Cash Flow Formula: A Complete Beginner’s Guide
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Contrary to what many business owners and investors assume, the cash flow formula is quite straightforward and not that complicated.
Table of Contents
- Free Cash Flow Formula
- Operating Cash Flow Formula
- Net Cash Flow Formula
- Discounted Cash Flow Formula
- Where Can You Find a Reliable Cash Flow Calculator?
- Bottom Line
Unfortunately, many business owners fail to grasp the cash flow concept and implement it in their business. It is why 30% of businesses fail due to running out of money. About 60% of business owners say that they don’t understand the cash flow formula and don’t know much about finance and accounting.
Since you’ve opened this article, congratulations on taking the first step towards understanding it. You’re on the right track to being able to monitor your cash flow and grasp anything to do with your business finances.
In this post, we’re going to look at three cash flow formulas, their benefits, and what they tell you about your business. Don’t worry if this looks like an alien concept. We’ll break the formulas down to the beginner level.
Free Cash Flow Formula
The free cash flow formula is one of the most important cash flow formulas. Most business owners use the free cash flow formula to plan and budget. The formula’s main benefit is that it helps you understand how much money is truly available or free to use.
With this formula, you can answer questions such as:
- Can you afford to pay for new business software?
- Do you have enough funds to pay your contractors when they send you an invoice?
- How much cash do you have to spend on personalized gifts for your clients?
What Is Free Cash Flow Formula?
Calculating your business’ cash flow is quite straightforward. What you need is the company’s balance sheet or income statement so that you can pull the crucial numbers.
First, let’s look at the financial metrics you’ll be needing:
- Net Income: Net Income is the income you remain with after deducting all business expenses from gross income. You can call it your profit. You can find the figure in the Income Statement.
- Working Capital: Working Capital represents the capital you need to run the day-to-day business operations. It’s the difference between business assets and liabilities. You can calculate it by finding the difference between your assets and liabilities on your balance sheet.
- Depreciation/Amortization: Remember, many business assets, including equipment, lose value as time goes by. Depreciation is the measure of how that value is lost. On the other hand, amortization is factoring in an asset’s initial cost and breaking it down over its lifetime. You can find the said metrics on your Income Statement.
- Capital Expenditure: Capital expenditure is the money you spend on your business’s fixed assets, such as real estate, land, or equipment. You can find the capital expenditure on the Cash Flows Statement.
With this in mind, let’s look at what the formula looks like:
Free Cash Flow = Net Income + Depreciation/Amortization – Working Capital – Capital Expenditure
Free Cash Flow Case Study
Let’s look at a real-life example of how you can apply the above formula in your business. Bill runs a real estate brokerage firm and wants to calculate his free cash flow to see if he can afford to hire an accountant for 10 hours a month.
Will’s annual financials look like the following:
- Net Income: $100,000
- Depreciation/Amortization: $0
- Change in Working Capital: $12,000
- Capital Expenditure: $3,000
As such, this is how Bill will calculate his business’s free cash flow:
[$100,000] + [$0] – [$12,000] – [$3,000] = $85,000
It means there is $85,000 available in cash for him to reinvest back into his business.
Operating Cash Flow Formula
As we’ve seen, free cash flow gives you an idea of how much cash you have to reinvest back into your business. However, there’s a slight problem with its approach; it doesn’t provide a clear picture of your regular daily cash flow. It is because its formula doesn’t factor in any irregular spending, investments, or earnings.
For example, let’s say you sell one of your large business assets. Using the previous formula, your free cash flow would increase. However, it doesn’t reflect your actual business cash flow. This is where the operating cash flow formula comes in.
Why is the operating cash flow formula important?
When you’re looking for financing for your business, lenders or venture capital firms are more likely to look at your operating cash flow since it represents the typical cash flow for your business. The same applies when you want to start working with a financial advisor or an accountant.
Related: Real Estate Remains Among the Best Cash Flow Investments
What Is Operating Cash Flow Formula?
As we said in the free cash flow above, you also need your business income statement and balance sheet to calculate your operating cash flow.
Also, note that when we refer to Operating Income in the formula, we mean the difference between total revenue and operating expenses, like worker wages and cost of goods sold.
This is how you get cash flow from operations formula:
Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital
Operating Cash Flow Case Study
Following Bill’s business example above, let’s assume this is how his business financials look like:
- Operating Income: $100,000
- Depreciation: $0
- Taxes: $10,000
- Change in Working Capital: -$15,000
This is how Bill will calculate his operating cash flow:
[$100,000] + [$0] – [$10,000] + [-$15,000] = $75,000
As such, Bill makes an annual operating cash flow of $75,000 from his regular operating expenses.
Net Cash Flow Formula
Simply put, Net Cash Flow (NCF) is a metric used to tell the amount of money that went in and out of a business’s account within a particular period. If the money that came in was more than the money that went out, the business experienced a positive cash flow. If the opposite is true, then the business was operating on a negative cash flow.
The main benefit of NCF is that it lets the business owner see if the business is doing well or if there’s a risk of filing for bankruptcy. Consistent periods of positive cash flow demonstrate that the business is doing well and can be ready to expand. Inversely, a negative cash flow means that the business is struggling.
To calculate your business’s NCF, you need to access your cash flow statement and look at the financing activities, investing activities, and operating activities.
Related: Seller Financing: The Ultimate Guide for Real Estate Investors
What Is the Formula for Net Cash Flow?
From how we’ve defined net cash flow, the simple formula would be as follows:
Net Cash Flow = Total Amount of Cash In – Total Amount of Cash Out
However, we can further expand that formula to make it more comprehensive, as follows:
Net Cash Flow = Net Cash Flow from Financing Activities + Net Cash Flow from Operating Activities + Net Cash Flow from Investing Activities
In case you don’t understand, here’s a breakdown of the metrics:
- Net Cash Flow from Financing Activities: The difference between the cash flowing in from financing activities, such as business loans, and cash outflows from financing activities, such as loan repayments.
- Net Cash Flow from Investing Activities: The difference between cash inflow from investing activities, such as selling investment property, and cash outflow from investing activities, such as buying fixed assets.
- Net Cash Flow from Operating Activities: Examples of net cash flow in operating activities include the change in net business income for the specific period. You can also include the differences to balance the net cash inflow or outflow for business operating activities.
Net Cash Flow Case Study
Let’s think of Iman from another company who wants to calculate her business’ net cash flow. Below are the numbers she gets from her statement of cash flow:
- Net Cash Flow from Operating Activities: $70,000
- Net Cash Flow from Financing Activities: $20,000
- Net Cash Flow from Investing Activities: -$50,000
This is what her net cash flow calculations will look like:
[$70,000] + [$20,000] + [-$50,000] = $40,000
Iman realizes a positive cash flow of $40,000 within that specific period. This is a good sign and she should work to ensure she maintains a positive cash flow.
Discounted Cash Flow Formula
Discounted cash flow (DCF) formula is used to evaluate the rate of return a business might generate in the future. The formula is used to determine the value of a company’s investment based on the estimated future cash flow of the business.
Business owners also use DCF to determine the current value of an asset or investment by evaluating its financial projections and looking at how much it could earn in the future.
The main benefit of DCF is that it helps business owners and professionals oversee or may decide to make business changes to their processes, such as hiring new workers or purchasing new equipment.
What Is Discounted Cash Flow Formula?
The DCF formula adds all the cash flows for every reporting period and then divides the total by one plus the discount rate raised to the power of n. This is what the formula looks like:
DCF = [(Cash Flow) ÷ (1 + r) ＾1] + [(Cash Flow) ÷ (1 + r) ＾2] + [(Cash Flow) ÷ (1 + r) ＾n]
Let’s breakdown the formula as follows to understand it better:
- Cash flow represents your business’s free cash flow. Remember, it is the money left after subtracting worker and contractor payments, operating expenses, and capital expenditures.
- R represents the discount rate. It is equal to the weighted average cost of capital (WACC). The WACC is the average rate your business expects to pay the stakeholders to fund its assets.
- N is the period number that your company is reporting. For example, if you’re reporting quarterly reports, the n value represents quarter one, then quarter two, and so forth.
Be careful when calculating your company’s discounted cash flow formula. Simple inaccuracies in estimating future earnings and return on investment can lead to undesired outcomes.
Also, the main limitation of the DCF formula is that it requires a lot of assumptions. For instance, you need to estimate future cash flows from a company investment, yet future cash flows depend on market demand, competition, technology, and other unforeseen circumstances.
If you estimate the future cash flows too high, you might choose an investment that might not pay off as expected. Estimating too low could make the investment seem too costly and result in missed opportunities.
Related: How Do You Achieve a Positive Cash Flow in Real Estate?
Where Can You Find a Reliable Cash Flow Calculator?
Now that we’ve understood the important cash flow formulas, you might be wondering how you can actually calculate your business’s cash flow. Mashvisor’s rental property calculator is the best tool for doing so, whether you’re earning passive income or managing your properties yourself.
For starters, Mashvisor is a real estate investment software whose main goal is equipping real estate investors with accurate data and the right tools to make smart investment decisions.
Book a demo to see how you can benefit from our tools.
Mashvisor’s property calculator uses machine learning and AI algorithms, big data, and predictive analytics. In addition, it comes with interactive capabilities. The tool provides you with accurate estimates for both traditional and short-term rental strategies. All the said features make it the best tool to calculate cash flow in the market.
The tool carries out the following functions:
1. Estimates Monthly Property Expenses
As we’ve seen with most cash flow formulas, you need to factor in property expenses. Mashvisor provides you with accurate projections of the amount of money you can expect to spend when owning and managing the property. The expenses include one-time costs, such as closing fees, and recurring expenses, such as maintenance.
Our platform uses rental comps to ensure our data and estimates are accurate. Since the calculator is interactive, you can change any figures you feel don’t match the market situation.
2. Estimates Monthly Rental Income
Mashvisor also provides reliable estimates for the monthly rental income you can expect to make. It also provides estimates for both traditional and Airbnb rental strategies. Just like the monthly expenses, you can also adjust the income projections if your research suggests that things might be different.
3. Calculates Cash Flow
After getting the estimates for expenses and income at hand, Mashvisor’s calculator then helps you calculate your investment property’s cash flow. The cash flow you get is for both traditional and Airbnb rental strategies. You can also adjust the rental income and financing fees to see how they’d affect the cash flow. This way, you can see how you can maximize your rental property’s cash flow.
Mashvisor’s Cash Flow Calculator helps determine your investment property’s cash flow for both traditional and Airbnb rental strategies.
4. Calculates the Return on Investment
Since it doesn’t account for the total cash invested, cash flow isn’t sufficient to determine whether a rental property is worth investing in. It’s important to calculate the return on investment before you can buy investment properties.
Mashvisor’s calculator also calculates return on investment metrics, such as cash on cash return and cap rate for both rental strategies.
Bottom Line
This cash flow formula guide has shown us that the calculations aren’t as complicated as one would think. You want to invest in an opportunity that guarantees you positive cash flow. After all, that’s the only way an investment opportunity would make sense. And the best way to invest in good investment properties is by using Mashvisor tools.
Sign up with us today for a 7-day free trial, followed by 15% off of your quarterly or annual subscription.
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