inventory)
- Add decreases in current assets
- Add increases in current liabilities (payables)
- Subtract decreases in current liabilities
Step 3: Calculate Investing Cash Flow
List and sum all cash transactions related to long-term assets:
- Purchases of equipment, property, or other businesses (negative)
- Sales of these assets (positive)
Step 4: Calculate Financing Cash Flow
List and sum all cash transactions with owners and lenders:
- Loan proceeds received (positive)
- Loan principal repaid (negative)
- Owner investments (positive)
- Owner withdrawals/dividends (negative)
Step 5: Sum the Three Components
Add operating, investing, and financing cash flows to determine your net cash flow.
Step 6: Verify Your Calculation
The difference between your beginning and ending cash balances should equal your calculated net cash flow.
Making Cash Flow Calculations Work for You
The real value in calculating cash flow isn’t in the backward-looking numbers—it’s in what those numbers tell you about your business and how you can use them to improve your financial future.
Cash Flow Pattern Recognition
Look for patterns in your cash flow statements:
- Is your operating cash flow consistently lower than your net income? You might have a collections problem.
- Is your investing cash flow consistently negative? Ensure these investments are strategic and will pay off.
- Is your financing cash flow consistently positive? Be careful about growing dependent on external funding.
Cash Flow Forecasting
Use historical cash flow patterns to predict future cash needs. Create a simple spreadsheet that projects:
- When customers will likely pay their invoices
- When you’ll need to pay suppliers
- Upcoming tax payments
- Planned investments in equipment or inventory
- Loan payments
This forecasting is invaluable for avoiding cash crunches and planning major purchases or investments.
Cash Flow Management
Once you understand how cash moves through your business, you can take steps to improve it:
- Negotiate better payment terms with suppliers
- Implement tighter credit policies with customers
- Manage inventory levels more efficiently
- Time major purchases to align with periods of stronger cash flow
- Establish lines of credit before you need them
Conclusion: Cash Flow as Your Business Compass
Knowing how to calculate cash flow gives you one of the most powerful tools for business decision-making. While profit figures tell you if your business model is theoretically sound, cash flow tells you if you can actually execute that model in the real world day to day.
Remember:
- Operating cash flow reveals the cash-generating power of your core business
- Investing cash flow shows your commitment to future growth
- Financing cash flow reflects your relationships with lenders and owners
- Net cash flow ties it all together, showing whether your cash position is improving or declining
By mastering cash flow calculation and analysis, you position yourself among the minority of small business owners who truly understand their business’s financial engine. That understanding doesn’t just help you survive—it helps you strategically plan for growth, respond to challenges, and ultimately build a more resilient and successful business.
Cash is indeed king, and those who track and manage its flow wear the crown.