Your accountant reports a good year, but there is a lot less in your account than you expected. How is that possible? And how do you know whether you can still pay your bills three months from now? Calculating cash flow shows how much money actually moves in and out of your business over a period, and that is something other than your profit.
In this article you will find what cash flow is, the two ways to calculate it, a fully worked example that reconciles with your bank balance, and how to build a forecast for the months ahead.
What is cash flow?
Cash flow is the difference between the money that comes in over a given period and the money that goes out. The Dutch word is kasstroom, and the two mean exactly the same thing. You will also see cash flow written as two separate words.
Where profit says something about your performance on paper, cash flow says something about your ability to pay your bills right now. A positive cash flow means more came in than went out, so your balance rose.
With a negative cash flow the opposite happened. That is not automatically a problem: if you have just made a large investment, a negative cash flow in that period is logical.
Structurally negative is a problem, and sooner than most entrepreneurs think. You can survive a year of thin profit. Three months of not being able to pay salaries and suppliers you cannot.
Why cash flow is not the same as profit
The difference lies in when something counts. Profit works with income and costs: those count at the moment the work is performed. Cash flow works with receipts and payments: those count at the moment the money actually moves.
If you sell something in March on thirty-day terms, the income sits in your books in March and the money lands in your account in April.
There are five items that push profit and cash flow furthest apart in practice:
Depreciation: a cost with no euro behind it. You paid for the machine last year; you spread the cost over several years.
Investments: exactly the reverse. The full payment goes out now, while only part of it sits in this year's profit as cost.
Loan repayments: a payment, not a cost. Only the interest counts towards your profit, not the amount repaid.
VAT: it passes through your account but was never yours. It sits there temporarily, and every quarter it leaves again.
Drawings and dividend: money you pay yourself is not a cost, but it certainly leaves your account.
On top of that comes working capital: money tied up in unpaid invoices and stock. If your revenue grows fast, that amount grows with it and your profit temporarily disappears into your receivables. That is the classic reason a profitable business runs out of money.
How do you calculate cash flow?
There are two ways to calculate your cash flow, with the same outcome but a completely different route:
The direct method: all receipts minus all payments in the period.
The indirect method: you start from net profit and correct it for everything that did not move money.
The direct method: receipts minus payments
You take your bank statements and add up what came in and what went out. Simple and concrete, and for most smaller businesses the quickest route. The drawback is that you only see that your balance changed and not why. For steering you need more than one number at the bottom.
The indirect method: starting from net profit
This method starts from the figure you already have, the net profit in your profit and loss account, and corrects it for every item that affects your profit but not your account. The full formula looks like this:
Operating cash flow = net profit + depreciation ± movement in provisions ± movement in working capital
If you want to derive this from annual accounts, you will find net profit and depreciation in the profit and loss account, and you calculate the movement in working capital by placing this year's balance sheet next to last year's.
Why "profit plus depreciation" is too blunt
On most sites you will find the indirect method given as net profit plus depreciation, and nothing more. That is a shortened version which only holds if your receivables, stock and payables have stayed exactly the same. In practice that almost never happens.
Suppose your revenue grew and your unpaid invoices rose by 15,000 euros as a result. Those 15,000 euros are in your profit, but they are not yet in your account. Use the short formula and your cash flow comes out 15,000 euros too high, which is precisely the amount you are actually missing.
So use the short version only for a quick indication, and the full one as soon as it matters.
The three cash flows in a cash flow statement
A cash flow statement splits your money flows into three categories. That split is where the statement gets its value, because the same negative cash flow means something very different depending on where it comes from.
Operating cash flow: everything from your day-to-day business. Customers paying, suppliers, salaries, rent, insurance.
Investing cash flow: the purchase and sale of business assets such as machinery, a company van or equipment.
Financing cash flow: loans you take out or repay, capital you put in, dividend and drawings.
Together the three form the movement in your cash position. And there is the check that makes the statement trustworthy: your opening balance plus those three cash flows must be exactly equal to your closing balance at the bank. If that does not match to the euro, an item is missing somewhere.
Operating cash flow
This is the most important of the three, because it shows whether your business model generates money on its own. If it is structurally negative, your normal activities earn less than they cost you, and a loan will not fix that. Something has to change in your rates, your costs or your payment terms.
Investing cash flow
In a healthy growing business this is often negative, and that is exactly as it should be. You are putting money into assets that will generate income later. If it is positive, you are selling business assets. That can be a deliberate choice, but it can also mean you are selling things in order to pay your bills.
Financing cash flow
This is where the most frequently forgotten item sits: drawings in a sole proprietorship. Many entrepreneurs leave them out because they are not costs, which makes their calculation structurally too rosy. Also note that a positive financing cash flow is not an achievement. That is borrowed money you will repay later.
Worked example: calculating cash flow in practice
Take a service business with a net profit of 60,000 euros and 12,000 euros of depreciation. Over the past year unpaid customer invoices rose by 15,000 euros, and the amount it still owed suppliers rose by 5,000 euros.
It bought a van for 30,000 euros and sold the old one for 4,000 euros. It took out a loan of 20,000 euros, repaid 9,000 euros and drew 25,000 euros. The year began with 18,000 euros in the account.
Operating cash flow: 60,000 + 12,000 − 15,000 + 5,000 = 62,000 euros
Investing cash flow: −30,000 + 4,000 = −26,000 euros
Financing cash flow: 20,000 − 9,000 − 25,000 = −14,000 euros
Net cash flow: 62,000 − 26,000 − 14,000 = 22,000 euros
The check: 18,000 euros opening balance plus 22,000 euros net cash flow is a 40,000 euro closing balance. That has to match what is actually in the account on 31 December.
Note what the short formula would have produced here: 60,000 plus 12,000 is 72,000 euros, while the real operating cash flow is 62,000 euros. A difference of 10,000 euros, caused entirely by money tied up in unpaid invoices.
Calculating free cash flow
Free cash flow is the money left over after you have paid for the investments needed to keep your business running. That is the amount you can genuinely dispose of: to repay debt, pay yourself or set aside.
Free cash flow = operating cash flow − investments
In the example above: 62,000 minus 26,000 is 36,000 euros of free cash flow. You will also find another definition online, in which loan repayments are deducted from cash flow. That is a usable figure, but it is a different concept.
If you want to know what is left after your financing obligations, calculate that separately and do not call it free cash flow, otherwise you will end up comparing apples with pears later.
What does your cash flow say about your business?
One figure over one period says little. The question is which cash flow is positive or negative, and what the trend does over several periods. A good cash flow is one where your operating cash flow is positive and large enough to carry your investments and repayments, without having to borrow again each time.
Two ratios make that concrete. Your debtor days show how long you wait for your money on average: divide the amount outstanding with customers by your annual revenue including VAT and multiply by 365.
If 45,000 euros is outstanding on revenue of 363,000 euros including VAT, you are waiting 45 days on average. Every day you take off that goes straight into your account.
Your runway shows how long you last if nothing comes in: divide your balance by your average net monthly outgoings. At 40,000 euros in the account and 8,000 euros net going out per month, that is five months. That is the figure you want to know before you take on a large commitment.
Making a cash flow forecast
Knowing what your cash flow was last year is useful. Knowing what it will do over the coming months is what you can act on. A cash flow forecast works with one simple rule per period: opening balance plus expected receipts minus expected payments is the closing balance, and that closing balance is the opening balance of the next period. Thirteen weeks ahead is a common horizon, twelve months if you want to look further.
Three rules determine whether your forecast holds up. Work with expected payment dates and not invoice dates, because an invoice from late March on thirty-day terms is money in May.
Put the VAT payment in as a separate line in the quarter you pay it, rather than smoothing it across the months. And enter peak items such as holiday pay, insurance premiums and tax assessments separately, because those are exactly what cause the months where things get tight.
Once that is in place, you can see in which week or month your balance dips below zero. That is the moment you can still do something about it, rather than noticing when it has already happened.
How to improve your cash flow
Most of the gain is not in more revenue, but in timing. Six levers you can pull yourself:
Invoice earlier: sending the invoice a week earlier is your money a week earlier, without having to sell anything extra.
Shorten your payment terms: if you agree nothing, thirty days applies by law. Large companies may not hold SMEs and freelancers to longer than thirty days in any case, and if they pay late you are automatically entitled to statutory commercial interest and a standard fee.
Work with deposits: on longer assignments this stops you pre-financing your own costs for months.
Set your VAT aside: the amount is in your account but it is not yours. Reserve it straight away and the quarterly payment is never a surprise. How the return works is covered in filing a business VAT return.
Chase unpaid invoices actively: waiting to send a reminder costs you money directly. What that involves is covered in managing accounts receivable and payable.
Use your suppliers' terms: paying on time but not earlier than necessary keeps money with you for longer. Paying late costs you interest and goodwill.
If things still get structurally stuck, there are financing options such as factoring, leasing or an overdraft facility. They move the problem and they cost money, so they are a solution for a timing problem and not for a business model that does not add up.
Keeping a grip on what comes in
Every calculation on this page starts from the same thing: knowing what actually happens in your account. That only works if your business transactions sit in one place, are categorised straight away and flow through to your bookkeeping.
If everything is spread across separate accounts and a personal account, every calculation starts with half a day of working out what belongs where.
That is where GoDutch helps. GoDutch is not a bank, but a business account in which your account, cards, invoices and expenses come together in one app, with a link to your accounting software.
You see in real time what comes in and what goes out, your expenses are categorised automatically, and you keep your VAT and fixed costs aside without thinking about it every month. If you run into something, you get a real person on the line 24/7.
Start with an account that gives you a view of your cash flow
Want to be able to calculate your cash flow without first having to dig through your bookkeeping? You apply for a GoDutch business account in 3 minutes and have your IBAN and card within 1 day. From that moment your transactions sit in one place and you see in a single overview what came in, what went out and what is left.
FAQ
Frequently asked questions about calculating cash flow
What is cash flow in plain language?
Cash flow is the difference between what comes into your account over a period and what goes out. The Dutch word for it is kasstroom. It says something different from profit, because profit looks at income and costs and cash flow at the moment the money actually moves.
What is the formula for calculating cash flow?
The formula depends on the method. With the direct method you calculate receipts minus payments. With the indirect method you calculate net profit plus depreciation, corrected for movements in provisions and working capital. Leave out that last correction and your cash flow comes out too high.
What is the difference between cash flow and free cash flow?
Free cash flow is your operating cash flow minus your investments. Where cash flow shows how much money moves in total, free cash flow shows what is left after you have invested in what your business needs to keep running.
Is a negative cash flow always bad?
A negative cash flow is not always bad, because it depends on which cash flow is negative. A negative investing cash flow belongs to a business that is growing. A negative operating cash flow is a warning, because it means your normal operations cost more than they bring in.
What is a good cash flow?
You recognise a good cash flow by a positive operating cash flow that is large enough to carry your investments and repayments without borrowing again each time. Look at the trend over several periods rather than at a single figure.
How do you calculate cash flow from annual accounts?
From annual accounts you calculate cash flow using the indirect method. You take net profit and depreciation from the profit and loss account, and you calculate the movement in working capital by placing this year's balance sheet next to last year's.
