What is Net Cash Flow?
Net Cash Flow is the difference between the money coming in (“inflows”) and the money going out of a company (“outflows”) over a specified period.
At the end of the day, all companies must eventually become cash flow positive in order to sustain its operations into the foreseeable future.
How to Calculate Net Cash Flow?
The net cash flow metric represents a company’s total cash inflows minus its total cash outflows in a given period.
The capacity of a company to generate sustainable, positive cash flows determines its future growth prospects, ability to reinvest in maintaining past growth (or excess growth), expand its profit margins, and operate as a “going concern” over the long run.
- Cash Inflows → The movement of money into a company’s pockets (“Sources”)
- Cash Outflows → The money no longer in the company’s possession (“Use”)
Since accrual-based accounting fails to accurately depict a company’s true cash flow position and financial health, the cash flow statement (CFS) tracks each inflow and outflow of cash from operating, investing, and financing activities across a specified period.
Under the indirect method, the cash flow statement (CFS) is composed of three distinct sections:
- Cash Flow from Operating Activities (CFO) → The starting line item is net income – the “bottom line” of the accrual-based income statement – which is subsequently adjusted by adding back non-cash expenses, namely depreciation and amortization, as well as the change in net working capital (NWC).
- Cash Flow from Investing Activities (CFI) → The next section accounts for investments, with the primarily recurring line item being capital expenditures (Capex), followed by business acquisitions, asset sales, and divestitures.
- Cash Flow from Financing Activities (CFF) → The final section captures the net cash impact from raising capital via equity or debt issuances, share buybacks, repayments on any financing obligations (i.e. mandatory debt repayment), and issuances of dividends to shareholders.
Conceptually, the net cash flow equation consists of subtracting a company’s total cash outflows from its total cash inflows.
The sum of the three sections of the CFS represents the net cash flow – i.e. the “Net Change in Cash” line item – for the given period.
Net Cash Flow Formula
The formula for calculating the net cash flow is as follows.
The three sections of the cash flow statement are added together, yet it is still important to confirm that the sign convention is correct, otherwise, the ending calculation will be incorrect.
For example, depreciation and amortization must be treated as non-cash add-backs (+), whereas capital expenditures represent the purchase of long-term fixed assets and are thus subtracted (–).
Net Cash Flow vs. Net Income: What is the Difference?
The net cash flow metric is used to address the shortcomings of accrual-based net income.
While accrual accounting has become the standardized method of bookkeeping per GAAP reporting standards in the U.S., it is still an imperfect system with several limitations.
In particular, the net income metric found on the income statement can be misleading for measuring the movement of a company’s actual cash flows.
The purpose of the cash flow statement is to ensure that investors are not misled and to provide further transparency into the financial performance of a company, especially in terms of understanding its cash flows.
A company that is consistently profitable at the net income line could in fact still be in a poor financial state and even go bankrupt.
Net Cash Flow Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Step 1. Business Operating Assumptions
Suppose a company had the following financial data per its cash flow statement (CFS).
- Cash Flow from Operations = $110 million
- Net Income = $100 million
- Depreciation and Amortization (D&A) = $20 million
- Change in Net Working Capital (NWC) = –$10 million
- Cash Flow from Investing = –$80 million
- Capital Expenditures (Capex) = –$80 million
- Cash Flow from Financing = $10 million
- Issuance of Long-Term Debt = $40 million
- Repayment of Long-Term Debt = –$20 million
- Issuance of Common Dividends = –$10 million
Step 2. Cash Flow from Operations Calculation
In the cash flow from operations section, the $100 million of net income flows in from the income statement.
Since the net income metric must be adjusted for non-cash charges and changes in working capital, we’ll add the $20 million in D&A and subtract the $10 in the change in NWC.
- Cash Flow from Operations = $110 million + $20 million – $10 million = $110 million
If the year-over-year (YoY) change in NWC is positive – i.e. net working capital (NWC) increased – the change should reflect an outflow of cash, rather than an inflow.
For instance, if a company’s accounts receivable balance increased, the impact on cash flow is negative because the company is owed more money from customers that purchased on credit (and thus this represents cash that has not yet been received).
Until the payment obligation is fulfilled in cash by the customer, the outstanding dollar amount remains on the balance sheet in the accounts receivable line item.
Step 3. Cash Flow from Investing Calculation
In the cash flow from investing section, our only cash outflow is the purchase of fixed assets – i.e. capital expenditures, or “Capex” for short – which is assumed to be an outflow of $80 million.
- Cash Flow from Investing = – $80 million
Step 4. Cash Flow from Financing Calculation
The final section is the cash flow from financing, which comprises three items.
- Issuance of Long-Term Debt: The issuance of long-term debt is a method of raising capital, so the $40 million is an inflow to the company.
- Repayment of Long-Term Debt: The repayment of other long-term debt securities is an outflow of cash, thus we place a negative sign in front, i.e. the intended cash impact is to reduce cash flow.
- Issuance of Common Dividends: Like the repayment of long-term debt, the issuance of common dividends – assuming these are dividends paid to shareholders in the form of cash – are also outflows of cash.
The overall net cash impact from these financing activities is $10 million.
- Cash Flow from Financing = $40 million – $20 million – $10 million = $10 million
Step 5. Net Cash Flow Calculation and Business Profit Analysis
The sum of the three cash flow statement (CFS) sections – the net cash flow for our hypothetical company in the fiscal year ending 2021 – amounts to $40 million.
- Net Cash Flow = $110 million – $80 million + $10 million = $40 million