Understanding how to calculate and evaluate net cash flow can help you to better evaluate your company’s financial situation month to month. Allowing you to identify where there are greater opportunities for growth or to reduce outgoings.
Net cash flow refers to the profitability of a business by discerning the amount of cash generated or lost by a company over a given period of time, most commonly, each month.
Although the premise of net cash flow sounds similar to profit and free cash flow, net cash flow measures the amount of cash flowing in and out of a business, whereas profit measures what is left over after you subtract expenses from revenue, and free cash flow calculates how much cash is left over after all operating expenses have been deducted.
Net cash flow can be calculated using the following formula:
Net Cash Flow = Net Cash from Operating Activities + Net Cash from Investing Activities + Net Cash from Financing Activities
In its simplest form, Net Cash Flow is the total amount of cash ‘flowing’ into the business minus the total cash flowing out. Net Cash Flow is often included in the business’ statement of cash flow, and can also be easily calculated by comparing the cash balance changes between two balance sheets.
For example, if a business has a net cash flow from operating activities of £200,000 at the end of the year, and a net cash flow of £50,000 from financial activities, but also had a negative cash flow from their investment activities of -£30,000, their net cash flow formula would be:
Net Cash Flow = £200,000 + £50,000 - £30,000
Giving them a net cash flow of £220,000 for that period.
To work this out from this business’ balance sheet, we would take the ‘Cash Balance’ recorded in this year’s balance sheet, and subtract from it the previous year’s Cash Balance to work out the net cash flow.
Understanding your company's net cash flow can give you valuable insight into its short-term financial viability. Net cash flow can be a valuable metric for identifying when opportunities for growth or expansion are possible.
Additionally, with the ability to identify and predict when prolonged periods of positive or negative cash flow may occur, can allow you time to make necessary adjustments to mitigate potential risks or capitalise on your situation.
While identifying when your company may experience periods of negative cash flow can be useful to help manage the risks, prolonged negative cash flow can expose your business to the following risks.
Inability to pay suppliers on time.
This can affect your relationship with your suppliers and potentially reduce the opportunity for paying on credit with them in the near future. Additionally, you may find that you are unable to restock products if your suppliers are not able to offer you credit to cover this period. This can reduce your revenue potential in the short term and create further cash flow problems.
Stunted business growth.
If you are experiencing negative net cash flow, then your business will have little or no money to reinvest to support growth. Priorities shift from expansion to keeping your business afloat.
Inability to pay taxes or bills.
If your negative cash flow issues cause your business problems with paying taxes or bills on time, you could be subjected to late fees which would increase your outgoings and cause potential knock-on effects on your next cash flow period.
Unable to pay dividends to shareholders.
Being unable to give your shareholders return on their investment in your company can be a cause for concern, if shareholders don’t receive their dividends and notice that your business is unable to expand or grow, they may sell their shares.
To help prevent your business from experiencing prolonged periods of negative cash flow in the future, you could consider ways to diversify your income. This could support your business through crises such as the COVID-19 pandemic.
As an eCommerce business, you may think that your company would be able to better withstand a crisis such as a global pandemic, as you do not have a physical storefront that would be subject to government restrictions. However, as noticed with the COVID-19 pandemic, many people lost their jobs or were living off a reduced income. This contributed to a large reduction in disposable income, which impacted revenue for many eCommerce businesses.
To help diversify your income, your business could look to provide an online service relevant to your products, such as an online class, course or activity. Participants in your online service are likely to then establish a positive association with your brand, which could also contribute to increased sales as lockdown restrictions ease and personal income returns to normal.
Although it can be useful to understand your business’ net cash flow, and expected periods of negative cash flow, it is important to remember that it does not provide an encompassing picture of your business success.
For example, your business may have a positive cash flow, and relying on the net cash flow metric alone would produce a picture of a successful business. However, your business could be experiencing positive cash flow due to being recently granted a loan. While this boosts cash flow in the short term, it will increase expenses in the long run. This also works the other way around. Your business may have negative cash flow for this period, but this may be due to large investments in new technologies, staff or processes that will increase your revenue in the future.
Due to this, it is important to consider cash flow alongside other financial metrics, such as monthly or yearly outgoing increases, short term debts and any significant changes in revenue, to get a better overall picture of your company’s financial health.
Understanding how to calculate net cash flow can be a very useful tool for understanding your business’ financial situation over a given period of time. Allowing you to understand the feasibility of investment or growth plans within your organisation, and prepare for periods where cash is expected to be much tighter.
To understand more about methods of calculating cash flow and how to gain a deeper understanding of cash flow to support your business, download our other eBook chapters.