Cash flow computation is the process of tracking the movement of money in and out of a business, organization, or personal account over a period of time. It involves monitoring where your money comes from (e.g., sales, investments, loans, etc.) and where it goes (e.g., bills, salaries, equipment, etc.). Calculating this flow will help you understand the health of your finances and whether you have enough cash on hand to cover expenses or take advantage of new opportunities.

With 82% of business failures attributed to cash flow issues, cash flow computation can impact every aspect of your business. Below, we explain why cash flow computation is important, the formula for cash flow, and common mistakes to avoid.

What’s in this article?

• Why is cash flow computation important?
  
• What is the formula for cash flow?
  
• What are the common mistakes in cash flow computations?
  

Why is cash flow computation important?

To operate and plan for growth, businesses need to have a clear sense of their financial sustainability and the timing of their cash inflows and outflows. Here’s how cash flow computation can help:

• Avoid liquidity crises: Even profitable businesses can encounter challenges if their cash inflows don’t align with outflows. For example, if a company has large upcoming payments for inventory but won’t receive customer payments for another 60 days, it can use cash flow computation to help anticipate and address the gap.

• Support important decisions: Businesses need precise cash flow data to assess risks when expanding operations, investing in new equipment, or securing financing. If the computation reveals tight cash reserves, the business might choose to delay nonessential investments or renegotiate payment terms.

• Understand operational efficiency: Analyzing cash flow reveals how efficiently a business is turning sales into cash. For instance, a company might have high revenue but poor cash flow because customers are slow to pay. This insight allows for targeted improvements, such as tightening credit policies.

• Meet debt obligations: Accurate cash flow computation ensures a business can service its debt on time. Missing a loan payment due to poor cash flow forecasting can harm creditworthiness and strain relationships with lenders.

• Respond to market changes: During periods of economic uncertainty or fluctuating demand, cash flow computation helps businesses stay agile. It allows for quick adjustments to spending, hiring, or inventory levels to protect long-term stability.

What is the formula for cash flow?

The formula for calculating cash flow varies depending on the specific type of cash flow being analyzed (e.g., operating cash flow, free cash flow, etc.). The simplest formula for overall cash flow is:

Cash Flow = Total Cash Inflows − Total Cash Outflows

Here are some other common formulas:

Operating cash flow (OCF)

OCF = Net Income + Noncash Expenses − Changes in Working Capital

OCF focuses on cash generated from core business operations. The formula can vary slightly depending on the method used (i.e., direct or indirect), but the indirect method shown here is the most common approach. Noncash expenses include depreciation and amortization, while changes in working capital refer to changes in accounts receivable, accounts payable, or inventory.

Free cash flow (FCF)

FCF = OCF − Capital Expenditures

This measures cash available after capital expenditures (CapEx).

Free cash flow to equity (FCFE)

FCFE = FCF + Net Debt Issued

This represents cash available to equity shareholders.

Free cash flow to firm (FCFF)

FCFF = (Earnings before Interest and Taxes × [1−Tax Rate]) + Depreciation and Amortization − Changes in Net Working Capital − CapEx

This represents cash available to all investors (i.e., equity and debt holders). Earnings before interest and taxes is also known as “EBIT.”

Cash flow from investing activities

Cash Flow from Investing Activities = Proceeds from Sale of Assets − CapEx − Purchase of Investments

This tracks cash used for and earned from investments.

Cash flow from financing activities

Cash Flow from Financing Activities = Cash Inflows from Issuing Equity or Borrowing − (Repayments of Debt + Repurchase of Equity + Dividends Paid)

This tracks cash related to financing activities, such as loans and equity.

What are the common mistakes in cash flow computations?

Mistakes in cash flow calculations can cause serious issues, from misguided decisions to outright cash shortages. Here are some common errors to avoid:

Skipping noncash items

If you’re using the indirect method to determine operating cash flow, it’s easy to forget about depreciation or amortization when running cash flow numbers. The problem is that they aren’t real cash expenses—they don’t impact your bank balance. But leaving them out means your cash flow statement won’t reflect all your expenses.

Mislabeling cash flows

Sometimes, cash gets miscategorized. For example, you might log a big equipment purchase as an operating expense instead of an investment activity. It might seem minor, but this type of mistake can disrupt your analysis and make it hard to tell what’s really driving your cash flow.

Ignoring timing

With cash flow, timing is as important as amounts. If you assume you’ll collect payments immediately or don’t account for delays in customer receipts, you might not factor in enough of a cushion to cover your bills.

Overlooking working capital changes

Receivables, payables, and inventory shifts can have a big impact. If you don’t adjust for changes in these areas, your cash flow calculations can be wrong. For example, growing sales might look great, but if customers aren’t paying on time, your cash flow will suffer.

Underestimating big investments

Capital expenditures (e.g., buying equipment, vehicles, or property) can be huge cash drains, but they’re easy to overlook in projections. If you don’t account for these expenses, you might overestimate how much cash is truly free to use elsewhere.

Forgetting financing activities

Cash flow from loans, equity financing, or dividends is sometimes left out of the equation. If you miss these, you’re not seeing the full picture of how your business is really funded or how obligations such as debt repayments impact cash.

Unrealistic projecting

Overconfidence in future sales or underestimating upcoming costs can lead to a cash shortage. If your projections aren’t based on reality, you might find yourself lacking funds when it matters most.

Double counting

Counting the same inflow or outflow in multiple places can lead to inaccurate calculations. For example, you might include a one-off sale in both operating and investing cash flows.

Missing irregular transactions

One-off events—such as selling an asset or paying a legal settlement—shouldn’t be treated as normal cash flow. If you combine them with recurring activities, it can skew your understanding of how your business is really performing month-to-month.

Skipping bank reconciliation

Cash flow statements should match what’s happening in your bank accounts. Reconciling the two helps catch errors, fraud, or overlooked transactions.

Forgetting about taxes

Taxes are easy to overlook until the bill is due, but they need to be counted as cash outflows. Misjudging your tax liability or ignoring it completely can derail your cash planning.

Looking only at the bottom line

It’s tempting to focus on the final cash flow number, but understanding how you got there is just as important. For example, if all your cash is coming from loans and none from operations, that’s a warning sign you need to address.