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Cash Flow Models

To keep your business cash in check, it is important to understand the role cash flow modelling plays in the financial management of eCommerce businesses.

Cash flow modelling refers to the practice of planning, managing and forecasting business cash flow. Cash flow modelling is valuable for understanding the cash health of a business and ensuring that you have enough cash to cover upcoming expenses or plan for periods when there might not be enough cash available.

Small eCommerce businesses are particularly vulnerable to cash flow problems, making it all the more vital to adopt effective cash flow management and consider cash flow modelling to keep the business afloat. 

Cash flow models contain a lot of financial jargon. Here is a short breakdown of the different types of cash flow that can be found in effective cash flow modelling.

 

What is free cash flow?

Free cash flow refers to the cash left over after all operating expenses and capital expenses have been accounted for. This includes expenses that cover salaries, rent and taxes. 
To work out free cash flow, you can use the following formula:

Free Cash Flow = Operating Cash Flow - Cash Expenditures

The most common method of calculating free cash flow is to use operating cash flow figures. However, sales revenue and net operating profits can also be used to reach the same figure, ideal if these figures are more readily available. 

Using Sales Revenue:

Free Cash Flow = Sales Revenue - (Operating Costs + Taxes) - Investments in Operating Capital

Using Net Operating Profit:

Free Cash Flow = Net Operating Profit after Tax - Net Investment in Operating Capital

As free cash flow calculations are made up of multiple components of business financial statements, they provide a more holistic picture of your business’ financial health. For example, an eCommerce business owner may be looking to understand if they have the cash available to invest in better equipment. By looking at their historic free cash flow statements, they can identify if they are experiencing periods of high free cash flow. This would indicate that there is untapped potential and capital available to reinvest into the business, demonstrating the cash viability of purchasing new equipment.

It is important to remember when using free cash flow in this way, that future free cash flow calculations will be impacted by any cash investments. Business owners should consider whether this would create negative free cash flow in the preceding periods, and whether their business is equipped to navigate these periods.

 

 

What is discounted cash flow?

Discounted cash flow (DCF) is used to estimate the value of an investment based on predicted future cash flow. This can be used to assess the value of investing in another company, opening a new office, buying stock or purchasing new equipment.

Discounted cash flow has a slightly more complex formula compared to free cash flow as it is used to create predictions on specific assets.

DCF = CF1/(1 + r) + CF2/(1 + r) + CFn/(1 + r)

CF means ‘Cash Flow’ and refers to the cash flow for a given year. In this calculation CF1 refers to cash flow for year one, CF2 is cash flow for year two, and CFn denotes cash flow for additional years. This calculation can be extended for as many years as your business needs. 

r  in this formula refers to the discount rate. The discount rate is a firm’s weighted average cost of capital. This value demonstrates to investors the return that they could expect from investing in your business.

Discounted cash flow can be used to evaluate an entire business, or an investment, project, share value or any other factor that would impact cash flow. 

For example, your eCommerce business may be considering investing in new computers for your office to speed up everyday processes. You know from previous financial analysis that your business’ average cost of capital is about 5%, this will be your discount rate for the calculation (r).

From completing a cash flow forecast taking into account the financial impact of your new investment, you know that your business has the following expected cash flow for the next 3 years:

Year 1 = £2,000
Year 2 = £6,000
Year 3 = £10,000

This would make your discounted cash flow:
 

Year Projected Cash Flow Discounted Cash Flow
1 2,000 1,904.76
2 6,000 5,714.29
3 10,000 9,523.81
TOTAL   17,142.86

 

 

What is operating cash flow?

Operating cash flow is simply money coming into and out of the business from regular business activities such as selling goods, providing services or manufacturing products. This type of cash flow does not include long-term capital expenses or investments. Because of this, operating cash flow simply gives you a representation of the amount of cash needed to maintain normal activities. 

Operating cash flow can be calculated using either the direct or indirect method. 

When using the direct method, the following formula can be applied:

Operating Cash Flow = Net Income + Non-Cash Expenses + Changes in Working Capital

When using the indirect method, operating cash flow can be calculated by taking the Net Income from a profit and loss statement, and making adjustments to this figure based on its inclusion of non-cash expenses, to reveal an estimate of operating cash flow.

Operating cash flow could be particularly useful to a business if they are in a situation where they are experiencing negative cash flow. By calculating operating cash flow owners can understand whether they have enough cash to cover all essential operating activities that keep the business afloat.

 

 

Why is cash flow modelling important?

Cash flow modelling can be a vital tool for an eCommerce business. Effective modelling can create a more comprehensive picture of your business’ financial position for past, present and future, allowing for more effective business decision making and goal setting.

One of the most valuable features of cash flow modelling is the ability to model or predict the financial outcome of different business scenarios to determine the best course of action. Such as evaluating the viability of a cash investment, understanding the impact of seasonal fluctuations on your cash liabilities or creating a plan for a worst-case scenario. 

Cash flow modelling can also show business owners where opportunities for investment or expansion lie, as well as provide the foresight to plan ahead for periods of negative cash flow. 

Effective cash flow modelling can be the difference between a business’ success or failure, as prolonged periods of negative cash flow can leave owners unable to pay for essential operating expenses that keep the business running.

 

 

Conclusion/Next Steps

Cash flow models are a valuable financial tool for any and every eCommerce business, regardless of industry or size. Maintaining a clear view of your financial and cash health can de-risk business decisions and allow for more informed investing. 

Understanding the different types of cash flow also ensures that owners use the most appropriate view of their finances for their modelling requirements.
To help your business get started with cash flow, as well as some handy tips for boosting your cash flow, download the rest of our eBook chapters. 

 

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