What is cash flow, how is it calculated and how is it managed?

When discussing business management, we often encounter technical terms like balance sheet, net profit, ROI, and margins. But there’s a concept, perhaps less obvious, that actually plays a crucial role in the survival and success of any business: cash flow.

Entrepreneurs, managers, and freelancers should be clear that the actual availability of cash is what allows a company to operate on a daily basis. A company can be profitable and yet not have enough liquidity to pay salaries, suppliers, or taxes. This is where cash flow comes in. But what does it really mean and why is it so important? Below, we’ll look at what it is, how it’s calculated, and how to manage it effectively, from both an operational and fiscal perspective.

Meaning and definition of Cash Flow

The term cash flow refers to the flow of cash into and out of a company over a given period of time. It is a measure of a company’s ability to generate liquidity through its operating activities, but also in relation to investing and financing activities.

"A fundamental element for internal management control and economic-financial analysis. Literature and practice have associated multiple definitions of cash flow, among which the most commonly used in current professional practice is operating cash flow and free cash flow."

Unlike accounting profit, which may include non-monetary elements, such as depreciation or provisions, cash flow concerns only actual cash movements. This makes it a fundamental tool for assessing a company’s financial sustainability in the short and medium term.

In this regard, it is also interesting to know that there are different categories of cash flow.

• Operating Cash Flow: flows related to the company’s core business, such as the sale of goods or services.
• Investing Cash Flow: Cash flows related to the purchase or sale of durable goods, real estate, machinery, and equity investments.
• Financing Cash Flow: Cash flows related to financial transactions such as loans, capital increases, and dividend distributions.

Cash Flow Calculation

Cash flow can be calculated using two main methods: direct and indirect. Specifically, with the direct method, you add together all cash inflows, such as customer receipts and reimbursements, and subtract all outflows, such as salaries, rent, suppliers, and taxes, in a given period. This approach is very intuitive and straightforward.

For example, let’s assume a company collects €50,000 and simultaneously pays €30,000 to suppliers and €10,000 in salaries. If all this weren’t enough, they also pay €5,000 in taxes. In this case, the cash flow is €50,000 – (€30,000 + €10,000 + €5,000) = €5,000.

To use the indirect method, however, you must start from the net profit and make adjustments to include non-cash items, such as depreciation and amortization, and changes in trade receivables and payables.

The following formula is then used: Cash Flow = Net Profit + Depreciation and Amortization ± Changes in Current Assets/Liabilities.

To better understand how it works, let’s assume a company records a net profit of €10,000 and depreciation and amortization of €3,000. Also noteworthy is an increase in trade receivables, meaning fewer collections, of €2,000, and an increase in trade payables, meaning deferred payments, of €1,000. Therefore, the cash flow will be: €10,000 + €3,000 – €2,000 + €1,000 = €12,000.

Cash Flow Management: How to Do It in Practice

Once you’ve seen what cash flow is and how it’s calculated, you’ll want to know what to do to manage it effectively. This doesn’t just mean avoiding a red account, but also knowing in advance what will likely happen in the coming months, understanding where the money is going, preventing liquidity crises, and having complete control over the company’s ability to sustain itself over time. The key is forecasting. Even a simple Excel spreadsheet can help you clearly estimate the income and expenses for the coming months. This allows you to understand if and when you might encounter liquidity problems and act in advance to avoid them.

Another good practice is, whenever possible, try to collect first and pay later. This doesn’t mean pushing suppliers too hard, but rather negotiating slightly more flexible deadlines and, at the same time, finding solutions to accelerate customer collections. For example, you can offer discounts for early payments or use automatic reminder systems. Expenses should also be kept under control. To this end, it’s advisable to cut what isn’t truly necessary and conduct an honest analysis of your activities. An often overlooked point concerns warehouse. Having too much inventory may seem like a good thing, but it actually means having money tied up in products that aren’t generating revenue. It’s better to manage inventory more streamlined, consistent with operational needs.

When it comes to investing, it’s also crucial to pay attention to timing. The right investment at the wrong time can create cash flow problems. Before purchasing new machinery, hiring new staff, or expanding, it’s important to ensure there’s sufficient liquidity or secure sources of financing. Turning to financing, there are several tools that can help manage times of cash pressure, such as bank overdrafts, lines of credit, leasing, invoice advances, and factoring. These tools shouldn’t be seen as a problem, but rather as levers to be used intelligently to maintain balance.

If all this weren’t enough, there are numerous software programs, often very accessible, that allow you to automate cash flow management and keep a close eye on your company’s financial situation. These tools are particularly useful for SMEs, as they can truly make the difference between simply surviving and achieving solid, steady growth. Ultimately, managing cash flow effectively means having a clear vision, making informed decisions, and never being caught unprepared. It’s not something to be improvised at the last minute, but a strategic habit to be built day by day.

Original article published on Money.it Italy. Original title: Cos’è il cash flow, come si calcola e come si gestisce