Understanding Cash Flow: Key Metrics and Analysis Methods
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What is Cash Flow?
Cash flow refers to the amount of cash received and paid by a business or individual over a specific period. It reflects the movement of money in business activities, including cash inflows and outflows. Cash flow is a crucial indicator of a company’s financial health and is a key focus for investors and financial analysts. As such, cash flow serves as an essential metric for assessing the financial condition and operational activities of businesses and individuals, involving the movement and management of funds critical for healthy financial operations.
Why is Cash Flow Management So Important?
Cash flow depletion is the primary reason for small business failures. For any organization, a continuous supply of cash is vital to pay salaries and bills, as well as to invest in growth. If cash flow is disrupted, even if a company can achieve significant sales, it may become unable to pay its debts, for example, in cases of unpaid invoices.
This is why tracking cash flow every month is necessary. By analyzing what happened in the previous month and creating cash flow forecasts for the coming months, you’ll be able to spot trends, predict when your business might need more cash, and prevent cash flow problems. Another advantage of cash flow forecasting is that it can help you determine the best time for investments, such as purchasing expensive software or machinery.
How to Calculate Cash Flow?
Before making cash flow predictions, you need to understand how to calculate cash flow.
Net Cash Flow Calculation
Calculating cash flow is simply comparing the cash coming in and going out over a period (e.g., the past three months).
The formula for net cash flow is: Cash Inflows – Cash Outflows = Net Cash Flow
Cash inflows correspond to the income you receive from resolved invoices, while cash outflows correspond to your business liabilities (e.g., accounts payable, interest payable, income taxes payable, notes payable, or wages/salaries payable).
As long as the first number is larger than the latter, you have positive cash flow, meaning you have cash in the bank. If your cash flow is negative, it means you have less cash at the end of the period than at the beginning.
Free Cash Flow Calculation
To gain a deeper understanding of the amount of cash available for you to spend, you can use the following free cash flow formula:
Free Cash Flow Formula: Net Income + Depreciation/Amortization Expenses – Changes in Working Capital – Capital Expenditures = Free Cash Flow
To help you use this formula, here are some common cash flow management definitions:
- Net Income: The figure obtained after subtracting costs, sales, general, administrative and operating expenses, interest, taxes, and other expenses from sales revenue.
- Depreciation/Amortization: A scheduled expense used to reduce the book value or market value of certain assets.
- Changes in Working Capital: Represents the difference between current assets (such as cash, unpaid customer bills, raw materials or finished goods inventory) and current liabilities (such as accounts payable).
Once you understand how to calculate cash flow, predicting future cash flow becomes easier.
How to Forecast Cash Flow?
Forecasting cash flow involves using estimated figures to predict the situation for the coming weeks or months. Here’s a simple method:
- Choose a time frame, such as the next six months, and estimate the amount of transactions during this period.
- List the cash you expect to receive:
- Start with sales forecasts (especially regular invoices, which can be predicted with more confidence)
- Add other cash inflows, such as investments, grants, asset sales, and tax refunds
- Separately list the cash you expect to spend: Include future recurring expenses such as salaries, rent, hardware, software, and taxes.
- Use the net cash flow formula mentioned above to calculate whether your cash flow is positive or negative for the chosen period: Cash Inflows – Cash Outflows = Net Cash Flow.
Despite your predictions and cash flow forecasts, unexpected situations can still occur. You shouldn’t wait until you’re in trouble to protect your business. The good news is that there are multiple options to consider, from improving your cash flow management processes to keeping a buffer fund for rainy days, or turning to trade credit insurance.
How Trade Credit Insurance Can Help Prevent Losses
Trade credit insurance protects businesses from losses due to unpaid commercial debts, specifically business-to-business accounts receivable. If a buyer fails to pay on time due to bankruptcy, insolvency, or other factors, trade credit insurance will cover 90% of the unpaid debt amount. This protects your capital and cash flow, allowing you to offer more competitive credit terms while ensuring profitability and potentially securing better corporate financing options.
With accounts receivable protection from trade credit insurance, you can easily manage commercial and political risks arising from trade, even if they are difficult to control. Additionally, purchasing trade credit insurance can provide peace of mind when extending credit to existing customers or developing potential large customers with higher credit risks.
Protecting Your Business from Payment Defaults
Through business risk management data analysis, Allianz Trade can help prepare your business for potential losses even if customers become insolvent. We invite you to get in touch with our trade credit experts to learn more about how we can support your business growth and risk management strategies.
By implementing robust cash flow management practices and considering trade credit insurance, you can better protect your business from the impacts of late payments or customer insolvencies. This proactive approach allows you to focus on growth opportunities while minimizing financial risks.
