How much free cash flow a company has is an indicator of a company’s solvency, and what it has available to save for growth in operations, investments, liquidity or ‘rainy day’ scenarios. Accurate calculation of free cash flow is therefore an essential aspect of cash flow management.
Cash flow is calculated using a simple formula:
Cash flow is calculated = 1: income from operating activities (less) 2: capital expenses (less) 3: cash dividends.
These figures 1, 2 and 3 can all be found in the statement of cash flows:
- Income = total in ‘operating activities’ section
- ‘Capital expenses’ in the ‘investing activities’ section
- ‘Cash dividends’ in the ‘financing activities’ section
Before you can apply this formula, you need to get to the figures used in the formula and there are two methods for this. The direct and the indirect method. The figures for cash flow calculation can be many and varied, and so calculation requires a presentation that is simple to use. The simplest is usually the ‘indirect method’.
Indirect method of calculating cashflow:
Starts with a net income (or loss) figure and involves the adjustment of this figure with changes in balance sheet accounts.
Direct method of calculating cashflow:
Adds specific cash flows associated with individual items. This is often too complicated and depends on specific record keeping and availability of figures.
The final step in a cashflow calculation requires verification that the ‘end balance’ in the cash flow statement equals the ‘end balance’ in the cash account on the balance sheet. If the two amounts do not match, it indicates an error in the cash flow calculation, or a ‘missing’ cash transaction.
A positive cashflow shows that your company is financial healthy. A negative figure shows that there is a problem. The formula above does not show what the problem is, but it is the starting point for analysis and cash flow management.
Your accountant can advise you on how your business cash flow is calculated, being aware of it can assist you in keeping your company on a healthy and cash free climb.
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