What is cash flow in simple terms?

Cash flow is a term often used as a measure of a company’s financial health. But what exactly does it mean? Cash flow, also referred to as the flow of money, flow of capital, or payment stream, provides insight into a company’s inflows and outflows of funds over a specific period, whether monthly, quarterly, or annually. This metric is crucial because it shows how well your company manages its financial resources, independently of non-cash items such as depreciation.

Simply put: cash flow shows how much money is actually available to your company after all ongoing costs and liabilities have been covered. This makes it possible to assess your company’s liquidity and financial strength, both of which are essential for sustainable business development.

Why is it so important to calculate cash flow?

Calculating cash flow is a crucial foundation for effective and precise financial planning. As a standardized and meaningful financial metric, cash flow creates transparency and reduces the risk of financial manipulation. This transparency allows investors and other stakeholders to gain a clear view of a company’s liquidity position.

The cash flow calculation shows exactly how much money is actually available for investments, debt repayment, or dividends. A deep understanding of cash flow helps identify and reduce financial risks at an early stage. This allows companies to act proactively before serious financial problems such as insolvency or bankruptcy arise.

Cash flow and liquidity: what is the difference?

Cash flow and liquidity are closely connected, but they do not mean the same thing. Cash flow is a flow variable and shows how much money flows into or out of the company over a specific period, for example from operations, investments, or financing. Liquidity, meanwhile, describes solvency, meaning the company’s ability to meet its payment obligations at a specific point in time.

Both are crucial for assessing financial stability: positive cash flow ensures that the company can operate effectively and grow in the long term, while strong liquidity ensures that short-term payment obligations can be met, even in the event of unexpected expenses or revenue fluctuations. A company can be liquid without having positive cash flow, and vice versa.

Types of cash flow and their importance for businesses

A company’s cash flow is divided into different categories, each highlighting different aspects of the company’s financial activities. They can be viewed separately, but together they provide the best picture of a company’s liquidity situation.

Operating cash flow (OCF)

Operating cash flow shows the result of all regular cash inflows and outflows from a company’s operating activities over a specific period. This includes revenue from the sale of products or services, minus operating expenses such as salaries, rent, and taxes.

A positive operating cash flow shows that a company generates enough funds to cover its ongoing expenses, which is a sign of operational efficiency.

Alternatively, operating cash flow can also be referred to as gross cash flow. If you subtract the taxes actually paid, you get net cash flow.

Investing cash flow (ICF)

Investing cash flow provides information about cash flows resulting from investment activities, such as the purchase or sale of fixed assets, equipment, and other long-term investments. Negative cash flow from investing activities is common during growth phases, when companies invest in their future. Positive cash flow usually results from the sale of assets, which may indicate a consolidation or downsizing phase.

Financing cash flow (CFF)

Cash flow from financing activities reflects transactions that affect the company’s equity and debt structure. This includes proceeds from issuing shares or bonds and payments for dividends or debt repayment.

Positive cash flow from financing activities shows that the company is raising new capital, while a negative value indicates that the company is returning capital to owners or repaying debt.

Free cash flow (FCF)

Free cash flow is the cash flow that remains after all operating expenses and investments have been deducted. It is an important indicator of a company’s financial flexibility because it shows how much money is freely available to pay dividends, reduce debt, or make further investments. Stable or growing free cash flow is often seen as a sign of healthy corporate management.

Overview

Operating cash flow = cash flow from ongoing business activities = shows the company’s ability to generate liquidity from its operations and measures the efficiency of the core business

Investing cash flow = payment flows from investments = provides insight into investments in future growth and long-term assets

Financing cash flow = inflows and outflows from financing activities = reflects capital structure and financing policy

Free cash flow = cash flow after deducting all investments and ongoing expenses = shows financial flexibility and the ability to invest, distribute profits, or reduce debt

Calculation methods: how to calculate cash flow

Cash flow can be calculated in two different ways: directly or indirectly. Which calculation method is chosen depends partly on the information available and partly on the goal of the calculation.

The indirect cash flow calculation

The indirect method is derived from the annual financial statements and adjusted for non-cash expenses and non-cash income. It is used when a statement about a company’s liquidity situation can only be made based on publicly available annual financial statements.

This is the case, among others, for external tax advisors and business consultants. This calculation does not allow daily updated figures to be included.

Calculation of indirect cash flow:

Cash flow from operating activities = net income + depreciation + changes in current assets and current liabilities

Explanation of the cash flow calculation formula:

Increasing receivables and increasing inventories mean cash outflows and are deducted.

Increasing liabilities mean cash inflows and are added. Example: A company has net income of 150,000 euros, depreciation of 50,000 euros, and an increase in receivables of 20,000 euros. The latter means that the company has effectively lent more money to customers, which represents an outflow of cash. The operating cash flow calculation is therefore as follows: 150,000 euros + 50,000 euros − 20,000 euros = 180,000 euros.

The direct cash flow calculation

The direct cash flow calculation provides information about a company’s timely cash flow because it is not based on retrospective annual financial statement figures, but on daily updated incoming and outgoing payments. In addition, the direct calculation enables a more precise breakdown of cash flows. However, when calculating it, you should pay particular attention to the accuracy of internal information, as this is used for the calculation without additional prior verification.

Inflows include:

Payments from product sales
Payments from the settlement of receivables
Loans received

Outflows include:

Payments for wages and salaries
Settlement of outstanding supplier invoices
Loan repayments

Calculating direct operating cash flow:

Cash flow from operating activities = payments from sales − payments to suppliers and employees

Example:

A company receives 500,000 euros from product sales over the course of a year and pays 300,000 euros for raw materials, salaries, and other operating costs. The operating cash flow would therefore be: 500,000 euros − 300,000 euros = 200,000 euros.

Calculating cash flow: metrics for cash flow evaluation

After you have calculated cash flow, various metrics help assess your company’s financial health more precisely. These metrics are relevant for better interpreting the generated cash flow and understanding its impact on company performance.

Applying methods such as discounted cash flow (DCF) or calculating cash flow profitability provides valuable insights into the effectiveness of capital use and the company’s long-term value. The DCF method analyzes estimates of a company’s future cash flows and discounts them to their present value. These metrics give both investors and internal decision-makers a clear perspective on the company’s financial stability and future viability.

Example: investment in a new production facility

You run a medium-sized company that manufactures household appliances and want to plan investments, for example in a new production facility.

Investment details:

Cost: 5 million euros
Useful life: 10 years
Expected benefit: additional revenue of 1.5 million euros per year and operating cost savings of 300,000 euros per year.

Cash flow estimate:

Annual free cash flow (FCF): 1.8 million euros (1.5 million euros in additional revenue + 300,000 euros in savings)

Calculating discounted cash flow:

Discount rate: 8%

To calculate the free cash flow for each year, the annual free cash flow is discounted using the discount rate of 8 percent. The formula for discounted cash flow in a specific year is: DCF_t = free cash flow / (1 + 0.08)^t

For the entire investment, you sum the discounted cash flows over the 10 years.

Investment decision:

If the sum of the discounted cash flows over 10 years exceeds the investment cost of 5 million euros, the investment is worthwhile. In this case, the sum of the discounted cash flows is around 12 million euros. The investment is therefore financially attractive.

Important information:

OCF, ICF, and FCF are direct measurements of the different types of cash flows that a company generates or uses, depending on its operating, investing, and financing activities. DCF, on the other hand, is an analysis or valuation method that uses these cash flows to determine the present value or fair value of a company.

Example: investment in a new warehouse and logistics center

As an e-commerce company, you plan to invest in a new warehouse and logistics center to shorten delivery times and increase storage capacity.

DCF application:

Future savings from more efficient warehouse processes and increased revenue from shorter delivery times are discounted in order to evaluate the profitability of the warehouse.

Expected cash flows:

Savings in shipping costs, increased revenue through higher customer satisfaction, and fewer returns. By discounting these cash flows to the present, you can assess whether the investment will pay off in the long term.

Example: investment in automation software

Your marketing agency plans to invest in automation software for project management and reporting in order to speed up workflows and improve client results.

DCF application:

The agency estimates future savings in working time and costs, as well as a potential increase in revenue through improved services, and discounts the cash flows.

Expected cash flows:

Savings through less time spent per project, potential new customers through better performance transparency, and improved customer retention. The DCF analysis shows whether the investment in the software pays off through long-term efficiency gains.

Positive vs. negative cash flow

As mentioned earlier, cash flow can be either positive or negative. Below, we look at both possibilities:

Positive cash flow: opportunities and benefits

Positive cash flow shows that a company has generated a surplus because inflows exceed outflows in the period under review. This is a sign of financial health and enables the company to cover operating costs, repay debt, invest, and build reserves. Strong cash flow also increases company value, which attracts investors and lenders.

Positive cash flow despite losses

A company can report losses in its profit and loss statement despite having positive cash flow because non-cash items such as depreciation reduce accounting profit without causing actual cash outflows. The company therefore remains liquid even if it is making losses.

Negative cash flow: risks and disadvantages

Negative cash flow means that more money flows out than flows in. In the short term, this can be normal during major investments, but in the long term it indicates serious financial problems. This can lead to dependence on external financing and limit growth plans. Persistently negative cash flow, also known as cash loss or cash drain, increases the risk of insolvency.

Cash flow analysis: assessing liquidity and stability

A comprehensive cash flow analysis is important for evaluating your company’s liquidity and financial stability. This process allows you to track the effectiveness of cash flows and understand how well your company is able to meet its short- and long-term financial obligations.

Calculating cash flows with Excel

As long as your requirements are relatively simple and you only have limited amounts of data to process, calculating cash flow with Excel is a good alternative. It is ideal for smaller companies with less complex financial structures or for those that need a cost-effective solution to manage their basic financial data.

Calculating cash flows with software

As your company grows and financial data becomes more complex, you will find that Excel is no longer sufficient. This is where specialized cash flow management software like Tidely offers decisive advantages. It automates many of the processes that you would otherwise have to perform manually in Excel and provides advanced analysis tools designed to give you a clear picture of your company’s financial health.

Conclusion: calculating, planning, and optimizing cash flow made easy

A cash flow plan helps you respond early to your company’s financial situation. With tools like Tidely, you can optimize your cash flow by planning scenarios and using regular cash flow forecasts to prevent liquidity bottlenecks at an early stage.

With Tidely, you always have your cash flow under control: automated, daily updated visualization ensures that you always know where your company stands financially. Our cash flow forecasts not only help you with short-term cash management, but are also a crucial part of strategic planning, whether for the next few months or the next five years.

Cash flow planning with scenario analyses

Scenario analyses are a key component of cash flow optimization with Tidely. They allow you to run through different developments, from best-case to worst-case scenarios. This lets you see how different decisions, such as investments in new machinery, or external events such as market fluctuations, affect your financial situation. Sensitivity analysis makes it easy to quickly evaluate the effect of each measure and make well-founded decisions.

Preventing liquidity bottlenecks

With Tidely, you can approach your liquidity planning quickly and easily and identify financial risks early. Automated cash flow forecasts and clearly visualized scenarios help you identify potential bottlenecks before they become a problem, so you remain able to act at all times.

Thanks to Tidely, you optimize your cash flow and remain able to act even when things get difficult. Manage your finances securely and proactively so your business can continue to grow strongly tomorrow.

FAQ

How is cash flow calculated?

Cash flow is calculated using either the direct or indirect method. The direct method considers actual cash inflows and outflows, while the indirect method is based on the annual financial statements.

What is cash flow in simple terms?

Cash flow measures the movement of money within a specific period. By contrast, liquidity describes a company’s ability to meet its liabilities.

What is cash flow on the balance sheet?

Cash flow is not listed directly on the balance sheet. Instead, it is derived from the profit and loss statement and other financial reports. It shows the change in the company’s liquid funds and provides insight into how they flow over a specific period.

Is cash flow before or after taxes?

Cash flow can be calculated both before and after taxes. Normally, the tax burden is included in operating cash flow because it represents a real expense for the company and affects actual liquidity.

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