Calculating Cash Flow

Calculating cash flow is essential in determining the financial health of your business. Different from your revenues, it is the only measurement by which you will understand how cash moves in and out of your company.

The difference between cash flow and revenue is caused by accrual-basis accounting, in which revenue and expenses are recognized when the work has been performed -- not when the cash is paid or received. Typically, companies will book revenue long before any money is flowing into the coffers.

When calculating cash flow, it is important to separate your cash transactions into three categories: operating, investing and financing.

The operating section includes everything from dividend income and gains or losses from the sale of investments, to purchasing raw materials. Obviously, you will have both inflows and outflows of cash. A positive net operating cash flow is desirable.

Investing activities include money spent on upgrading facilities, equipment and staffing, and purchasing stock in other companies. Don't worry if you do not have a positive net cash flow in this area, as investing money helps your business in the long run.

Financing activities include selling equity to investors and loans taken to cover start-up or ongoing operating costs. However, ideally, financing should mainly be used for the purposes of investing back into your business, not for operations.

Once you have the sum total of operating, investing, and financing activities, you are ready to calculate your net cash flow and in turn, your cash position.

Take your earnings before interest, taxes, depreciation and amortization (EBITDA) and then deduct taxes, cash flow to investors and lenders, and operating activity expenses.

Hopefully you will find that cash inflows are greater than outflows--a good cash position to be sure. You are not finished yet, however.

In order to measure how well your cash covers your current obligations, you must now calculate the operating cash flow ratio. To calculate this ratio, divide cash flows from operations by current liabilities. The bigger the number, the better your business outlook.

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