Cash flow analysis: Definition, process and tips

What is cash flow analysis?

Cash flow analysis is a crucial financial process that delves into the movement of money in and out of a company. It provides valuable insights into a business financial health, sustainability, and ability to meet its obligations.

Cash flow analysis helps to answer critical questions about a business' financial position:

• Liquidity: Does the company have enough cash on hand to meet its short-term obligations, such as paying suppliers and employees?
• Solvency: Can the company meet its long-term financial obligations, such as debt repayments?
• Financial flexibility: Does the company have the financial capacity to pursue growth opportunities or withstand economic downturns?
• Profitability: Is the company generating sustainable profits that translate into positive cash flow?

Interestingly, both earning and spending money can have different implications. Gaining cash isn't always positive, and spending cash isn't always negative. This depends on the type of cash flow involved.

Why is cash flow analysis important?

While profits from the income statement are crucial, cash flow analysis reveals more about a company's financial health. It shows whether cash inflows come from sales, loans, or investments and details where the money is going. Businesses can survive short periods of negative cash flow, but long-term negative cash flow is unsustainable. 

New businesses might have negative cash flow because of heavy spending on growth, which is acceptable if backed by investors and lenders. However, these businesses eventually need positive cash flow from operations to stay afloat.

Cash flow analysis clarifies if a business' strong bank balance is due to sales, debt, or other financing methods. This analysis can point out unexpected problems or confirm healthy operating cash flow. These insights come from reviewing cash flow statements and detailed cash flow analyses.

Calculating different versions of cash flow provides even deeper insights. For example, free cash flow excludes non-cash expenses and interest payments but includes changes in working capital, giving a clearer picture of operational cash flows. Unlevered free cash flow shows cash flow before paying off any debts or financial obligations. On the other hand, levered free cash flow considers all bills and obligations, showing the net cash left after all payments. Learn more about the difference between unlevered vs levered free cash flow here. 

Regularly reviewing different types of cash flow helps businesses plan financially. It prepares them for the future, whether it's the next quarter, year, or even economic downturns. Tracking cash flow helps businesses understand their revenue, profits, and overall earnings, making managing total cash and net cash flow easier. The ability to analyse cash positions and understand net income is vital for maintaining financial stability.

Using cash flow analysis, businesses can make informed decisions, ensuring they maintain healthy cash positions and achieve positive cash flow. This approach helps manage free cash and plan for unforeseen financial challenges. Regular, thorough cash flow monitoring keeps businesses prepared for any economic shifts.

Cash flow analysis basics

What are the three core components?

1. Cash Flow from Operating Activities (CFO): This represents the cash generated or used in the course of the company's core business operations. It includes cash received from sales, payments to suppliers, salaries and wages, and other operating expenses. A positive CFO indicates the company's operations are generating sufficient cash to cover its day-to-day activities.
2. Cash Flow from Investing Activities (CFI): CFI reflects the cash flow associated with the acquisition or disposal of long-term assets, such as property, plant, and equipment (PPE), as well as investments in other companies. Negative CFI is often seen in growing companies that are investing in their future, while positive CFI might indicate a company selling off assets or scaling back investments.
3. Cash Flow from Financing Activities (CFF): CFF tracks the cash flow related to the company's capital structure. This includes the issuance or repurchase of stock, the payment of dividends, and borrowing or repaying debt. Positive CFF often signifies a company is raising capital through debt or equity, while negative CFF can indicate the company is using cash to pay down debt or return capital to shareholders.

To get the full picture, cash flow analysis digs deeper, considering net income, current liabilities, and tricky non-cash items like depreciation and amortisation. It's about understanding not just how much cash you have but also where it's coming from and where it's going. This insight helps gauge your company's liquidity—its ability to meet short-term obligations—and provides a vital snapshot of its overall financial well-being.

Preparing the cash flow statement: A closer look

Building a cash flow statement involves meticulously accounting for each of the three core areas:

• Operating cash flow: This section is packed with details like cash from sales, inventory purchases, employee wages, payments to suppliers, interest paid or received, and even legal settlements.some text
  • Direct method: This method directly tracks the actual cash received and paid out in operating activities. It's like following the money trail in real time.
  • Indirect method: This method starts with net income and adjusts it for non-cash items to arrive at the operating cash flow. It's more like reverse-engineering the cash flow from the income statement.
• Investing cash flow: This part is all about major moves. It includes cash from selling assets, collecting on loans, or selling stock. It also subtracts the cash spent on acquiring assets, buying stock, or paying off loans. It reflects the company's investment strategy and its impact on cash resources.
• Financing cash flow: Think of this as the money between your company and its financial stakeholders. It covers issuing or repurchasing stock, paying dividends, borrowing money, and repaying debt. Analysing this section helps understand the company's financial leverage and ability to raise capital.

Cash flow analysis can be applied in various ways, such as:

• Comparing cash flow to net income: This highlights discrepancies between accounting profits and actual cash flow.
• Calculating free cash flow: This metric represents the cash flow available for discretionary purposes after accounting for capital expenditures.
• Projecting future cash flows: This aids in financial planning and decision-making.
• Evaluating investment opportunities: Cash flow analysis is integral to assessing the viability of potential investments.

Remember: Cash flow analysis is an ongoing process. Regularly reviewing and interpreting cash flow statements allows businesses to stay on top of their financial performance, identify potential problems early, and make proactive adjustments to ensure long-term financial stability.

Five steps to cash flow analysis

Aim for positive cash flow.

Maintaining positive cash flow is crucial. When a company's operating income exceeds its net income, it indicates that the business can stay solvent and grow. This means that the cash generated from daily operations is sufficient to cover all expenses and leave some surplus.

Be wary of positive cash flow from investments.

Positive investing cash flow is not always a good sign if operating cash flow is negative. This often suggests that the company is selling off assets to cover operating expenses, which may not be sustainable in the long run. It is important to carefully analyse why the cash flow from investments is positive while the operating cash flow is negative.

Evaluate negative cash flow in investing.

Negative cash flow from investing doesn't always indicate trouble. It might mean the company is purchasing property, equipment, or other investments to boost future production. A situation where operating cash flow is positive, but investing cash flow is negative could signify effective growth strategies, as the company is generating money and reinvesting it.

Calculate free cash flow.

Free cash flow is the money left after covering operating and capital expenditures. This remaining cash can be used for various purposes like paying down principal and interest, stock buybacks, or business acquisitions. Monitoring this metric helps in making decisions about resource allocation and financial strategies.

Operating cash flow margin.

This ratio measures the cash generated from operating activities as a percentage of sales revenue during a specific period. A high operating cash flow margin reflects strong profitability, efficient operations, and high-quality earnings. Investors and stakeholders typically view businesses that maintain positive margins as more reliable and stable.

Cash flow analysis and Profit First

Cash flow analysis and the Profit First system are two interconnected pillars that, when combined, form a robust foundation for financial stability and growth. Cash flow analysis reveals the dynamic movement of money within your business. Profit First, on the other hand, is the proactive prescription, ensuring that profit is prioritised and allocated systematically.

Thriday's accounting software doesn't just provide the tools for cash flow analysis; it also seamlessly integrates the principles of Profit First, offering a holistic view of your financial health.

Thriday's intuitive interface allows you to see the tangible impact of Profit First. Witness how your revenue is strategically divided into separate accounts for Profit, Owner's Pay, Taxes, and Operating Expenses. This visual representation transforms the abstract concept of profit allocation into a concrete reality.

With Thriday, you don't have to switch between different tools to track your cash flow and Profit First allocations. Monitor them side-by-side in real-time, gaining a comprehensive understanding of how prioritizing profit affects your overall financial picture. Learn more about how it works here.

Analyse cash flow with an accounting software like Thriday

Performing a cash flow analysis can be challenging, especially for businesses with intricate finances. Utilising bookkeeping or accounting software like Thriday simplifies this task significantly. Once the initial setup is complete in systems, generating reports on cash flow, free cash flow, and other critical financial metrics becomes straightforward.

Benefits of using accounting software for cash flow analysis

1. Automation: Automates many tedious tasks, saving time and effort.
2. Accuracy: Reduces human errors, providing precise financial data.
3. Speed: Quickens the generation of detailed financial reports.
4. Insightful: Uses AI-driven analysis tools to identify patterns and opportunities.
5. Accessibility: Makes crucial information readily available with just a few clicks.

Regular check-ins on cash flow and cash position are vital for businesses of all sizes. By leveraging the advanced features of tools like Thriday, companies can achieve better results through automated reporting, machine learning, and comprehensive financial analysis tools. This ensures that accurate and timely information about the business' financial health is always at hand.

Cash flow analysis is critical for every business

Cash flow analysis is essential for investors, shareholders, and analysts to gauge a company's financial health. Business owners, managers, and executives must regularly review this data to align with their short-term and long-term financial goals. Effective financial management relies heavily on understanding cash flow, as it offers insights into how a business performs now and in the future.

Accounting software such as Thriday can provide in-depth cash flow analysis, allowing business leaders to make informed decisions. Without this vital information, running a business is like navigating without a map. Updated and accurate cash flow data should be a priority for anyone involved in financial planning and decision-making.

Cash flow analysis FAQs

What is a cash flow review with an example?

Cash flow review involves examining the cash movements within a business, such as reviewing the latest cash flow statement or performing detailed calculations, ratios, and comparisons.

Why do you perform a cash flow review?

Performing a cash flow review assists business owners, sole traders, managers, and other stakeholders understand whether a company is generating or spending cash. It also shows where these cash movements occur within the company.

What makes up a complete cash flow review?

A thorough review of cash flow involves several parts. It includes examining cash inflows, such as sales revenue and financial gains, and cash outflows, like operational costs, investments, and loan repayments. The review also considers cash from operating activities, investing, and financing.

How can cash flow be calculated from financial records?

One needs to start with net income to calculate cash flow from financial statements. Adjustments are made for non-cash items like depreciation and changes in working capital. These calculations result in net cash from operating, investing, and financing activities.

What are effective practices for forecasting future cash flows in an analysis?

Projecting future cash flows involves a combination of historical data analysis and market trends. Using realistic assumptions and regularly updating projections based on new data is best. Scenario analysis, which includes best-case and worst-case scenarios, can also provide a comprehensive outlook on future cash flows. To delve deeper, you can learn how to prepare a cash flow forecast on this blog.

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