How To Do Cash Flow Analysis

How To Do Cash Flow Analysis

Are you a small business owner or an investor trying to figure out how to do cash flow analysis? It’s an essential skill for determining where your money is going.

Knowing the ins and outs of cash flow analysis can be the key to keeping your business finances healthy. And it will help to ensure your business’s long-term profitability.

Cash flow analysis is a vital tool for understanding the movement of cash in and out of the business and planning accordingly. It involves pinpointing income sources, determining business expenses, and drawing up a cash flow statement.

This helps prepare for upcoming expenses, increase income, and re-examine payment schedules. Regular analysis can ensure the success and sustainability of a business.

This blog post will guide you through the process of cash flow analysis step by step. We’ll begin with understanding the basics and progress to examining cash flow statements. And we’ll provide you with essential tips for cash flow management.

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By the end of this post, you will have a solid understanding of how to do cash flow analysis and how to use it to make informed financial decisions for your business.

Cash flow analysis: what is it?

Cash flow analysis is a crucial financial evaluation method that helps businesses understand how money moves in and out of their operations. It involves the creation of a cash flow statement, which records the cash inflows and outflows within a specific accounting period.

By examining cash flow, businesses can better assess their financial health and make informed decisions for future growth and stability.

Types of cash flows

There are three primary types of cash flows that companies need to track and analyze to determine their liquidity and solvency:

These cash flow categories form the foundation of a company’s cash flow statement, highlighting where money is coming in and going out. Understanding these cash flows can help businesses identify potential financial challenges and opportunities.

Cash cutflow

Cash outflow refers to the money a business spends across different activities. It generally comprises three primary categories:

  • : These are the expenses related to the daily operations of a business, such as employee salaries and payments to suppliers.
  • : This category includes loans to other entities or expenditures to acquire fixed assets.
  • : Cash outflows in this category involve payments to pay dividends or repurchase shares from shareholders.

Cash inflow

Cash inflow represents the money coming into a business. It typically originates from several sources, including:

  • : This is the revenue generated from day-to-day operations, commonly known as sales revenue.
  • : This source of cash revenue.
  • : This source of cash inflow is distinct from business activity, as it involves one-time sales not associated with daily operations. Examples include selling property, plant, or equipment.
  • : Financing activities can also generate cash inflows. An example is selling treasury stock to shareholders or raising capital through loans or investments.
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Analysing cash flow

Cash flow analysis involves examining the inflows and outflows of cash across the three primary cash flow categories to draw conclusions about the company’s current financial situation.

It’s important to note that not all cash inflows are necessarily positive, and not all cash outflows are inherently negative. The context in which the cash flow occurs plays a significant role in determining its impact on the business.

For instance, newer businesses might experience negative cash flow from operations spending on growth and expansion. While this can be a concern in the short term, it may not be detrimental if investors and lenders are willing to support the business.

However, it’s crucial for cash flow from operations to eventually turn positive for the company to remain sustainable in the long run.

Knowing how to do cash flow analysis helps businesses understand the sources of their healthy bank account balances. This could be from sales, debt, or other forms of financing.

This analysis can reveal potential issues or confirm healthy operating cash flow. Still, it’s essential to review cash flow statements and perform an in-depth analysis to determine the company’s overall financial health.

Additional cash flow metrics

Beyond the standard cash flow statement, it can be helpful to calculate various cash flow metrics to gain additional insights. For example:

  • : This metric excludes non-cash expenses and interest payments while incorporating changes in working capital. It provides a clearer view of operating cash flows.
  • : This metric shows cash flow before considering financial obligations.
  • : Levered free cash flow indicates cash flow after accounting for all bills and obligations.

Depending on your company’s size, financial situation, and goals, tracking and reviewing different cash flow metrics can be invaluable for financial planning and preparing for future periods. It can also help businesses anticipate potential sales declines or shifts in economic conditions, enabling them to make informed strategic decisions.

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The benefits of doing cash flow analysis

Knowing how to do cash flow analysis benefits your business, enabling you to understand its financial health.

This aids in making well-informed decisions and attracting potential investors or lenders when needed. Below are some of the key advantages of learning how to do cash flow analysis:

Accurate working capital assessment

Cash flow analysis allows businesses to calculate their working capital and the money available to run day-to-day operations and complete transactions.

Working capital is determined by subtracting current liabilities (due during the upcoming accounting period) from current assets (cash or near-cash assets like accounts receivable).

By understanding their working capital, businesses can ensure they have sufficient liquidity to meet their short-term obligations.

Indication of financial health

Analyzing cash flow helps businesses determine if they can pay their bills and generate enough cash to continue operating indefinitely.

Persistent negative cash flow may signal potential bankruptcy. In contrast, continuous positive cash flow often suggests a bright future for the company.

Comparability and tangibility

Cash flow analysis provides a quantifiable and tangible measure of a company’s financial performance, allowing for accurate business comparisons.

Since cash is universally accepted as a store of value, cash flow analysis offers a straightforward evaluation of a company’s financial standing.

Reduced misrepresentation

Cash flow analysis is less susceptible to manipulation compared to other financial metrics. These include non-cash items, and techniques can artificially inflate profits or asset values.

When you know how to do cash flow analysis, you have a more transparent and reliable representation of your business’s financial performance.

Attracting financing

Financial institutions often rely on cash flow statements when considering business financing. A continuous negative cash flow can deter banks and lenders from providing financial support. They need assurance that their money will be returned.

On the other hand, a healthy cash flow can demonstrate a business’s ability to meet its financial obligations, increasing the likelihood of securing loans or investments.

Identifying patterns and trends

Regularly analyzing cash flow allows businesses to recognize patterns and trends in their financial performance.

By understanding when cash inflows and outflows occur, companies can better anticipate periods of high expenses or increased sales volumes. This insight can inform decision-making and help businesses plan for the future more effectively.

Improved decision-making

A thorough cash flow analysis enables businesses to make informed decisions based on their financial situation.

By understanding the sources of cash inflows and outflows, business owners and managers can allocate resources more effectively, prioritize investments, and manage cash reserves to ensure long-term sustainability.

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How to do cash flow analysis

1. Pinpoint income sources

To begin your cash flow analysis, identify all sources of income for your business. Consider revenue from services or goods sold, investments, or assets sold.

Ensure you include income generated within a specific timeframe, such as a month, quarter, or year.

2. Determine business expenses

Next, identify your total business expenses, such as inventory purchases, accounts payable, deferred revenue, and other liabilities.

Remember to include depreciation on fixed assets and income tax expenses. As with income, limit your expenses to the same specific timeframe.

3. Draw-up the cash flow statement

Establish the starting balance

Begin by determining your starting cash balance. This figure represents your business’s cash holdings at the beginning of the chosen timeframe.

Determine the cash flow from operations

Calculate the cash flow from operations by analyzing your net income, non-cash expenses, and current assets and liabilities changes. Use direct or indirect methods to determine the cash flow from operations.

Verify the cash flow from investments

Examine your business’s investment activities, such as purchasing or selling long-term assets, stocks, or bonds. Add money received from these activities and subtract money spent on them to determine your cash flow from investments.

Calculate the financing cash flow

Financing cash flow accounts for money moving between your company and its owners, investors, and creditors. Include activities such as buying back or issuing stocks, borrowing and repaying loans, and paying dividends.

Work out the end balance

Sum the cash flows from operations, investments, and financing to calculate the ending cash balance. This balance represents your business’s cash holdings at the end of the chosen timeframe.

4. Carry cut a cash flow statement analysis

Identify positive cash flow

Positive cash flow occurs when your operating income exceeds your net income. This indicates your business’s ability to maintain solvency and sustainably grow its operations.

Identify negative cash flow

Negative cash flow can result from increased expenses, reduced income, or both. Understanding the reasons behind negative cash flow and assessing its impact on your business’s financial health is essential.

Analyse positive & negative cash flow

Examine the cash flow from operations, investments, and financing to identify trends and outliers. A positive operating cash flow and a negative investing cash flow may indicate that your business is making money and investing in growth.

Determine your free cash flow

Calculate your free cash flow by subtracting capital expenditures from your operating cash flow. Free cash flow can pay down principal, interest, buy back stock, or acquire another company.

Establish your operating cash flow margin ratio

The operating cash flow margin ratio measures cash from operating activities as a percentage of sales revenue in a given period.

A positive margin indicates profitability, efficiency, and earnings quality. Tracking this ratio over time can help you better understand your business’s financial performance and make informed decisions.

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Cash flow analysis example

Let’s look at a simplified example of how to do cash flow analysis for a small business, XYZ Bakery:

Cash flow from operations

  1. Net income: $10,000
  2. Add non-cash expenses: Depreciation ($1,000)
  3. Changes in working capital: Increase in accounts receivable (-$500), decrease in inventory ($2,000), increase in accounts payable ($1,500)
  4. Cash Flow from Operations: $14,000

Cash flow from investing activities

  • Purchase of new equipment (-$5,000)
  • Sale of an old delivery van ($3,000)
  • Cash Flow from Investing Activities: -$2,000

Cash flow from financing activities

  • Issuance of new shares ($4,000)
  • Payment of dividends (-$2,000)
  • Cash Flow from Financing Activities: $2,000

Net cash flow and ending cash balance

  • Net Cash Flow: $14,000 (Operations) – $2,000 (Investing) + $2,000 (Financing) = $14,000
  • Starting cash balance: $5,000
  • Ending cash balance: $5,000 (Starting balance) + $14,000 (Net Cash Flow) = $19,000

The XYZ bakery example explained

In this example, XYZ Bakery has a positive cash flow from operations, indicating that the business generates sufficient cash from its core activities.

The negative cash flow from investing activities is due to purchasing new equipment, which can be considered a long-term investment for the business.

The positive cash flow from financing activities indicates that the company can raise funds by issuing new shares and has enough cash to pay dividends to shareholders.

Overall, the net cash flow for XYZ Bakery is positive, which means that the business is generating more cash than it is spending. The ending cash balance of $19,000 shows that the business has a healthy cash position, which can be used to fund future growth opportunities or as a buffer for unexpected expenses.

This example demonstrates the importance of conducting regular cash flow analyses to ensure the financial health of a business. By analyzing the sources and uses of cash, businesses can make informed decisions to improve their cash flow, manage expenses, and plan for future growth.

Cash flow analysis limitations

Learning how to do cash flow analysis is invaluable for investors and business owners to evaluate a company’s financial health. But it’s essential to recognize its limitations.

In this section, we’ll discuss some of the challenges associated with cash flow analysis and how to account for them.

Absence of growth indicators

Cash flow analysis primarily focuses on a company’s past performance, which may not accurately represent its future growth potential. For instance, perhaps a company has made significant investments in research and development that could lead to ground-breaking innovations.

In this case, these aspects may not be reflected in the cash flow statement. Investors must consider other factors, such as market trends and industry developments, to completely understand a company’s growth potential.

Interpretation challenges

Interpreting a cash flow statement can be challenging without the context provided by other financial statements, such as the income statement.

It may be difficult to discern whether a company is paying off debt, investing in assets, or engaging in other financial activities solely based on cash flow analysis. Investors should review additional financial information and seek expert advice to make informed decisions when necessary.

Inability to determine profitability

Cash flow analysis does not account for non-cash items, which means it’s unsuitable for assessing a company’s profitability.

Cash flow statements may exclude essential information about a company’s earnings and expenses by focusing exclusively on cash inflows and outflows. Investors should also examine the income statement and balance sheet to gain a comprehensive understanding of a firm’s profitability.

Dependence on cash basis accounting

Cash flow statements rely on the cash basis of accounting, which doesn’t consider the accrual concept. This means revenues and expenses are recorded when cash is received or paid rather than earned or incurred.

As a result, the cash flow statement may not accurately represent a company’s financial activities during a specific period. Investors should be aware of this limitation and supplement their analysis with accrual-based financial statements, such as the income statement and balance sheet.

Addressing the limitations

Despite these limitations, knowing how to do cash flow analysis is essential for assessing a company’s financial health. By understanding the drawbacks of cash flow analysis, investors can take appropriate steps to compensate for these shortcomings:

Essential tips for cash flow management

After completing a thorough cash flow analysis, you’ll have valuable insights to help you improve your business’s cash flow. Here are some essential tips for managing your cash flow effectively:

Plan for upcoming expenses

Being aware of your cash inflows and outflows enables you to set aside funds for upcoming expenses or periods when cash may be tight. You can proactively maintain a consistent cash flow and fulfill your financial obligations by anticipating potential cash crunches.

One option is obtaining a business line of credit, which provides quick access to funds when needed or for seizing unexpected opportunities.

Increase your income

Enhancing your sales and raising the prices of your products or services can increase your income from operating activities.

Consider investing surplus cash in hiring more employees to boost production or expanding your business to new locations. However, be cautious when raising prices, as this may deter customers and negatively impact your cash flow.

Re-examine your payment schedules

Altering your payment schedules can help you retain more cash on hand for longer. For example, negotiate extended payment terms with vendors or encourage customers to pay you more quickly.

Offering incentives for early payments, such as discounts on invoices paid before the due date, can help speed up cash collection. To maintain a healthy cash balance, strive to maximize the time between receiving customer payments and paying vendors.

Strategies for improving cash flow

Managers can enhance cash flow using the following strategies, which fall into three categories: revenue growth, operating margins, and capital efficiency.

These strategies can be further divided into specific tactics, including:

  • Increasing sales volume.
  • Raising prices.
  • Lowering the cost of goods sold.
  • Reducing Selling, General & Administrative (SG&A) expenses.
  • Enhancing the efficiency of Property, Plant & Equipment (PP&E).
  • Optimizing inventory management to boost cash flow margins.

What to do when cash flow runs short

Using cash flow statements to forecast your cash position in the coming months can help you identify potential shortages. When facing a cash crunch, you can take various measures to protect your business:

  • Adjust staffing levels to decrease payroll costs.
  • Reduce inventory orders if stock levels are adequate.
  • Pay vendors later than usual while still meeting due dates.
  • Implement marketing tactics, such as sales promotions, to increase revenue.
  • Pursue accounts receivable for outstanding balances.
  • Raise prices as needed.
  • Secure short-term financing to overcome cash flow challenges.

Many of these solutions provide temporary relief, so finding long-term strategies to ensure your business’s financial health is crucial.

However, implementing these measures would be nearly impossible without a cash flow statement. By following these essential tips for cash flow management, you’ll be better equipped to maintain a healthy cash flow and drive your business’s growth and success.

How to do cash flow analysis conclusion

Learning how to do cash flow analysis is essential for any business owner or investor. It helps to understand the movement of cash in and out of the business.

Carrying out a cash flow statement analysis can improve cash flow management by planning for upcoming expenses. And it can help with increasing income and re-examining payment schedules.

Measures can be taken in case of a cash flow shortage to bridge the gap until long-term resolutions can be found. Although cash flow analysis has limitations, it is a valuable tool for assessing the financial health of a business and making informed decisions for its success and sustainability.

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FAQs about how to do cash flow analysis

What is the difference between cash flow and profit?

Cash flow is the movement of cash in and out of a business. But profit is the amount of money earned after deducting expenses. Cash flow and profit are related but not the same. A company can have high profits but poor cash flow if its revenue is tied up in accounts receivable, inventory, or other non-cash assets.

What is a cash flow statement?

A cash flow statement is a financial statement that shows a business's cash inflows and outflows during a specific period. It provides a snapshot of a company's liquidity and ability to meet its short-term obligations.

How often should a business do a cash flow analysis?

A business should do a cash flow analysis regularly, preferably monthly. This will help the business owner or manager stay on top of their finances and identify potential cash flow issues early on.

Can cash flow analysis be used for personal finance?

Yes, cash flow analysis can also be used for personal finance. It can help individuals track their income and expenses, identify areas where they can cut costs or increase revenue, and plan for future expenses.

What are some common cash flow problems that businesses face?

Some common cash flow problems that businesses face include slow-paying customers, high inventory levels, unexpected expenses, and seasonal fluctuations in sales. These can all impact a business's ability to meet its financial obligations and may require careful cash flow management.


April 25, 2023
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