Cash Flow Analysis: Definition, Process & Examples

A business is like a car. There are hundreds of moving parts that must be managed, maintained, and measured for the vehicle to move forward efficiently.

This is particularly the case when it comes to accounting. Successful business owners know that to drive revenue and increase cash flow, the numbers must be watched and carefully analyzed. 

This is what optimizes data-driven decision-making and leads to intelligent forecasting. Cash flow is so important that among failed SMEs, 60% cited poor cash flow management as a cause.

One of the most effective strategies to stay on top of accounting and “out of the red” is known as cash flow analysis.

What is Cash Flow Analysis?

A cash flow analysis is the examination of the cash inflows and outflows of a business to determine a company’s working capital. It looks at a certain period of time for different activities, including operations, investment, and financing. Cash flow analysis is calculated by subtracting current liabilities (during a specific accounting period) from current assets.

Cash Flow Analysis Explained

In order to perform an effective cash flow analysis, you must examine every part of the business that affects cash flow. This includes (but is not limited to):

• Accounts payable
• Inventory
• Credit
• Accounts receivable
• Investments and financing

A company’s cash flows are revealed by the numbers that appear on the statement of cash flows. The cash flow statement will show how an organization spends its money (called cash outflows) and how it receives money (referred to as cash inflows).

In order to analyze your cash flow statement accurately, a business must also keep up-to-date and accurate records of all revenue and expenses. Cash flow analysis is not an easy thing to calculate and you must first understand financial terms, how they are captured on documents, and how they reflect the income statement.

Factors of Cash Flow Analysis

Cash flow analysis has several components to consider before you can determine net cash flow. There are three distinct sections of a company’s business activity that you will see on a cash flow statement. They are:

Cash Flow From Operations

Cash flow from operating activities includes the amount of cash a business generates from the revenue it brings in, excluding costs associated with long-term investment. It includes any spending or source of cash that comes from a company’s day-to-day business operations. Operating cash flow is also generated from normal operations, less the interest and taxes paid.

For example, if a client pays an invoice, it would be considered an AR activity and recorded as cash from operations. Changes in current liabilities or assets are also recorded as operating cash flow.

Cash flow from operations is the section on the cash flow statement that reports the amount of cash from the income statement that was originally recorded on an accrual basis. Items included in this section include:

• Accounts receivable
• Accounts payable
• Income taxes payable

To calculate the cash flow from operating activities, you must first calculate the cash generated from customers, and the cash paid to suppliers. The difference between the two is the amount of money that reflects cash flow from operations.

Cash Flow From Investing

The cash flow from investing activities looks at long-term uses of cash. This may include the sale or purchase of a fixed asset like property or equipment. This can also include proceeds from the sale of a division or a cash-out as a result of a merger.

Cash outflows are generated from investing transactions such as the purchase of investment securities and capital expenditures for property and equipment.

Cash inflows come from the sale of businesses, assets, and securities. Investors will usually monitor capital expenditures used for a company’s physical assets to see how an organization is investing in itself.

The cash flow from investing section on a cash flow statement records the cash flow from sales and purchases of long-term investments like fixed assets. Items included in this section can be the purchase of furniture, vehicles, buildings, or land.

Overall, investing activities will involve any changes in the cash position of a company from assets, investments, or equipment.

Cash Flow From Financing

Financing activities include any transaction that involves debt, equity, and dividends. This part of the cash flow statement will show the net funds of cash that are used to fund a company. Here are a few different cash flows that would be under this section:

• Payment of dividends
• Cash received from a loan
• Repurchase or sale of stocks and bonds
• Cash used for repayment of a long-term debt

Cash flow from financing activities will provide investors with insight into a company’s financial health and how well the capital structure is managed. Investors that prefer dividend-paying businesses will be hyper-focused on this section since it shows cash dividends paid.

Analysts will use the following calculation to determine if a business is on sound financial ground:

CFF = CED − (CD + RP)

In this formula:

• CED is Cash inflows from issuing Equity or Debt
• CD is Cash paid as Dividends
• RP is Repurchase of debt and equity​

How to (Easily) Analyze Cash Flow

In basic terms, a company’s cash flow is defined by the number that appears in the cash flow statement as “net operating cash flow”. However, there is no universally accepted definition for what cash flow truly is. It all depends on your specific circumstances.

For example, many financial professionals consider an organization’s cash flow to be the sum of the net income, depreciation, and amortization (non-cash charges on the income statement). While this often comes close to calculating the net operating cash flow, the shortcut can be inaccurate.

While a cash flow analysis can include several different ratios, there are some indicators that prove a good starting point to measuring the quality of a company’s cash flow. This includes the operating cash flow/net sales ratio, free cash flow, and comprehensive free cash flow coverage.

Operating Cash Flow/Net Sales

This ratio is expressed as a percentage of a company’s net operating cash flow to its revenue (from the income statement), or net sales. It will tell you how many dollars of cash are generated for every dollar of sales.

The higher the percentage, the better. Monitoring how cash flow increases as sales increase will help detect significant variances from the average cash flow/sales relationship, as well as how the business compares to its peers. Both figures should be moving at a similar rate over time.

Free Cash Flow 

Free cash flow (FCF) is typically defined as the net operating cash flow minus capital expenditures. It’s important because this figure demonstrates how efficient a business is at generating cash. Investors use free cash flow to measure whether a company has enough cash (after capital expenditures and funding operations) to pay investors through share buybacks and dividends.

FCF is calculated from the cash flow statement using the figure in the “cash flow from operations” section. Subtract the capital expenditures required for current operations from that number.

A business can take it a step further by expanding what is included in calculating the free cash flow number. In addition to capital expenditures, you can also include dividends to arrive at a more comprehensive figure, which can then be compared to sales.

It’s very important to monitor free cash flow over multiple periods and compare it to businesses within the same industry. If it’s positive, it indicates the company can meet its obligations, including funding operating activities and paying dividends.

Comprehensive Free Cash Flow Coverage

The comprehensive free cash flow ratio is calculated by dividing the free cash flow by net operating cash flow to get a percentage. The higher the percentage, the better.

Steps in Cash Flow Analysis

When it comes to cash flow analysis, there are a few major trends that can show you a lot about the health of your business. Here are a few smart steps to take when analyzing cash flow:

1. Shoot for Positive Cash Flow
   If operating income exceeds net income, that’s a strong indication a business has the ability to remain solvent and sustain growth.
2. Investigate Positive Cash Flow
   If you have positive investing cash flow but negative operating cash flow, this could signal an issue. It may indicate, for example, that a business is selling off assets to pay operating expenses, which is not a sustainable solution.
3. Analyze Negative Cash Flow
   Negative cash flow isn’t necessarily a bad thing. It could mean a business is making investments in equipment and property to grow inventory. Positive operating cash flow and negative investing cash flow demonstrate your company is most likely making money and spending to keep up.
4. Determine Free Cash Flow
   This is the figure left after you pay operating and capital expenditures. Free cash flow can be used to pay down principal and interest. It can also be used for acquisitions or to buy back stock.
5. Calculate the Operating Cash Flow Margin
   This ratio measures cash from operating activities as a percentage of the sales revenue in a given period. A positive margin indicates efficiency, profitability, and earnings quality.

An effective cash flow analysis is financial modeling that will help your team better manage cash inflows and outflows, ensuring there is enough money to operate and grow the business.

Preparing a Cash Flow Statement

A cash flow statement is one of the most important financial statements a business can create. That’s because it includes all cash inflows from ongoing operations and external investment sources, as well as cash outflows for business activities and investments in a given time period.

Operating Cash Flow

The line items typically factored into your net income, and included in the operating cash flow statement, include:

• Cash from goods/services sold
• Purchase of inventory or supplies
• Staff wages and cash bonuses
• Payments to contractors
• Utilities, rent, and/or lease payments
• Interest on loans and other long-term debt
• Fines or cash settlements from lawsuits

There are two common methods used to calculate the operating activities section of cash flow statements: the Direct Method and the Indirect Method.

• Direct Method – Takes all cash collections from operating activities and subtracts all cash disbursements to reach net income.
• Indirect Method – This starts with net income and adds/deducts from the amount for non-cash revenue and expenses.

Investing Cash Flow

The investing cash flow bottom line is calculated by adding the cash received from the sale of assets, the paying back of loans, and the selling of stock; then, subtracting the money spent to buy assets, stock, or loans outstanding.

Financing Cash Flow

Financing cash flow is calculated by reviewing the cash moving between a company and its owners, creditors, and investors.

Example of Cash Flow Analysis

Let’s say a company called Red Bikes has just opened and earned a net income of $75,000 to start and generated additional cash inflows of $95,000. Cash outflows (expenses like rent and payroll) totaled $25,925. This leaves an ending cash balance of $144,075.

Small changes in any of these line items can show the impact of how paying taxes, hiring more people, buying equipment, and more can affect a business. 

Here is a template of the balance sheet for our cash flow analysis example. It is simplified for quick reference:

Limitations of Cash Flow Analysis

Cash flow analysis is one of the best tools to find out if a company is doing well financially, but it also has limitations. Some of the disadvantages to this method include:

No Room for Growth

There’s no growth considered in the cash flow statement, which always reflects what happened in the past. That means, this may not be the most accurate data to present to investors. For example, if you’ve invested considerably into R&D (which will generate a huge amount of cash in the future) it may not be reflected in the current statement.

Understanding Profitability

A cash flow statement is not the best document to understand a company’s profitability because non-cash items are considered. Therefore, all profits are deducted and losses are added back to get actual cash inflows and outflows.

Ignores Accrual Accounting

The cash flow statement is articulated only on the cash basis of accounting and leaves no room for the accrual method.

Accrual vs Cash Accounting

How you perform cash flow analysis also depends on the type of accounting your business performs. When it comes to cash vs. accrual accounting, a cash flow analysis doesn’t consider accrual at all. Therefore, if your business uses this form of accounting, performing a cash flow analysis will prove rather difficult.

What is the difference between the two?

Accrual accounting is used by most public companies. It is the method where revenue is reported as income as soon as it is earned (not when the company receives payment). Expenses are already reported when incurred, even though cash payments have not been made.

Cash accounting is a method in which payments are recorded during the period they are received, and expenses in the period in which they are paid. Expenses and revenues are only recorded once cash is received and invoices are paid.

Using Automation to Analyze Cash Flow

Cash flow analysis is only part of the process of optimizing cash flow. Once problems or weaknesses in cash flow are discovered, a business must be ready to make the proper changes. That’s where automation comes in. In fact, it’s reported that 64.4% of SME owners in the United States use accounting software.

Automated cash flow technology streamlines the treasury process by reducing the administrative burden and helping a business focus on strategic tasks like risk management and liquidity. It can assist with other aspects of finance like taxes, payroll, accounts payable, mass payments, global transactions, and much more. This works to boost team efficiency, drive productivity, and streamline workflows.

Over the past few years, with increasing liquidity concerns, new advances in fintech have been made to automate cash flow analysis. One such tool is called cash forecasting automation. It helps the finance department eliminate manual processes, minimize errors, and provide a universal source of truth for continuous access to data.

Automated Cash Forecasting

For more than a decade, treasury departments have been prioritizing cash flow forecasting to stay on top of fluctuations. It shows if a business has enough cash to run normal operations and/or expand by estimating future costs and sales. Cash forecasting is a critical tool for projecting an organization’s financial health and helping to set a budget accordingly.

Artificial intelligence and automation work to improve cash forecasting accuracy and refine decision-making. Robotic process automation (RPA) helps to automate repetitive processes with precision and speed. The technology minimizes the variance between forecast and actuals by analyzing historical data. It will also determine discounted cash flows.

What is Discounted Cash Flow?

Discounted cash flow (DCF) is a financial analysis method that computes forecasted cash flows for years in the future, using today’s lower value. The DCF formula uses a specific time period, the time value of money, and the risk with a selected discount rate. It can be calculated to assess the value of a company, potential projects, and the expected return from securities investments. 

Discounted cash flow analysis is always applied in different areas. This includes:

• M&A valuation
• Business investment project selection
• Investors looking for the market value of stock

Cash vs. Earnings

When it comes to accounting, cash and earnings are two totally different terms. Earnings occur in the present when a sale is made. But, cash inflows can happen at a later date.

Profit is shown as net income on the income statement, which is the bottom line for a business. However, due to accrual accounting, net income doesn’t necessarily imply that all receivables have been paid by customers. Even though, from an accounting standpoint, the company looks profitable, if receivables become past due, you could run into problems.

Even successful businesses can fail to effectively manage cash flow, which is what makes cash flow analysis such a critical tool for growth.

Importance of Cash Flow Analysis

Cash flow analysis is important for many reasons. Reports demonstrate that small businesses consider cash flow one of their top 5 challenges. Engaging in an ongoing analysis helps to quickly identify any problems with incoming and outgoing cash. For example, if a company has revenue streams that aren’t producing as much as they should, cash flow analysis will show that.

Analyzing cash flow helps to understand if a company is capable of paying the bills and generating enough cash to keep operating—or better yet, grow. Long-term negative cash flow can lead to potential bankruptcy, while a continuous stream of positive cash flow is a good indicator of success.

Good cash flow means a company is poised to expand its business and avoid excessive borrowing. It enables you to pay dividends, weather hard times, and engage more investors. 

Free cash flow is an important evaluative indicator for shareholders and investors. It captures all of the positive qualities of internally produced cash from operations, while monitoring the use of cash for capital expenditures.

If your cash flow analysis shows you are running low on cash, a business can make quicker and more informed decisions. It can adapt by cutting costs, obtaining financing, or increasing income. This is what makes examining cash inflows and outflows one of the most important aspects of maintaining a proactive accounting strategy.