Cash Flow Estimation: A Simple GuideKnowing how to estimate your cash flow will help you make wiser budgeting decisions for your business. Learn more about cash flow estimations here.
Many small businesses rely on their CPA to keep track of their company’s financial health. But, as a business owner, you should understand cash flow estimations.
Knowing how to estimate the amount of cash flow your business will have at any given time will help you make wiser capital budgeting decisions.
This article will break down some of the different types of cash flow you should understand.
We will also share a few helpful formulas and templates for estimating cash flow, as well as some business strategies to use based on how your cash flow is looking.
What Does “Cash Flow Estimation” Mean, Anyway?
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.
If you can build accurate and informed cash flow estimations, you’ll make much smarter investment decisions for your business.
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:
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 – minus 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 (use this calculator to help).
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.
Now is the time to make some 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
Unfortunately, there may be a time when your financial statements predict low cash flow. This is normal for any growing business.
In order to continue running your business and cover your current liabilities, you may need to find outside funding or get a loan.
Of course, you don’t want to overextend yourself. Be sure to take interest expenses into account.
This is where the importance of cash flow forecasting becomes very clear. It’s good to recognize downward trends before you have negative cash flow, which can lead to the failure of your business.
But now, you have time to fix any problems that could lead to major financial tragedies.
Aside from the amount of free cash flow, there are several other factors that businesses may take into consideration when making investment decisions.
See also: Cash Flow Planning (A Guide for Beginners)
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.
To calculate the rate of return, use this formula:
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 to have more reliable cash flow, you can always speed up invoice payments with an accelerated invoice payment service.
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.
If you are feeling the pressure of low cash flow, you can increase it by collecting unpaid invoices.
The best way to do that, since many of your larger clients follow their own bill payment schedule, is to open an accelerated invoice solutions account.
Now allows you to grow your business without the fear of running low on cash flow!
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