What is cash flow?
Before we dive into net cash flow, it’s helpful to understand the basic concept of cash flow. Cash flow is the movement of money in and out of your business.
What is net cash flow?
Net cash flow is the difference between the money coming in and the money coming out of your business for a specific period. When you’re making money, this number will be positive. But when you’re in the negatives, that means your business is losing money. Cash inflow refers to what comes in, and cash outflow is what goes out.
Net cash flow comes from three business activities:
- Operating: Cash generated and spent by a company to be able to run standard business operations. This includes cash payments from customers, cost of goods sold, administrative expenses, and marketing.
- Financing: Financing cash outflow and inflow includes debt and dividend payments, company shares, and small business loans, among others.
- Investment: When businesses earn or pay interest on investments or purchase a business investment like equipment or property.
You can look at net cash flow both for an isolated period of time and comparatively, period over period. It’s important to do both. The former will show you the likelihood of your business continuing in the short-term, while the latter will give you a bigger picture idea of trends over time — and, more importantly, long-term viability.
While you want to aim for positive cash flow, a period or two of negative cash flow isn’t necessarily a bad thing. You may have purchased significant investments, like a brick-and-mortar shop, which can put a dent in your short-term cash flow. But over time, your business should be able to recover and get back to a positive cash flow.
This is also why it’s important to consider other metrics in addition to your net cash flow — things like free cash flow, operating cash flow, discounted cash flow, and others.
Net cash flow vs. net income
Net cash flow and net income are similar but there are key differences. While net cash flow tells you how much operating cash moves in and out for a given period of time, net income also includes all expenses. Net income subtracts both operating expenses and non-operating expenses, such as taxes, depreciation, amortization, and others.
A net profit is when a company earns money after accounting for all those expenses, so the number is positive. When the number is negative, this is recorded as a net loss, and indicates the company has lost money for that period.
Net income gives a bigger, more accurate look into profitability, but net cash flow indicates a business’s ability to earn a profit from typical business operations.
The importance of net cash flow
Net income sounds great, so what’s the point of net cash flow? Net cash flow shows you how much capital you have on hand to continue operating the business. Cash is important for day-to-day operations — you often need it to pay bills, vendors, insurance, and other necessary operating expenses.
If you run out of cash flow, you run the risk of not being able to keep the lights on, both literally and figuratively speaking.
The importance of net cash flow goes beyond making sure you stay in the positive and have enough money to keep the business running. It’s important to keep track of it over time to understand when and why cash flow fluctuations happen. In turn, this will allow you to identify issues early on, before they develop into bigger issues.
If you need to raise capital via business loan or investors, net cash flow is one of the relevant metrics. Lenders and potential investors will look at net cash flow to determine whether they can expect repayment of the loan or return on their investment.
How to calculate net cash flow
To calculate net cash flow, you need to find the difference between the cash inflow and the cash outflow. The basic net cash flow formula is straightforward and easy to use:
- Customer payments
- Sale of goods or services
- Loan receipts
- Cash dividends
- Interest earned
- Fixed asset sales
- Supplier and vendor refunds
- Third-party funding
- Lawsuit settlements
- Insurance claims
- Equipment sales
- Property sales
- Any form of cash received
While cash outflow includes:
- Supplier and vendor payments
- Interest paid
- Fuel and transportation costs
- Marketing and advertising spend
- Debt payments
- Equity investment
- Buy back stocks
- Shareholder payout
- Property purchase
You can also use your balance sheet to calculate net cash flow. Just look at the cash balance for two different periods and calculate the difference.
Net cash flow example
Now that we have the formula handy, let’s put it into practice. For this example, we’ll say you own a hair salon. Your cash flow for the month of January breaks down like this:
Cash flow from operating activities
- $50,000 came in
- $10,000 went out
Cash flow from investment activities
- $2,000 came in
- $4,000 went out
Cash flow from financial activities
- $10,000 came in
- $5,000 went out
Net cash flow = ($50,000 – $10,000) + ($2,000 – $4,000) + ($10,000 – $5,000)
Net cash flow = $40,000 + -$2,000 + $5,000
Net cash flow = $43,000
Over time, you track your net cash flow each month. It looks like this for the first six months of the year:
Everything looks pretty normal, until we get to April. This dip in net cash flow needs further investigation.
Let’s say you moved locations in April to fit into a bigger salon. This new location also has higher rent and utilities. These increased operating costs will naturally lower your net cash flow. So while the decline isn’t cause for alarm, you want to make sure you continue to trend upward — otherwise this move wasn’t a more profitable one.
There are so many scenarios that can cause fluctuations in net cash flow. It’s important to look at the bigger picture and consider the context in addition to the actual metrics.