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Cash Flow – A Basic Definition

Cash flow is the ability of a business to turn its product or service into cash.  It is generally measured in dollars or in dollars against a time period.  The simplest example I can think of is a child selling lemonade.  The child purchases the lemonade and sugar in the morning, starts selling in the afternoon and by nightfall has turned all the lemons and sugar into cash.  The child has the cash invested (lemons and sugar) back plus the profit made that day.  However, it isn’t this simple in the real business world.

You cannot and should not compare the cash flow of Apple Corporation to the local hot dog vendor.  Cash flow is not a comparison statistic.  It is designed to inform the owner of the amount of time it will take to turn the product or service into cash.  You can use the measurement to compare your business to others in the same industry.  But don’t use it compare lemons to oranges.

How do you calculate cash flow?  Once I have the measurement, how do I know what is good and what is bad? 

Almost every business out there uses the dollar figure to determine cash flow.  Rarely do businesses use the ratio of cash to time to evaluate their cash flow.  It is inherently more difficult to understand and the common businessman has a difficult time applying the ratio into practice.  In accounting, we calculate cash flow on a monthly or quarterly basis which is the typical time period for an accounting cycle.  Most small businesses use monthly, the larger stock exchange corporations use the quarterly cycle. 

A report is generated called a Cash Flows statement whereby cash is calculated from three distinct groupings.  This article only covers Cash from Operations (the actual conducting of business).  We take the net income and add back the non-cash expenditures such as depreciation/amortization (See Depreciation – This is Weird Accounting  or What is Amortization? for further information).  Then we add or subtract for the current balance sheet issues.  Use the following examples as guidance in the formula:

  • Accounts Receivable – when the receivables balance decreases during the accounting period, this means we received the cash from the customers and so therefore we add this to our operating income as more cash.  If we allow customers to buy more on credit thereby increasing the receivables, you are owed cash and therefore you indirectly lent cash from the company.  So you would then subtract this increase from the operating income to determine actual cash flow.
  • For payable items such as taxes owed including payroll, accounts payable such as owing money to vendors or to the credit card companies we determine the change during the accounting period in question.  If we reduced how much we owe, then we had to have paid cash to achieve this reduction.  Therefore we subtract this cash from our operating income number to determine cash from operations.  If we increased our vendor amounts that we owe, then it is like borrowing money from them and therefore we didn’t have to use our cash to do this.  If this is true, then add this amount to the cash flow calculation.

So to determine the cash flow from operations, the basic formula is as follows (+ sign means to add the change in balances, a – sign means to subtract the change during the accounting period):

Net Income                                                    ZZZ
Depreciation/Amortization                        Add Back
Increase in Receivables                                     –          (lending money to customers)
Decrease in Receivables                                   +         (Customers paid cash to decrease balance)
Increase in Payables/Taxes/Credit Cards          +         (Vendors/Creditors lent money to business)
Decrease in Payables/Taxes/Credit Cards         –          (Company used cash to pay down debt)
Cash Flow from Operations                        ZZZ

It is important to understand, this is the basic formula, it is much more complex but very few new businesses will need to go beyond this depth of the formula.  Furthermore, cash flows from operations is the most important measure in the Cash Flows Statement.  It evaluates the overall ability of the business to generate cash from production.  Now to expand upon the lemonade stand above, let’s adjust the outcome from the daily profit and adjust it for the balance sheet accounts as identified above:

Daily Profit                     $17.25  (we earned 31.00 and spent $13.75 for sugar and lemons)
Increase in Receivables       (.25) (Billy agreed to owe us money for his glass of lemonade)
Increase in Payable             3.75   (Mom paid $3.75 at the grocery store because we only had $10)
Cash Flow                       $20.75 

As a check mechanism, we earned $31.00 total, we have $20.75 in cash which is $31.00 less the $10.00 spent on lemons and sugar and less 25 cents for what Billy owes to us.  Once Billy pays his 25 cents, we’ll have $21.00 in our cash box, pay Mom the $3.75 and we’ll end up with $17.25 which is the profit from the day.

Notice that cash flow does not mean profit.  It is strictly the ability of the business to turn its products or service into cash.  Had we only sold half of the lemonade, we didn’t do too well that day because we still have lemons and sugar as cash out items.  

Huge corporations spend cash for raw resources, inventory, and manufactured parts.  They combine these parts and resources and produce products for sale in the market.  They may sell several million dollars to one store chain and have a receivable on their books from that customer.  During this process they owe money to parts suppliers, vendors for services etc.  So you can see their cash flow statement is much more complicated in nature than a small business operation.

Remember what the cash flow is really about.  It is a measurement usually in dollars of the ability of the company to turn its product or service into cash.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol)  I would love to hear from you. If interested in my services as an accountant/consultant; click on My Services in the footer of this article.


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About David J Hoare (395 Articles)
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns

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