Cash flow calculation: formula, methods and example

A cash flow calculation converts net profit into money by adjusting for items that never touched the bank: net profit plus depreciation, minus the increase in working capital, minus capital expenditure, plus the balance of financing. The result is what the business actually generated or consumed during the period.

For a controller that is a different number from profit, and usually the more important one. A company can report an excellent result and still run dry, because the growth ended up in receivables and inventory. Profit allocates revenue and cost to a period; cash flow is what happens on the bank statement.

Which cash flow are you measuring?

Cash flow is not a single figure. A cash flow statement has three levels, and most confusion comes from two people meaning different ones.

• Operating cash flow – the money the operation itself produces, after correcting for the movement in working capital. This is the level banks and investors look at.
• Investing cash flow – purchases and disposals of tangible and intangible fixed assets and of participations.
• Financing cash flow – new and repaid loans, capital contributions and dividends paid.

On top of these sits free cash flow: operating cash flow minus the investment needed to maintain capacity. That is what remains for repayment, dividend and acquisitions, which is why it drives valuations and bank covenants.

The cash flow calculation formula

Operating cash flow = net profit + depreciation and other non-cash items − increase in working capital

Free cash flow = operating cash flow − investment in fixed assets

1. Start from net profit after tax in the profit and loss account.
2. Add back the non-cash items: depreciation, amortisation, movements in provisions and unrealised exchange rate differences.
3. Correct for the movement in working capital. Rising receivables and inventory consume cash, while rising payables release it. The mechanics are set out in working capital.
4. Deduct investments in fixed assets and add the proceeds of any disposals.
5. Add the financing balance: new borrowings less repayments, dividends and capital movements.
6. Close with the reconciliation: the three cash flows together must equal the movement in cash between the opening and closing balance sheet. If they do not, a balance sheet movement is missing or counted twice.

Worked example

A manufacturing company closes the financial year with the following figures.

Item	Amount
Net profit after tax	€ 620,000
Depreciation	€ 240,000
Increase in receivables	− € 180,000
Increase in inventory	− € 60,000
Increase in payables	€ 95,000
Operating cash flow	€ 715,000
Investment in machinery	− € 310,000
Free cash flow	€ 405,000
Loan repayment	− € 150,000
Dividend paid	− € 100,000
Movement in cash	€ 155,000

Profit is € 620,000, yet only € 155,000 lands in the bank. The gap of € 465,000 has nothing to do with trading: € 145,000 went into working capital, € 310,000 into machinery and € 250,000 to the lender and the shareholder, while the € 240,000 of depreciation cost no money at all.

Direct and indirect cash flow calculation

Two routes lead to the same answer. The direct method adds up actual receipts and payments, usually from bank movements and open items in the sales and purchase ledgers. It is accurate at weekly level and forms the basis of a 13-week cash flow plan, but it demands an administration in which every payment can be traced to a category.

The indirect method starts from the result and the balance sheet movements, exactly as above. It reconciles to the annual accounts by construction, which is why external reporting standardises on it. Smartbooks works this way: the cash flow statement is built from the profit and loss results and the balance sheet movements between two periods, so the historical view follows the ledger automatically. Forecasting uses the same logic. You plan the profit and loss account and the balance sheet, let the result flow into equity through the profit reserves, and make cash the balancing item for all remaining balance sheet movements. Tie receivables and payables to a DSO or DPO metric and working capital moves with the plan on its own.

When is the outcome good enough?

There is no fixed threshold as there is for the current ratio, but three tests hold up in practice.

• Operating cash flow against net profit. Over several years operating cash flow should exceed profit, if only because depreciation is added back. Structurally below it means profit is being funded out of working capital.
• Cash conversion. Operating cash flow divided by EBITDA sits roughly between 80% and 100% for a stable business. Fast growers and project-driven companies run below that; how the denominator is built up is covered in EBITDA calculation.
• Free cash flow across the cycle. A single year of negative free cash flow is normal when a major replacement investment falls due. Three consecutive years is not, unless the company is deliberately growing on debt and the lender knows it.

Always test the outcome against your own loan documentation as well. Covenants such as net debt to EBITDA or a minimum debt service coverage differ by bank, by sector and by financing round; there is no universal rule of thumb.

Pitfalls

• Reading EBITDA as cash. EBITDA ignores working capital, capital expenditure, interest and tax – the four items that separate a good year from a liquidity problem.
• Taking balance sheet movements at face value. A balance sheet in foreign currency carries translation differences that are not cash flows, and neither are revaluations or disposals. Include them and the statement still balances, but it measures something other than cash.
• Consolidating without eliminations. Intercompany current accounts create group-level cash flows that never existed.
• Counting cash in a subsidiary as available. Without a cash pool, or under dividend restrictions, that balance is out of reach for the holding company.
• Looking backwards only. A cash flow statement explains the past. Steering needs a forward-looking cash budget alongside it.

Frequently asked questions

How do you make a cash flow calculation from annual accounts?

Take net profit from the profit and loss account, add back depreciation and other non-cash items, and correct for the movements between the opening and closing balance sheet. That is the indirect method. The outcome must equal the difference in cash between the two balance sheets, and that reconciliation is your check.

What is the difference between cash flow and profit?

Profit allocates revenue and cost to the period they belong to, regardless of when payment occurs. Cash flow measures the payment itself. An invoice on thirty-day terms is profit today and money a month from now.

Is EBITDA the same as cash flow?

No. EBITDA is operating profit before depreciation and therefore a rough proxy at best. It contains no working capital movements, no capital expenditure, no interest and no tax, and those are precisely the items that decide what remains in the bank.

How often should a cash flow calculation be made?

Monthly, at the close, as a standard part of the reporting pack. A cash flow statement that appears only with the annual accounts arrives too late to act on.

Start at the month-end close: put one page next to the profit and loss account showing the three cash flows and the reconciliation to the bank balance. If you would rather not repeat that work by hand every month, see how budgeting and cash flow planning come together in one model, or browse the knowledge center for the neighbouring ratios.