Anyone with a personal checking account understands the challenge of keeping track of the money available to pay the bills. The point of watching a checkbook is to ensure that the money coming in exceeds the money going out. The movement of money in and out of a checking account represents cash flow. Businesses are like households in that respect. They must keep a close eye on their checkbook to maintain a positive cash flow, or to anticipate a possible negative cash balance by sourcing (or raising) money from other sources. Ahead, learn more about the different types of cash flow.
What is cash flow?
A business’s cash flow is a record of both money received and money paid during a given time period.
Accounts receivable, or money owed to a business, and accounts payable, money owed by a business, are ignored in cash flow. They are recorded in another financial statement, the balance sheet, of a business’s total assets and liabilities. Only once receivable amounts are collected, and payable amounts are paid, does a business record them as cash flow.
The 3 types of cash flow
- Cash flow from operations
- Cash flow from investing
- Cash flow from financing
There are three types of cash flow recognized in business accounting. US companies typically list them in quarterly financial reports in a statement of cash flows. The cash flows are:
Cash flow from operations
Cash flow from operations tracks the flow of money that stems from the production and sale of a company’s goods and services. It includes cash received from the company’s business operations minus cash expenses, which includes the cost of goods sold and held, plus general and administrative expenses. Cash from operations is the most important of the three cash flows because it shows whether a company is viable and is bringing in enough money on a regular basis to pay its bills without needing outside financing.
Cash flow from investing
This tracks money spent or received to buy or sell assets used in the business, such as property, plant, and equipment. It also includes money spent to buy stocks, bonds, or other securities, and money received from selling securities. While cash from investing may show a negative balance, it’s not necessarily a red flag if the cash is invested in income-producing assets or in activities such as research and development that can bring about future sales and profit.
Cash flow from financing
This accounts for money the business receives from outside sources to fund its operations, including proceeds from loans or bond sales, the sale of an equity stake to an investor, or a public offering of shares. It also accounts for money spent to repay loan or bond principal (the interest paid on loans and bonds comes out of cash from operations), repurchase shares or equity stakes, and pay any dividends. Cash from financing shows how much a business is relying on outside sources of money, rather than internally generated cash from operations.
Cash flow vs. profit
A business’s profit and cash flow can be quite different, because of the differing methods of accounting.Income statements (also called profit-and-loss statements) use accrual accounting, which means that sales, expenses, and profit are recorded as they are incurred in a given period, regardless of when money is received or paid. So for example, a company that sells $10 million in goods during a given period of time records the full amount on the income statement, even if all $10 million hasn't yet been collected from customers. Similarly, if expenses are $8 million, they are fully recorded because they were incurred during that period, even if payment of some of the expenses was deferred.Cash accounting, in contrast, records only the portion of sales that were collected in the period, and the portion of expenses that were actually paid.
Example of profit vs. cash flow
Here’s a hypothetical example of how profit and cash flow can differ, based on accrual accounting versus cash accounting.An entrepreneur with a business making sports apparel has seen it grow to about $10 million in monthly sales. Expenses of $8 million yield a profit of $2 million.But half of the sales, or $5 million, are on 30-day payment terms from customers, leaving $5 million in cash sales. Meanwhile, the entrepreneur pays $4 million of the monthly expenses in cash, and the remaining $4 million will be paid on 30-day credit terms.So while the business’s profit was $2 million, cash flow was half that amount: $5 million cash sales - $4 million cash expenses = $1 millionAccrual accounting is guided by something called the matching principle: sales for a specific period are matched with expenses associated with the production of the sales. So in the example above, the $10 million in sales and $8 million in expenses are matched in the same period, rather than just the cash portion of each in cash accounting.
How to calculate cash flow
Cash flow can be calculated in different ways, depending on what type of cash flow you’re focusing on. Three often-cited types are listed below, with the formulas for calculating each.
Operating cash flow
Companies can vary in their formulas, depending on the amount of details they provide. Most big companies provide a line item that accounts for their operating cash flow. But in the absence of a cash-flow statement, you could use this basic formula to figure it out:
Net income + non-cash expenses - change in working capital - taxes = operating cash flow
Non-cash expenses from the income statement are added to cash flow. These expenses include depreciation of asset values and stock-based compensation to employees. Net change in working capital is subtracted; working capital is current assets minus current liabilities. Taxes are subtracted because they must be paid in cash.
Free cash flow
This is simply operating cash flow, minus spending to maintain or upgrade the business’s assets, such as factories and offices. Such spending is called capital expenditure, or capex, and the free cash flow formula is:
Free cash flow, which is calculated by financial analysts and corporate managers, is a key measure of the strength of a business, because it shows how much money the business has at its disposal to use for expansion, acquisitions, pay dividends or buy back stock, or repay debt. It gauges how well a company can rely on its own resources without needing outside financing.
Cash flow forecast
Just as a business creates a budget and a seasonal forecast for sales growth and profitability, it might consider a forecast for cash flow. A simple formula could be:
Beginning cash balance + projected inflows - projected outflows = cash flow forecast
Projections may need to incorporate any expected price and cost changes during the forecast period—for example, if the business foresees a 10% increase in its product costs and overhead, and plans to raise its prices by 12%. Cash flow forecasts may need continual monitoring and adjusting, based on how money actually flows into the business and flows out.
Cash flow FAQ
What’s an example of a cash flow?
An example of a cash flow would be collection of money from a customer (an account receivable, cash inflow). Another would be payment to a supplier, or payment of rent for a warehouse (accounts payable, cash outflow).
What are the different types of cash flows?
Cash from operations, cash from investing, and cash from financing.
What’s an example of a positive cash flow?
A hypothetical sports-apparel business collected $5 million of its $10 million monthly sales in cash, and gave customers 30 days to pay the other $5 million. The business paid $4 million of its $8 million in monthly expenses in cash, deferring payment on the other $4 million. So the business’s positive cash flow for the month is: $5 million - $4 million = $1 million