What is Cash Flow? Calculation and Example

How to calculate the cash flow of a company from the income statement?

September 3, 2019 Siert Bruins

What is cash flow? For many persons “cash flow” is a confusing subject. Yet, cash flow is a very important quantity that is used by finance professionals, and anyone who wants to know, for example, what is this company worth? The reason for the confusion is that there are items on the income statement that are subtracted or added, while there is no money changing hands. However, in reality it's not that difficult, so let us explain to you why.

Cash flow calculated from the Income Statement

Cash flow is obtained from the Income Statement, but is not a separate item and thus has to be calculated from the figures presented. This is easier than it sounds if one takes the following definition into consideration.

What is cash flow?

The cash flow in a business is the total cash generated by the business minus the cash spent, e.g. on costs, expenses, interest and taxes.

Let us illustrate this with a hypothetical Income Statement of a hypothetical business.

Income Statement: Hypothetical, Inc.

1. Income/Revenue/Sales: 1.000.000
2. Cost of Sales: 300.000
3. Gross Income: 700.000
4. Expenses: 400.000
5. EBITDA: 300.000
6. Ammortization: 50.000
7. Depreciation: 80.000
8. EBIT: 170.000
9. Interest: 10.000
10. Tax: 58.000
11. Net Profit: 102.000

Looking at this Income Statement and taking the definition of cash flow into consideration, it is easy to find out what the cash flow for this company is. Let”s go through this income statement line by line.

Income, also sometimes called “revenue” or “Sales” is self-explanatory. This is the cash generated by the sales of goods or services. After we subtract the “Cost of Sales” we arrive at “Gross Income.” Be aware that not all Income Statements will feature a “Cost of Sales” item. This item is important in a trading business, for example, a second hand car dealer sells a car (Sales) that he bought earlier(cost of sales). So far so good. Now we subtract “Expenses,” for example salaries, raw materials, office equipment etc., to arrive at the item Earnings Before Interest, Tax, Depreciation, and Amortization, or EBITDA. After subtracting the items depreciation and amortization we arrive at EBIT. Then we subtract the interest, pay the taxman, and arrive at the bottom line, Net Profit. So is this the cash flow? No, it is not and let me show you why.

Look again at the hypothetical Income Statement, and think about our definition of cash flow. If you look carefully you see that there are two items that represent no cash out- or inflow; these items are “Amortization” and “Depreciation” on lines 6 and 7. These two non-cash items are allowed by the taxman to be subtracted from income to arrive at the Net Profit figure; however, the cash remains in the business. Therefore these items must be added back to Net Profit to arrive at the cash flow.

There can be many more non-cash items that have to be added back, or cash items that have to be subtracted - one thinks for example at payments of (preferred) dividends or other gains or losses - to arrive at the cash flow.