The liquidity of any business is vital to the person who owns the business and the one who operates it. A simple way to gauge the company’s capacity to survive through economic downturns is by analyzing the cash flow statement of a business.
For those who own a rental of any real estate property, it is essential to know if the cash-on-hand can sufficiently pay for all of the cash expenses. The cash flow statement of a business is an indicator of whether the real estate property is actually earning money or if it is operating in debt.
What is Cash Flow
The International Financial Reporting Standards define cash flow and cash flow statements as:
Cash flows are inflows and outflows of cash and cash equivalents. Cash comprises cash on hand and demand deposits. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.(http://www.ifrs.org/documents/ias7.pdf)
In simple terms, the cash flow of a business is the indicator of the liquidity of a company. It shows the capacity of a company to pay off its loans and any other expenses in a short period of time. Moreover, it also indicates if a company is generating cash income. In the case of rental properties, it shows whether the rental income can sufficiently cover all the expenses related to the real estate property, such as repairs and mortgages.
How to Calculate Rental Property Cash Flow
There are three types of activities that are computed in a cash flow statement: Operating, Investing, and Financing. If you are engaged in a non-real estate business, you would put all the purchases related to the acquisition of a property in the Investing Activity section of your cash flow statement. However, if you are engaged in the business of renting out your real estate property, the usual income and expense related to this business is placed in the Operating Activity section since this is your real line of business.
When computing for the cash flow from operations, the formula is rather simple since you just deduct your cash expenses from your cash income. However, it really is not as easy as it appears since there are other considerations involved in the classification of these items.
1. Total Income
Determining the income to put in your cash flow statement is the first step in filling up the cash flow statement. The most common item to be included in the income section is the actual rental income, which means that unpaid rental income should not be considered.
Moreover, any cash and cash equivalents paid during this period should be included in the cash flow statement of the current accounting period. There are also other items that should be added to this section such as any advance payment or the deposit made on the property, tax savings, reservation fees, and income from late payment.
2. Total Expense
When it comes to the expenses incurred during the current period, it is important to list all the actual expenses that are paid using cash first. The most common cash flow expenses are the taxes paid on the property, mortgage payments, and other basic operational expenses on real estate property such as utility bills and repairs.
There are expenses that are quite volatile since they do not occur regularly, but you must include these kinds of expenses, such as the vacancy cost, office supplies expenses, and renovation costs. It is essential to include all the related operational expenses, especially when they are of material value.
However, there are other expenses such as depreciation and bad debt that do not have any effect on your actual cash flow and these types of expenses are disregarded in the computation of your total expenses related to the real estate rental.
Net Cash Flow - Sample Computation
Case: A landlord is trying to compute the cashflow of a real estate property he is renting out. The rental income he collected was at $1,000, but a tenant also paid an additional $10 as a default fee due to late payment. They incurred the following expenses: $50 for depreciation of the property, $60 for taxes, $200 for mortgage payments, and $150 for operational expenses.
Net Cash Flow = Income - Expense
$600 = $1010 - $410
Note: The total net cash flow for the period is $600. We did not include the depreciation expense of $50, since it does not have an actual effect on the cash flow because it has no monetary effect.
Cash Flow Statement Analysis
Now that you know how to compute the cash flow statement, it is important that you know what the results imply based on your business.
First, the rental income part of your cash flow statement can be an indicator of whether your tenants pay on time. If the fees for late payment are high, it could indicate that the tenants living on your real estate property pay in a delayed manner. There are also times when you have a significantly higher cash inflow, but this could be due to a high tax savings or if a new tenant made an advance payment. The cash inflow from these transactions are included in the current period since it should be recorded when the payment was made, not when the payment is applied.
Second, the expense section is the section that most owners pay more attention to since it states the amount of money that is being spent by the business. There are instances where the major expenses are paid all at once like landscaping cost so this can contribute to a higher cash outflow, which then leads to a lower net cash flow. There are also instances where the expense section is quite low because there are payments that weren’t made, such as when the utility bill has been left unpaid.
Additional Ratios for Real Estate Cash Flow Analysis
As you can see, there are various factors that can affect the status of your cash flow, but they do not indicate clearly the status of the business based on profitability. There are other computations that you can use to gauge the cash flow standing of your business.
If you want to compute the rate of return of your cash income versus your cash investment, you can use cash-on-cash return formula. It indicates the ratio between the cash flow and the total cash invested, so this formula only takes into consideration the investments that were paid in cash.
Cash Flow Margin Ratio
The cash flow margin ratio is more than an indicator of liquidity, since it also indicates whether a business can turn their sales into profit. The net sales is the income earned by the company, but the net profit is what actually stays with the company after the operational expenses. So the Cash Flow Margin Ratio is the relationship between the net cash flow from operations and the net sales.
The real estate industry might rely heavily on the appreciation of properties, but if you are running a rental property, it is important to be well-informed about the solvency, liquidity, and profitability of your business. In the end, this will indicate whether your business can still keep up with its operating expenses.