Running a business involves all sorts of processes, figures and calculations. However, only one is essential to the viability of a business and that is cash flow. In this article, we will tell you about what the meaning of cash flow is and why it is essential.
Content:
- What is cash flow?
- Different types of cash flow
- How do you calculate cash flow?
- What does cash flow have to do with business sales?
1. What is cash flow?
Cash flow is the English word for cash flow. Cash flow represents how much money is coming into a business, as well as how much is going out. If cash flow is negative, then too much money is going out, but if cash flow is positive, enough money is coming in.
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In economics, cash flow is defined in another way, using a simple formula.
Cash flow = profit after taxes and depreciation
In English, you can describe this formula as EBIT: Earnings Before Interest and Tax. For many business owners, this is confusing as it deviates from the familiar cash flow.
2. Different types of cash flow
To take a closer look at it, we will discuss three types of cash flows.
- Operational cash flow
- Investment cash flow
- Financing cash flow
Operational cash flow
Operating cash flow represents all the income and expenses you see coming by in the day-to-day running of your business. You buy things, pay salaries and sell services and/or products. If a business is healthy, this will show positive cash flow. If the cash flow is negative (i.e., you have a negative variance), then you are in financial distress. You are experiencing payment problems or can expect them in the near future.
Investment cash flow
These are the results that come from a company's sustainable investments. Costs for patents, software and computers, furniture and machinery are capital expenditures. Income is less common here because it is the sale of equipment or inventory. We also call this incoming cash flow disinvestment. Obviously, a healthy business has negative cash flow from investments.
Financing cash flow
Did your business take out a loan or did a share issue take place? Then there is an incoming cash flow. If a loan is repaid, then there is a negative cash flow. Is a company experiencing growth? Then there is almost always a positive cash flow.
3. How do you calculate cash flow?
We have already discussed a lot about cash flow, but how do you better chart these cash flows? Actually, it is simple because it is a matter of deductions:
Cash flow = incoming cash flow - outgoing cash flow
We can of course add a calculation example. Suppose €50,000 of income was generated in Q1 and €40,000 goes out again. Then the cash flow is positive because € 10,000 remains.
4. What does cash flow have to do with business sales?
Maybe you want to sell your business now. Then it's good to know how your business is doing, because cash flow plays an important role in business valuation.
The value of a business can be calculated using the so-called DCF method: discounted cash flow method. In that formula, you bring in two important variables: the annual free cash flow and the cost rate. The free cash flow is also called the operating cash flow, as discussed above.
After all, a potential buyer wants to know whether sufficient income is being generated to cover expenses, or in other words whether solvency is in order.
