6 Ways to Measure Cash Flow: What Works for Your Business?

An old adage says: “revenue is vanity, cash flow is sanity, but cash is king.” In other words, just because a business appears profitable on paper doesn’t mean it isn’t on the verge of bankruptcy as well.

What is Cash Flow?

Contrary to popular belief, cash flow is not the same as paper earnings. While earnings only provide information about money coming into the business, cash flow is a statement addressing how a business receives money (from its sales and investments) as well as the ways in which it spends money (on operating expenses, capital investments, taxes and interest). In other words,

If your company isn’t doing a good job of managing the amount of cash entering and exiting, you may be setting yourself up for failure. A business will struggle to keep its doors open if it lacks the cash to manage operations and cover day-to-day liabilities. In fact, a report by the Small Business Administration reveals that 28% of businesses that declare bankruptcy report that a problematic financial structure is to blame. If you want to give your business the best shot at succeeding in the coming years, it’s crucial that you learn to measure and manage all incoming and outgoing cash flow effectively.

While cash flow is clearly one of the most vital financial metrics for a business to track, not all organizations need to use every method of measurement. By understanding the strengths, weaknesses and applicability of each of method of measuring different types of cash flow, small business owners can avoid becoming just another statistic.

1. Free Cash Flow

Free cash flow (FCF) represents the cash that a company has available after capital expenditures, such as mortgage payments and equipment, and is one of the most common metrics for measuring cash entering and exiting a company. Free cash can be used to expand product and service lines, pay off debts and allow businesses to pursue other activities that help increase the company’s value to shareholders.

To calculate free cash flow, companies should start by finding their EBIT, or earnings before interest and tax. FCF is then equal to:

EBIT x (1-Tax Rate) + Depreciation + Amortization – Change in Net Working Capital – Capital Expenditure

If you have already calculated your company’s operating cash flow (see item No. 3 below), you can find free cash flow by subtracting capital expenditures from OCF.

While free cash flow is a useful metric for many businesses, it’s especially valuable for corporations as they strive to determine how much cash is available for paying back investors or expanding the business. After all, a company that extracts too much money risks harming overall operations and jeopardizing the business’ future in the long term. See how your business is performing with these ten KPI metrics.

2. Discounted Cash Flow

Discounted cash flow (DCF) measurements are vital for evaluating investment prospects by comparing future cash flow projections against current capital costs.

A company calculates DCF by dividing expected yearly earnings by a discount rate based on the weighted cost of increasing capital by dispensing debt. By discounting projected future revenue and costs, investors can estimate the current value of an opportunity. If the calculated value is higher than the investment’s current cost, it may be a good prospect.

DCF is common in a wide range of industries including investment finance, real estate and patent valuation.

3. Cash Flow From Operating Activities

Cash flow from operations (CFO) conveys money accumulated as a result of normal, continuous business activities. With respect to CFO, “business activities” includes earnings before interest and taxes (EBIT), but does not include long-term capital or investment costs. To calculate cash flow from operations, start by finding the business’ EBIT. CFO is then equal to:

EBIT + Depreciation – Taxes

The value of the cash flow from operations lies in the fact that it considers money from the sale of goods and services while excluding long-term capital costs. As a result, this metric is especially useful for companies with many fixed assets in the form of buildings and equipment. Typically, asset depreciation reduces net income. By calculating operating cash flow, companies can discount depreciation as a non-cash expense and get a more realistic view of their cash holdings.

4. Unlevered Free Cash Flow

Unlevered free cash flow (UFCF) reveals the money that’s available before factoring in debt and other responsibilities. To determine your business’ unlevered cash flow, start by calculating EBITDA and CAPEX, or capital expenditures used to fund business activities. Unlevered free cash flow is then equal to:

EBITDA – CAPEX – Working Capital – Taxes

While unlevered cash flow may seem like an inaccurate measure of a company’s financial health, it can be very helpful for internal accounting. In fact, managers frequently consider this metric when assessing the efficiency with which their department heads utilize funding. As a result, UFCF can be an incredibly useful tool for budgeting money.

5. Levered Cash Flow

Levered cash flow (LCF) refers to the free cash flow that a company has left after fulfilling its debts. Determining LCF is crucial to stockholders, as it tells them how much cash is available for distribution and investment purposes.

If the cash paid out for debts exceeds incoming cash flow, a company may have negative levered cash flow even if its OCF is positive. You can find your business’ levered cash flow with the following formula:

Unlevered free cash flow – Interest + Mandatory Principal Repayments

Calculating levered cash flow is especially important for companies looking to take on debt. Because investment bankers evaluate levered free cash flow when making lending decisions, companies that have too much debt may find themselves unable to get the financing they need to survive and grow. Additionally, levered cash flow helps companies assess whether or not they have the resources to expand.

6. Cash Flow From Financing Activities

Cash flow from financing activities takes into account external activities that enable businesses to raise capital and pay off debts and, by extension, can be used to reveal a company’s financial strength to investors. Possible financing activities may include issuing cash dividends and stocks, taking on additional loans and refinancing. To calculate your company’s cash flow from financing activities, use the following formula:

Cash Received From Issuing Stock – Cash Paid as Dividends and Re-Acquisition of Stock

If your company needs funding, you may want to calculate this metric sooner rather than later. After all, investors might be turned off to learn that you have a prolonged history of repeatedly raising cash from new debt or equity.

While it’s great to be able to say your business is generating profits, you won’t survive long without sufficient cash flow to pay your workers and purchase the goods you need to operate. Choose the best metric, or metrics, for measuring cash flow, and ensure your business’ doors remain open for years to come.

Now that you understand the basics, check out our article on the six essentials of a cash flow statement.