Why cash flow forecasting matters
Many small business owners rely on their CPA to track financial health, but understanding your own cash flow forecast puts you in control.
Knowing how much cash you’ll have on hand helps you make smarter investment decisions and avoid surprises.
This guide walks through the core formulas, terms and forecasting steps every operator should know.
What does “cash flow estimation” mean?
In simple terms, cash flow estimation (or cash flow forecasting) is a prediction of how much inflow and outflow of cash a business will have at any given time.
It’s a bit more complicated than that, of course, especially when non-cash factors, like depreciation and compound interest, come into play.
Either way, performing these forecasts can help you decide when to invest in your own business and when to seek more funding.
Building accurate cash flow forecasts helps you make smarter investment decisions with more confidence.
How to estimate cash flow
The simplest way to do a cash flow forecast is to use this equation:
Starting cash + projected income by a specific date – projected expenses by that same date
This formula will help you to come up with a rough estimate of how much cash flow you’ll have by your chosen point in time.
If you want a more exact project, you’ll have to account for factors like taxes, asset depreciation and deflation, which we’ll get into in the sections below.
Types of cash flow
There are a few different types of cash flow.
- Net cash flow
- Free cash flow
- Operating cash flow
- Incremental cash flow
Each type accounts for different financial factors, and they’re all useful for different reasons.
We’ll define each of them below.
1. Net cash flow
Net cash flow is a business’s total cash inflow and outflow. This number includes the inflow and outflow of cash equivalents, such as investments.
To calculate your net cash flow, you’ll need to know the sum total of your:
- Operating activities
- Investing activities
- Financing activities
What are operating activities?
Basically, any expenses required to keep the company in business are considered operating activities. Goods, services, marketing costs, manufacturing costs and employee wages all fall into this category.
Operating activities make up the bulk of a company’s spending.
What are investing activities?
Investing activities include the purchase or sale of fixed assets, such as property, machinery and vehicles.
Relevant cash flows would relate to the sale of any current assets or the cost of any investment.
What are financing activities?
Financing activities include the cost or profit of any debt, equity or dividends that a company possesses.
For example, a company may be paying down debt interest and be charging interest on a debt owed to them. Both of these are considered financing activities.
How to calculate net cash flow
To find your net cash flow, total up the sum (both income and expenses) of your operating activities, investing activities and financing activities.
In other words:
Net cash flow = operating activities + investing activities + financial activities cash flow
2. Free cash flow
Free cash flow is different from net cash flow in that it only accounts for operating expenses and capital expenditures.
Capital expenditures include the acquisition and maintenance of equipment and property — any physical, non-human assets that help you produce your goods or services. As we said above, operating expenses include things like rent, payroll, insurance, inventory and vendor payments.
Free cash flow shows more than just the inflow and outflow of money. It shows how well the company is balancing its net working capital.
A free cash flow estimate shows how profitable you expect your company to be without looking at non-cash factors. It illustrates how much money you’ll have after you “pay the bills,” so to speak.
The more free cash flow an operating business has at the end of the month, the more opportunity the company has to grow and pay down debts.
How to calculate free cash flow
To estimate your free cash flow, use this equation:
Free cash flow = operating expenses – capital expenditures
3. Operating cash flow
Operating cash flow describes the difference between your EBIT (earnings before interest and taxes) and your operating expenses.
This is the cash flow that doesn’t account for any investments or financing activities.
Operating cash flow does, however, account for asset depreciation. Depreciation is the tax deduction a company can get for the cost of the value of a large investment over time.
A company’s tax liability can be lowered by accounting for the depreciation of your assets as an expense. This will reduce the amount of money you pay in taxes.
The depreciation expense is added back to net income before subtracting operating expenses and taxes on the balance sheet.
How to calculate operating cash flow
Here’s a simple formula to help you:
Operating cash flow = operating income + depreciation – taxes + change in working capital
Operating cash flow vs. free cash flow
These two types of cash flow seem similar, but they’re actually quite different.
While operating cash flow tells whether a company can continue to operate on its current earnings, free cash flow tells whether a company can continue to pay off debts and dividends, or even make investments for growth.
This is important information for outside investors, as they obviously want to see growth.
4. Incremental cash flow
Many business owners use incremental cash flow estimates to determine whether a potential investment is worth the projected return.
The investment could be something like purchasing new equipment or upgrading their technology to develop a new product.
How to calculate incremental cash flow
Estimating incremental cash flow is simple. You take the revenue of the project and subtract the initial investment and expenses of the project.
As a formula, it looks like this:
Incremental cash flow = projected revenue – expenses
If this formula has a positive solution, the project is a good business move.
You can get a more accurate prediction of an investment’s viability by estimating its discounted cash flow (DCF).
DCF is similar to incremental cash flow, but it accounts for inflation, interest, tax rate changes and other factors that change over the lifespan of an investment.
How to use your cash flow estimates
Once you have some numbers, you can use that information to make some business decisions.
What to do when free cash flow is high
If your estimates project high cash flow, this means that your business is headed in a good direction.
This may be the right time to make capital investments. You can put some money toward improving your business by purchasing new equipment, hiring more employees, or increasing your marketing budget.
This is when your book value will be high, and you will be a good candidate for investors. You can take advantage of this and begin a new project.
Before you take this step, however, you should determine whether the potential value of an investment project is worth it. We’ll discuss this more in depth later.
What to do when free cash flow is low
When cash flow is tight, some businesses consider loans to bridge the gap. Loans can help in certain cases but also add debt and repayment pressure. More businesses are taking control with Revenue On Demand™ – choosing when to get paid on invoices rather than waiting or taking on debt.
Additional tips for cash flow estimations
Here are a few more helpful tips to keep in mind when forecasting cash flow:
Understand internal rate of return
Another term that you will hear a lot during discussions about cash flow estimations is internal rate of return, or IRR.
Many times, IRR is used to determine whether to invest more into an existing project or to start a new one. You can use IRR to determine which would be more profitable.
The internal rate of return is the annual return expected from an investment with the net present value set to equal zero.
The term net present value, or NPV, is also used to determine the viability of an investment.
It uses the time value of money to determine the value of an investment made now by using the discount rate of the resulting cash flow in the future.
Rate of return = (value with interest and dividends minus the initial value) ÷ the initial value
Be sure to consider seasonal cash flow
Most businesses have yearly recurring periods when cash flow increases or decreases. It may be due to the influx of spending during a particular season or due to the nature of your business.
For example, small businesses that provide services or goods for swimming pools will have lower cash flow during the winter months, but it increases as temperature rises and more people spend time in their pools.
Tracking your cash flow from year to year will help you to adjust spending to fit each season.
Don’t miss the opportunity to invest in your business during times when cash flow is high.
New ventures are unpredictable
Many small businesses face the unpredictability of new ventures, especially when they are just starting out.
Whenever trying to make cash flow calculations for these capital outlays, be as conservative as possible.
With new ventures, you don’t have any history on which to base your calculations. You need to be aware of sunk costs versus possible return on your investment.
Salvage value is much less than market value, and if your project ends up failing, you may have to rely on the salvage value of your investment.
Don’t use accounts receivable in the calculation
Many businesses make the mistake of calculating accounts receivable and accounts payable when estimating cash flows.
While you do have control over when you pay your vendors, you don’t know when or if you will be getting payments on your invoices.
If you want more reliable cash flow, consider unlocking the revenue you have already earned through Revenue On Demand™.
This approach lets you turn unpaid invoices into working capital and get paid right away, without adding debt or disrupting customer relationships.
Turning cash flow insights into action
Big companies use future cash flow estimates to appease stockholders, justify valuations and prove that they predict profit increases from last year.
For small businesses, however, these formulas are used to make wise investment decisions. It allows them to have better intel on how and where their financial moves need to be adjusted.
But it’s hard to invest in growth when your cash is tied up in slow payments.
Instead of waiting on long payment cycles, more businesses are tapping into the revenue they’ve already earned and turning unpaid invoices into working capital.
Want to see how Revenue On Demand can support your growth plans?
Talk to a Now specialist to learn how you can get paid right away without debt or losing control of your customer relationships.