Calculating and Managing Your Cash Flow

Cash flow isn’t a very difficult concept… in theory. But in practice, it can be a little more complicated. In theory, it’s simply a matter of seeing how money moves in and out of your business. In practice, it’s one of the most important elements of your business’ financial health. Getting it right is essential for the wellbeing of any business, but especially small to medium enterprises.

Without adequately understanding and managing cash flow, your business is at risk. In fact, ASIC’s 2018-2019 data shows that 51% of failed businesses believe that the failure was directly due to inadequate cash flow. And that risk is even higher during uncertain times, like those brought on by the impact of COVID-19.

As an SME, your wiggle room may not be as large as a bigger corporation. And when things go wrong, they can go really wrong, really fast. Understanding your cash flow can help you to prepare for and mitigate those risky times so that you can continue to survive and grow despite set backs.

But what is cash flow? What is the best way to calculate it? And how can you manage cash flow so that your business doesn’t fall into ASIC’s 51% failure rate?

What is Cash Flow?

Definition: Cash flow is simply the measurement of the net amount of money coming into and going out of your business over a defined period of time.

Though that’s the simple definition, it’s importance actually lies in its ability to help you understand the financial health of your business by helping you understand your liquidity position (or your access to funds available for you to use). And understanding your liquidity is vital to understanding whether you are in a position to repay your debts, meet your obligations and reinvest in and grow your business. Or whether uncertain times put you at increased risk.

How to Calculate Cash Flow

There are several methods for calculating cash flow. These include the free cash formula, the operating cash flow formula and the cash flow forecast formula.

Basic Cash Flow Formula

The basic cash flow formula is:

Cash flow = Cash from operating activities +(-) Cash from investing activities + Cash from financing activities

This will give you a basic understanding of the money coming in and out of your business.

Free Cash Flow Formula

The basic free cash flow formula is:

Free Cash Flow = Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure

The benefit of the free cash flow formula is that you understand what cash you have available or free to use.

Operating Cash Flow Formula

The operating cash flow formula is:

Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital

This formula helps you understand the typical cash flow for your business.

Cash Flow Forecast Formula

The cash flow forecast formula is:

Cash Flow Forecast = Beginning Cash + Projected Inflows – Projected Outflows = Ending Cash

This is a simple calculation of the cash you expect to bring in and spend over (typically) the next 30 or 90 days.

Using Cash Flow Statements

The simplest method of calculating your cash flow is simply to use the cash flow statements that are generated as part of your accounting software. Cash flow statements give you an understanding of your current cash position as well as forecast how much cash you can expect to have at any given point.

Managing Cash Flow

Once you understand your current and projected cash flow positions, you are in a good place to begin managing cash flow for your business, including how and when payments are due and made. And once you’re in control of cash flow, you’ll be in a much better financial position within your business and better able to weather any difficulties whether internal or external.

Here’s the steps you can take to help you better manage your cash flow.

Working Capital Requirements

First, you need to understand your working capital requirements – that is the money that you need to keep your business running on a day-to-day basis. In order to accurately calculate this requirement you’ll also need to understand what your assets are (or how much inventory you hold), what money is owed to you and the amount of time it takes to cycle from cash out to your suppliers to cash in from your customers. (This is known as a ‘cash conversion cycle’.)

Establish a Buffer

Once you’ve determined your working capital requirements, you’ll want to work to ensure that you build a buffer above that level. Accountants used to suggest that this be three months to six months’ worth of working capital funds, and while that’s still a good benchmark that set amount has gone by the wayside. Instead, consider how much you would need in the situation where your customers were unable to pay you or you lost income for other reasons.

Remember, you don’t always have to rely solely on business income to create your buffer, particularly in the early days of your business. The buffer can come from business savings, personal funds, overdraft or even a revolving credit facility. Eventually you’ll want to have that money in business funds, but in the beginning that just may not be possible.

Check Your Systems

Review your systems and processes to ensure that you’re invoicing your customers regularly and reviewing incoming invoices to make sure that you are being charged accurately. This will help you keep up to date on how much is owed to you and how much you owe others.

Speed Up Your Conversion Cycle

Speeding up the time between when you spend money (for example, on purchasing inventory from suppliers) and when you collect money (from your customers) will benefit your cash flow position. You could also cut back how much inventory you keep on hand or negotiate longer payment terms with your suppliers to give you more cash on hand at any given point.

Be Easy to Pay

Make it easy for your customers to pay you. Offer multiple payment routes, such as account transfers, credit card payments or even PayPal. And consider incentives to customers who pay on time or better yet, early.

Plan Ahead

When it comes to cash flow, planning ahead will help you to survive when things go wrong. You can do this by preparing cash flow forecasts both for the upcoming year, and on a month-by-month basis. Then make sure that you have buffers in place to cover the tight times.

Talk to Your Accountant

At the end of the day, the best way to manage your cash flow is to have a great working relationship with your accountant who can give you tips and strategies for maximising your cash flow and therefore maximising your success.

For more information on calculating and managing cash flow, get in touch. We’re here to help.