Blog | 04 Jul 2024

Taking Money Out Of Your Business: A Cash Flow Formula (Part 1: Determining Free Cash Flows)

By William Wedlock, Senior Manager | Accounting

You’ve got a successful business under management and profits are rolling in – congratulations are in order! It must be time to celebrate by treating yourself to that big, shiny, expensive thing you’ve had your eye on. It’s easy to dip into the cash sitting in your business – but should you? Let’s talk about it!

As we’ve said many times before, cash is what keeps the lights on at your company. From paying salaries (including your own), to covering office rent and investing in equipment and software, cash is what allows you to, well, make more cash. Running out of it can stop a business in its tracks.

All businesses need a strong cash flow formula to maintain momentum and growth.

We’re often asked, “How much cash do I really need to keep in the business?” Our answer always starts with, “Well, it depends.” That’s because it really does depend—the way you take money out of your business might not work for the next business owner.

What Are Free Cash Flows?

Free cash flow is a measure that can help show you how much money your business actually generated in a time period. While there’s no standard formula for calculating your free cash flow, the resulting figure can be seen as a more accurate reflection of how much cash is available to take out of your business. So, how do you determine the free cash flow of your business? A commonly used way of calculating it is:

Free cash flow = Net income + Taxes + Interest + Depreciation + Amortization – Changes in non-cash working capital – Capital assets purchases

You could also take a more conservative approach by not adding back taxes and interest to account for monthly tax instalments, or loan payments.

What To Consider When Determining Free Cash Flow

Since there’s no standard way to determine your formula, here are some things you should consider when deciding on your business’ free cash flow:

Average Monthly Expenses

Create and review cash flow statements over the past 3-6 months (if there is seasonality to your business, you may want to extend this period) to see how much you’ve been spending. Monthly amounts can vary, so take an average. Then, multiply the average by the number of months you think your business would need cash to cover expenses.

Fixed and Variable Expenses

Cash flow management strategies will differ for almost every business because of things like purchasing requirements, equipment maintenance costs, and industry-standard receivable timelines. Make sure to consider all variable and fixed expenses as part of the cash flow formula when determining how many months of cash you may need.

Stockpiling Cash

The first half of this blog talks about determining the minimum amount of cash you should have on hand, but can you have too much cash on hand? Yes, of course.

Having a lot of cash in reserve means it’s not being used to grow the business or being invested where it can earn passive income. There’s a delicate balance that needs to be met between having cash on hand, having cash for expenses, and having cash to invest.

Tax on Passive Income

Corporate active business and passive income are taxed differently in Canada. Passive income earnings in a Canadian Controlled Private Corporation (CCPC) are taxed at around 50%. Business income, however, in a CCPC is taxed at 12.2% on the first $500,000 in the Province of Ontario. Any amount over that is taxed at the higher, general tax rate of 26.5% (in Ontario).

This all seems pretty straightforward until the passive income tax rule kicks in—making over $50,000 per year in passive business income will impact how much of your active business income qualifies for that small business tax deduction. For every $1 over $50,000 earned in passive income per year, you lose $5 of your $500,000 small business deduction. Once you’ve earned more than $150,000 of passive income in your CCPC, you will have no small business deduction left. These tax regulations should be considered when planning for how much to keep in your business versus how much to take out.

There’s no one-size-fits-all answer to determining just how much cash a business needs readily available. Each cash flow formula involves many different inputs, variables, and up-to-date bookkeeping records. What every business does need to know is that having the right financial team to determine its cash flow formula is key to keeping it moving forward and growing! Let our experienced team of CPAs be your cash flow experts.

Contact us today.

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