how to calculate cash flow

how to calculate cash flow

How to Calculate Cash Flow Ratios

Cash flow ratios provide valuable information about the economics of the firm.

The three financial statements that every company produces include the income statement, the balance sheet and the statement of cash flows. The cash flow statement provides information about the state of funds moving through your firm. The balance sheet describes the amount of assets, liabilities and owner's equity in the firm. Using the data in these statements you can calculate cash flow ratios such as the quick ratio, the current ratio and the operating cash flow ratio.

1. Find the current assets and current liabilities on the balance sheet. They are line items on the balance sheet. Divide the current assets by the current liabilities to find the current ratio, which is a fast way to calculate a firm's health. If the company has $600,000 in current assets and $200,000 in current liabilities, the current ratio ($600,000 divided by $200,000) equals 3.0 times.

2. Sum the cash, cash equivalents and accounts receivable which are all line items on the balance sheet. Take this total and divide by the current liabilities which is also on the balance sheet. The result will equal the quick ratio which is a better measure of a firm's solvency. If the company has $100,000 in cash, $50,000 in cash equivalents and $150,000 in accounts receivable as well as $150,000 in current liabilities, the quick ratio is (($100,000 plus $50,000 plus $150,000) divided by $150,000) equals 2.0 times.

3. Find the cash flow from operations on the cash flow statement. Divide that number by the current liabilities on the balance sheet to find the operating cash flow ratio. This number gives analysts an idea of how much cash the company can provide beyond its liability payments. If the company has $900,000 in cash flow from operations as well as $150,000 in current liabilities, the operating cash flow ratio is ($900,000 divided by $150,000) equals 6.0 times.

4. Obtain the operating cash flow from the cash flow statement and divide by the total sales found at the top of the income statement. This number describes the efficiency of the company's efforts of turning sales into cash. If the company has $200,000 in operating cash flow and $1,000,000 in sales, the calculation is ($200,000 divided by $1,000,000) equals 0.2 times.

How to Calculate Free Cash Flow

Intermediate Accounting For Dummies

Investors are very interested in free cash flow, which is the net cash provided by operating activities minus capital expenditures and dividends. You figure free cash flow by subtracting money spent for capital expenditures, which is money to purchase or improve assets, and money paid out in dividends from net cash provided by operating activities.

Free cash flow is important to investors because, in the long run, it can have a major effect on whether the company can continue as a going concern (which means the company anticipates being in operation for at least the next 12 months).

It also has a bearing on whether investors can anticipate being paid dividends in the future and on the stability and possible increase of the market price of the stock. This consideration is important if the investor is planning to sell the stock in the near future at a price equal to or above what he originally paid for it.

The following illustrates a free cash flow calculation using our old familiar net cash provided by an operating activities figure of $115,000 and assuming capital expenditures of $45,700 and dividends of $25,000. In this calculation, free cash flow is a positive amount, which is always a good thing.

However, many users would not consider the $44,300 to be a substantial amount. One pending debt payment could eat it up entirely, leaving no free cash for other uses.

Any ratio by itself is rather meaningless unless you have some point of comparison, such as an industry average or a competitor.

How to calculate discounted cash flow (DCF)

Corporate finance, MBA topics, Personal finance

Suppose I offered to give you either $1000 in June 2006 or $150 every June for the next 10 years, starting in 2007. Which offer is worth more? How would you figure this out? The answer is: by calculating discounted cash flows.

Discounted Cash Flow or DCF analysis is one of the first things taught in finance class in an MBA program. It’s a natural consequence of the time value of money, which states essentially that a dollar today is not worth the same as a dollar in the future. Discounted Cash Flow analysis is most commonly used to value a project or company (or lottery payout, as in the simple example above) using a discount rate or weighted average cost of capital, also abbreviated as WACC. (Did I forget to mention finance is big on acronyms?)

Determining an appropriate discount rate or WACC can get complicated, so for now, we’ll just simplify it and call it a percentage rate that we use to “discount” future cash flows to the present. For example, if you earned $100 every year, you can imagine that the $100 you earn 10 years from now won’t be worth the same as the $100 you earn this year. Inflation, the return you could be getting on the $100 during that time, risk, all sorts of aspects can play into evaluating what $100 in 2016 is worth in 2006.

If you’re working in corporate finance, chances are Treasury or some other official department has dictated an “official” cost of capital to use in your analysis. On this site, when I calculate Experiments in Finance’s NPV each month, I choose to use an annual rate of 5% as my discount rate, remembering to change this to its the monthly equivalent rate since I’m calculating monthly cash flows. My reasoning is that the cash flows for this project aren’t large, and a comparable activity of similar risk might be to put the money in a saving’s account instead. This is one of those situations where finance is more like art than science. You could argue ’til you were blue in the face about what the “right” cost of capital to use should be, but in the end it may not matter too much, especially if you conduct a sensitivity analysis using different rates.

Let’s get back to talking about DCFs. Discounted cash flow analysis essentially takes the cash flows for each period and discounts them back to the current moment. So, suppose we have cash flows of $100 starting next year for the next 10 years, and our discount rate is 8%. Then what we’re calculating looks like the following:

DCF = $100/(1+0.08) + $100/(1+0.08) 2 + $100/(1+0.08) 3 + … + $100/(1+0.08) 10

(In this particular case, we’ve set a constant $100 per year as our cash flow. If we were receiving different amounts each year instead, say, $100 every year, except for $150 in year 2 and $1000 in year 10, then we’d simply plug in those amounts instead in their respective years.)

What you’re doing is essentially “bringing back” the future cash flow to the present time, using the discount rate of 8%. This means that the value of receiving $100 every year for 10 years isn’t $1000 but $671. In fact, receiving $100 at the end of this year isn’t the same as having the cash in your at the beginning of the year. It’s worth $100 less the amount you would have earned in interest had you had it at the beginning of the year. And the $100 you earn two years from now is worth $100 less the amount you would have earned in compound interest over the two years. And so on. This is why wise articles about how much you need to save for retirement often result in seemingly large amounts.

Getting back to our original example, it turns out that if you assume a discount rate (which might represent the constant interest rate you can earn on your money) of 8%, then having $1000 in your pocket now versus having $150 for the next 10 years is the same. But if you assume that you can only earn 5%, then the stream of income is a better deal ($130 per year is the breakeven).

Discounted cash flow analysis is the basis of many things in finance, including Net Present Value or NPV, bond prices, annuity pricing, and many more. NPV and DCF calculations are one of the most frequently used finance tools for valuation purposes. But, like everything else, they have their limitations and are simply tools. If your numbers aren’t accurate to begin with, adding and dividing them will only result in a worse answer. DCFs and NPVs are also pretty inflexible. If future earnings and cash flows are very uncertain, or management has the option of changing a project midway through, then this type of analysis may not be the best way to go. In those cases, Real options or Monte Carlo might be more complex but better tools to use.

How to Calculate Rental Property Cash Flow – A Comprehensive Guide

Investors don’t decide to buy properties; they decide to buy the income streams of the properties.” – Frank Gallinelli

Some rental buildings are beautiful. I particularly admire well-constructed, brick structures with hardwood floors and large, dry crawl spaces. But the building only matters indirectly for rental property investors.

The beauty of the building is relevant if it attracts good tenants who pay you rent consistently. Then that rental income stream can be used to cover your expenses, produce cash flow, and increase your bank account balance.

Cash in the bank. Ahhh. Isn’t that also beautiful?

Cash flow is like a pristine mountain stream that continually provides nourishment to your business and to your life. It pays your bills. It helps you pay off your mortgages. And it gives you a resource to reinvest and grow your pool of investments to a point of financial independence.

But this beauty of cash flow from real estate is elusive. Not all properties produce it equally. And too many investors ignore the steps required to calculate cash flow up front.

When this happens, you invest with your eyes only half open. And negative or sub-par cash flow tends to follow you for years.

I know this from first-hand experience!

I hope to remedy that situation in this article. I’m going to show you the most common ways to calculate real estate cash flow so that you can recognize it and seek it out from your investments.

You can think of real estate cash flow sort of like a waterfall. The investor (you) is at the bottom. Here’s what that waterfall looks like:

  1. Collect rent
  2. Operating expense payments (taxes, insurance, maintenance, etc)
  3. Capital expense payments (replace roof, heat-air system, etc)
  4. Mortgage payments
  5. Income tax payments
  6. Pay owner/equity partner

That’s a long waterfall, isn’t it? There are a lot of opportunities for that precious cash flow to be diverted away from you.

Since the goal of real estate investing is to pool as much cash as possible at the bottom of the waterfall, it’s critical to understand and correctly calculate all of the prior steps. This will help you negotiate the right price and financing terms that ensure a steady stream of cash flow to you for years.

The first cash flow calculation is Net Operating Income.

Net Operating Income (aka NOI) is the foundational formula used to calculate rental property cash flow. I have an 11-minute YouTube Video that explains this concept in detail, but I’ll also briefly share it with you here.

NOI tells us the income left over after paying all of our every-day rental expenses (not including financing). These are called operating expenses, and they include things like vacancy reserves, management fees, property taxes, insurance, and maintenance.

The formula for NOI looks like this:

These operating expenses are items you will likely write checks for some time during the year. Without paying these expenses, you would not be able to operate and rent the property.

But notice the expenses this formula does not include, like mortgage costs and capital expenses. Mortgage expenses vary for each investor depending upon the financing amount and terms. Capital expenses are something I’ll discuss more later in the article.

An example with real-life numbers might be a house that rents for $1,500 per month. Here is a possible monthly net operating income calculation for that property:

NOI is helpful because it begins to tell us how much cash flow we have available to pay lenders and equity partners. But as you’ll see in the next section, the normal calculation for NOI is missing one critical ingredient.

While net operating income is important, its close cousin cash flow from operations (CFO) more accurately tells you what you need to know as an investor.

Here is the formula for cash flow from operations:

For commercial investors, this definition would also include deductions like leasing commissions and tenant improvements. But for those of us in the small residential investing world, the important thing to include are capital expense reserves.

What are capital expenses (aka CapEx)? They are THE real-life expenditure I see ignored by real estate investors more than any other at the time of purchase. CapEx includes the large expenses like roofs, heat-and-air systems, driveways, and other structural items.

These items wear out over time and must be replaced. And when this happens, it’s not a small check you must write! It’s the kind of event that can empty your bank account if you have multiple properties needing the same repairs.

So, in order to avoid cash flow catastrophes, use this formula below to budget for future capital expenditures. And then set up a reserve savings account where you deduct the CapEx reserve just like you would any other monthly expense.

Trust me – you will be VERY happy that you did this!

Here is an example of the monthly cash flow from operations using the same single family house. I’ve included a $900 per year or $75/month capital expense reserve. This may or may not be enough. If you want to dig in further to CapEx budgeting, read this article by my friend Brandon Turner at BiggerPockets.com.

With cash flow from operations calculated, you can now proceed to figure out how much you can afford to borrow against the property and how much cash flow you’ll actually put into your bank account.

Although free and clear real estate can be a wonderful thing, most investors start off using borrowed money to purchase real estate. So, the cash flow our property produces will be used to make regular payments to our lender.

In order to ensure you have enough cash flow both to pay your lender AND to pay yourself, you need to figure out cash flow after financing. Here is the formula:

This is a simple formula. The only real effort is calculating your financing cost, and there are a couple of different ways to do that.

If you have an amortizing loan where it automatically pays down over a period of time like 30 years, then you can use a loan calculator. Here are a few resources that may help:

Here’s an example to show how you might use this while analyzing a prospective rental purchase.

Let’s say the asking price of a property is $150,000. Your lender requires 20% down on a loan at 5% interest for 30 years. This means at most you can borrow $120,000 (80% of $150,000).

You would then enter $120,000 and the other loan information into your loan calculator in order to get the monthly payment. The steps are illustrated below:

The result given by the calculator will be your monthly payment on the loan. This will be both principal and interest.

In this example, the payment amount is $644.19 Now you can calculate the cash flow after financing.

This means you will put $206 per month or $2,470 per year into your bank account. Does that mean you’re all finished? Can you swim in your pool of cash yet?

Actually, there is one more buddy who gets angry if he’s forgotten. That’s big ‘ol Uncle Sam the tax man:).

So far you’ve paid all of your operating expenses, your capital expenses, and your lender, but you’ve still got to pay income taxes before you can figure out what YOU get to keep.

The final calculation, then, is cash flow after tax. It will take a couple of steps.

First, you need to figure out how much of your rental income is taxable. Here is the basic formula.

Taxable income is different than our prior calculations, cash flow from operations or cash flow after financing. It’s different because not everything you spend cash on is a taxable expense. For example, capital expense reserves and mortgage principal both cost you cash but are not deductible on your taxes.

Taxable income is also different than cash flow because you can deduct some expenses, like depreciation, which don’t actually come out of your cash flow. Instead, depreciation is considered a “paper loss” which means it could make your taxable income less than the actual cash flow you receive. This is a good thing!

To calculate depreciation, you must know your cost basis for the physical building you own. According to the IRS, land does not depreciate in value, so we must separate the land and building costs before calculating depreciation.

In the single family house example, let’s say $120,000 of the $150,000 house purchase was building and $30,000 was land. This is residential property, so as of this writing the IRS requires you to depreciate $120,000 over 27.5 years.

To calculate depreciation, we take $120,000 / 27.5 = $4,364 in depreciation expense per full year.

Hold that number in mind while we calculate the second expense of this formula, interest.

Interest expense is just the portion of your mortgage payment that goes towards interest. In our example of a loan for $120,000 at 5% interest for 30 years, the first year of interest will be about $5,960.

You can use the same amortization calculator I recommended earlier to calculate this. Just click the checkbox for “Show Amortization Schedule,” which I’ve pointed out with a purple arrow below:

Once you press the Calculate button, a schedule will show you how much interest was paid in the first year.

Now that you have the depreciation and interest expenses, it’s possible to calculate taxable income. Here is the full calculation for the example:

Interestingly enough, your taxable income is only $776 per year even though the cash flow in your bank account (cash flow after financing) is $2,470 per year! This shows the effect of the depreciation expense to shelter your rental cash flow from taxes.

The final step is to finally calculate the cash flow after paying your income tax bill.

Just assume the tax bracket for the income in this example is 25%. That means the taxes owed will be 25% of the taxable income.

So, 25% x 776 = $194. That number is your income tax owed.

Now you’re ready to make the FINAL cash flow calculation. Using the numbers from the example here is the final cash flow after tax:

The Power of Real Estate Cash Flow

The point of the step by step calculations in this article was to help you understand the details of cash flow produced from your rental properties. I hope you’ll use the formulas shared here as tools to pick apart and analyze any investment you may own or are looking to purchase.

But more than everyday tools, these cash flow concepts also start revealing the bigger picture strategies of wealth building in real estate.

For example, did it strike you that the effect of income taxes on your rental income was relatively minor in the illustration above? Assuming you are an employee taxed at 32.65% (25% income tax and 7.65% for social security and medicare tax), you would have to earn MUCH more than the $2,470 cash flow after financing in order to end up with the same cash. This is true because you only keep 67.35% (100% – 32.65%) of each dollar earned on the job.

On the other hand, you kept 92% of your cash flow after financing ($2,276/$2,470) from the rental property. To put the same amount of cash in the bank from your job, you’d need to earn $3,379 ($2,276 ÷ 67.35%). For a family that makes $7,000 per month, this is the equivalent of working half a month.

So, if you own 12 rental properties like this example, you could put $27,312 in the bank (12 properties x $2,276 cash flow after tax). That is the same cash flow after tax as working half a year at a full-time job. Rental properties certainly require some effort, but I can tell you from first-hand experience that even self-managing 12 rental properties is like a vacation compared to a full-time job.

If rental properties interest you, the payoff will be worth the effort of getting started. The cash flow advantages I’ve shared here and the many other advantages of investing in real estate make it an ideal choice for wealth building and long-term cash flow generation.

How to Calculate Business Cash Flow

Tracking your cash flow is a crucial step toward establishing a healthy small business. Unless you’re a former bookkeeper, the task might seem daunting, but the actual equation is relatively simple: Cash in minus cash out.

Richard Schwartz, a registered tax return preparer and owner of Schwartz Accounting & Tax in Denver, recommends using software such as QuickBooks to stay organized. However, if you’re looking for a straightforward approach to tracking your cash flow — and don’t have experience with bookkeeping — a simple spreadsheet will get the job done.

If you’re using credit cards or cash-flow loans to help stretch your capital, it’s even more important to stay organized.

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Here’s a simple how-to on calculating cash flow.

How to calculate business cash flow

To start, list the months of the year side by side across the top of your spreadsheet. (We made the calculations below in Microsoft Excel.) Then use the left side for a running list of your cash assets and cash expenses.

Your cash assets will include the starting balance in your bank account and monthly income, such as sales and interest. For example, say you started the year with $10,000. In January, you made $3,000. Add the two together to get a total cash balance of $13,000.

Your most regular cash expenses will probably be rent and your credit card and/or loan payments. Put them each on individual lines, then list every other cash expense you’ve paid during the month. Let’s say your rent is $2,000, and your monthly credit card payment is $400. You know you’ll be on the hook for $2,400 each month. But maybe you had to pay back a relative who loaned you $300 to fix your computer and you opted to pay your $250 utility bill in cash. (Right now you’re only tracking your cash flow, so you don’t need to include expenses you’ve financed with a credit card). Add them together, and you have total cash expenditures of $2,950 for the month.

Now, refer back to the original equation: cash in minus cash out. Subtract your expenses from your total cash balance, and you’re left with your monthly income.

This is the balance you’ll roll over to the next month, and the number you’ll use to determine how much money to stash away for taxes.

As you repeat the process each month, you’ll generate a comprehensive overview of your cash flow.

Nerd note: The more complex your business, the more complex your spreadsheet will be. But if you’re using Excel, you can rely on some of its features — such as automatically summing your totals and rolling over the balance each month — to keep you on track. You can also choose another spreadsheet program, or even rely on a pencil and a notebook, if that makes you feel more comfortable.

Remember, warns Schwartz, cash flow is only part of the picture. You’ll need to consider your overall liabilities, including credit card and loan balances, when determining whether you’re profitable.

The bottom line on calculating your cash flow

Cash flow is just one element of your business operations, but tracking it is an important step in ensuring your success.

You can use financing to help your cash stretch further, Schwartz says. “If you pay for everything in cash, you may run out of cash before your business has really had a chance to take off,” he says.

Find and compare small-business loans

NerdWallet has come up with a list of the best small-business loans to meet your needs and goals. We gauged lender trustworthiness, market scope and user experience, among other factors, and arranged them by categories that include your revenue and how long you’ve been in business.

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