Understanding Net Cash Flow

Net Cash Flow

Understanding the flow of money in and out of your business means knowing the pulse of its financial health. One critical metric that helps determine this is net cash flow.

So, what exactly is net cash flow, and why is it important for your business? In this KPI glossary entry, we'll answer these questions in detail.

Why is net cash flow important?

Net cash flow is a crucial measure of financial health for a business. Without a clear grasp of your net cash flow, making informed business decisions becomes nearly impossible.

Positive net cash flow means your business has more cash flowing in than out. This surplus allows you to reinvest in your company, cover day-to-day operations, and even set aside funds for unexpected operating expenses. On the flip side, a negative cash flow can spell trouble, indicating that you’re spending more than you’re earning.

Having a healthy net cash flow makes your business more attractive to potential investors and lenders. It shows that you are financially stable and has growth potential. The bank feels more secure extending credit, and investors see an opportunity for a good return on their investment.

Tracking your net operating cash flow helps identify areas where you might be overspending or under-collecting. Whether it’s delayed invoice payments from clients or sky-high operational costs, pinpointing these issues allows you to make adjustments that improve your financial health.

A consistently positive net cash flow sends a strong signal about your business’s performance. It shows that you’re not just making a profit on paper but actually generating a real, spendable form of cash. This cash can be put back into the business for growth, paying down debts, or even distributing profits to stakeholders.

Cash flow forecasting can help your business to anticipate your business's future cash flow needs and plan accordingly. If you'd like to learn more about cash flow forecasting, you can read more about this in our comprehensive guide: what is cash flow forecasting?

How to calculate net cash flow

It doesn't have to be a daunting task to compute your net cash flow. By breaking it down into manageable steps, you can accurately assess your business’s cash position.

Start by tallying up all the cash you receive from various operations, sales, and other business activities. This includes every dollar that comes through your doors, from customer payments to sales of assets. This is your total cash inflow.

Next, subtract all your cash outflows. These are the expenditures required to keep the business running: operational expenses, salaries, taxes, and any other costs that require cash payments. Don’t forget to include any investments you’ve made, such as purchasing stocks or property, which count as cash outflows too.

Additionally, consider any cash from financing activities. This includes payments for loans, dividends paid to shareholders, and money raised by issuing equity. These figures can either increase or decrease your total cash flow, depending on whether you’re receiving funds from loans or paying them off.

Finally, subtract your total outflows from your total inflows over a specified period. This gives you your net cash flow. If your inflows exceed your outflows, you have a positive net cash flow. If not, you need to dig deeper to understand the causes and take corrective actions.

Is net cash flow the same as net income?

It's easy to confuse net cash flow with net income, but they are not quite the same. Understanding the key differences between net cash flow vs net income will help with clearer insights into your business health.

Net income includes non-cash expenses like depreciation and amortization. While these figures impact your profitability, they don’t affect your actual cash in hand. Net income is an accounting measure that shows how much profit you make after all expenses, including non-cash ones, are deducted.

Cash flow statements, on the other hand, focus solely on actual cash transactions. They reveal your liquidity—how much cash you have available to meet your obligations. This makes cash flow statements crucial for normal business operations where liquid assets are vital.

Net income can sometimes paint a rosy picture that's not entirely accurate. For instance, high net income might suggest a profitable business, but if your revenues are tied up in unpaid invoices, you could face cash shortages. That's why understanding cash flow is crucial—it shows the real cash you have available.

By looking at both net income and net cash flow, you get a complete financial picture. Net income lets you gauge profitability, while cash flow helps you understand liquidity and operational health. Both metrics are essential, but they tell different parts of the financial story.

What are the limitations of net cash flow?

While net cash flow is a critical indicator of financial health, it has limitations. Knowing these can help you avoid common pitfalls.

Net cash flow ignores non-cash expenses such as depreciation and amortization. This can sometimes overestimate the amount of cash available, leading to misguided decisions. While it might look like you have a lot of cash on hand, you might  be overlooking significant depreciation-related losses.

For seasonal businesses, net cash flow can fluctuate dramatically, making it a less reliable indicator of year-round performance. A retail store might see cash flow spikes during the holiday season but suffer during off-peak times. Such variations can complicate long-term financial planning and decision-making.

Large capital expenditures can throw off short-term cash flow assessments. Investing in new equipment or property can lead to temporary negative cash flow, even if the investment is beneficial in the long run. This unevenness can make it challenging to get a clear picture of your financial health.

Net cash flow statements also fail to account for future cash commitments and liabilities. While you might have a positive cash flow from operations today, upcoming obligations can quickly drain resources. Factoring in these future commitments is essential for obtaining a comprehensive financial view.

Over-reliance on net cash flow might obscure long-term strategic decisions. While maintaining positive cash flow is crucial, focusing solely on this metric might lead you to overlook investments that could benefit your business in the long run. Balancing short-term cash flow needs with long-term growth strategies is the key to sustainable success.

Conclusion

Understanding net cash flow from operating activities is pivotal for effective financial management. It’s more than just a number; it’s a reflection of your business’s financial health and operational success.

Regularly monitoring your cash flow lets you make informed decisions, ensuring your business remains agile and responsive. Accurate calculations provide transparency, enabling better planning and resource allocation.

Take the time to delve into your net cash flow, make necessary adjustments, and watch your business thrive. After all, understanding where your money is coming from and where it’s going is the cornerstone of sound financial health.

Fathom automatically calculates a comprehensive range of financial KPIs, including the cash flow adequacy ratio.  For more information, check out our list of default KPIs or visit our help centre. Additionally, you can explore tutorial webinars and testimonials on the Fathom blog.

Interested in our KPI tracking software?

KPI tracking software can be used by businesses looking to get a clearer understanding of their performance, by tracking Key Performance Indicators (KPIs) and metrics that matter to their business.

Watch our KPIs Demystified webinar  for more information on defining and tracking the KPIs that are most important to your company.

We have also written glossary entries on other default Fathom KPI’s that you may want to explore, such as cash flow margin, cash flow coverage ratio, and cash flow adequacy ratio.

Smarter growth starts with the right metrics. With Fathom, you can select from 50+ common financial KPIs or create your KPIs for a comprehensive view of business health and performance. If you're not yet a Fathom user, remember you can explore the capabilities of our KPI tracking software when you start a free 14-day trial today.

Frequently Asked Questions

How is the net cash flow formula calculated?

Simply put, net cash flow is calculated by subtracting total cash outflows from total cash inflows. In other words, it is the difference between the money that comes into your business and the money that goes out.

How much net cash flow is good?

A positive net cash flow is generally considered good as it indicates that your business can generate more cash than it spends. However, the ideal amount varies depending on the size and industry of your business. It's important to compare your net cash flow with industry benchmarks to determine what is considered good for your specific situation.

What is the difference between net cash flow vs net income?

Net cash flow and net income are two financial metrics that are often used to assess a company's financial health, but they represent different aspects of the company's performance.

Net income is the total revenue generated by a company minus all expenses, including taxes.

On the other hand, net cash flow is the total amount of money moving in and out of a company during a specific period, considering all cash inflows and outflows. While net income gives a picture of a company's profitability, net cash flow provides insight into its liquidity and ability to meet financial obligations.

In simpler terms, net income is about the bottom-line profits, while net cash flow is about the actual cash moving through the business. It's important for investors and stakeholders to consider both metrics when evaluating a company's financial health

Is net cash flow the same as profit?

While both net cash flow and profit are important financial metrics, they are not the same.

Profit is the total revenue minus total expenses, while net cash flow, as Investopedia explains, focuses solely on the cash coming in and going out of your business.

Profit can be affected by non-cash items like depreciation, while net cash flow provides a clearer picture of your business's liquidity.

Other popular KPIs

Activity Ratio: A Comprehensive Guide
Gross Profit Growth
Operating Profit Margin
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