Anyone with a checking account is familiar with the task of balancing a checkbook. Balancing (or reconciling) allows us to see how much money is coming in, via deposits, and how much is going out, via checks written or online payments. We can also square up our checkbook balance by examining any deposits or payments not yet reflected on our last bank statement. It lets us know how much money we really have, so we can replenish the account if necessary and avoid writing bad checks.
Businesses also must examine their checking accounts to understand how much money they have. A small business might do this the same way we do at home, by comparing the checkbook against the latest bank statement. Larger businesses will do it through a more formal process called cash flow analysis.
What is a cash flow analysis?
Cash flow analysis refers to a company’s regular review of the money it receives from all sources and the money it pays out for all uses. A company may examine the flow of cash through the business monthly, as many of us do with our checkbooks, but most perform an analysis quarterly and annually.
Just as we square up our checkbook balance against our bank statements, a company will use cash flow analysis to compare its statement of cash flow against its income statement, which records revenue, expenses, and net income (or profit). The company does this so it can explain the differences between cash flow and profit, a process called reconciliation.
Analysis of cash flows is essential, because many businesses, particularly small businesses, struggle to generate enough cash, even if they are profitable. A business wants to find ways to produce consistent positive cash flow and maintain a positive balance in its checkbook.
What are the benefits of cash flow analysis?
The primary purpose of cash flow analysis is to give business owners a comprehensive understanding of the business, so they can plan ahead to meet any challenges or move on opportunities.
For instance, if the analysis shows cash flow is positive or growing, the company can consider how to use the excess cash profitably. On the other hand, if cash flow is declining, a company has time to take measures such as increasing sales, cutting expenses, or arranging short-term debt financing to cover a temporary cash crunch.
Examination of the timing of cash flows also allows a company to make adjustments. For example, if the company pays its bills (accounts payable) within 30 days but customers are taking 90 days to pay (accounts receivable), it might decide to stretch out bill payments and tighten up on customer collections. This is critical to managing the company’s working capital, which is its current assets minus current liabilities. Working capital, a part of operating cash flow, determines the company’s ability to pay expenses in the current operating cycle, whether a quarter or a year.
Three types of cash flow
Cash flows are separated into three categories as follows
1. Cash flow from operations
This is money received and money paid from the company’s normal business operations. It’s the most important of the three cash flows because it shows if a company is self-sustaining by generating enough money to pay all expenses and pursue other opportunities, without the need for outside funding. The main object of any business is to produce consistent, strong positive cash flow.
Cash from operations excludes capital expenditures, or the money spent to update and maintain the operating efficiency of the company’s assets. Free cash flow is what’s left after capital expenditures. Business owners and investors use free cash flow to measure a company’s financial strength, including its ability to expand, make acquisitions, or pay dividends, among other things.
2. Cash flow from investing
This is money spent to buy assets, commonly known as capital expenditures, and money received from selling assets. These assets include property, plant, and equipment (PPE), which are called fixed tangible assets, as well as trademarks, brand names, patents, and other intellectual property, typically referred to as intangible assets.
Cash from investing includes money received from buying securities held for investment, and from selling such securities. The goal of investing cash flows is to buy the most productive assets, which offer the best potential return on investment, and to sell less productive assets.
3. Cash flow from financing
This is money received from outside sources, and money paid to such sources. Money received would include the proceeds from loans, bond issues, or stock sales; money paid would include loan or bond principal repayments, and stock dividends or stock buybacks. Interest paid on loans and bonds is treated as a cash flow from operations.
Cash flow from financing is important if a company uses borrowed money, or leverage, in an effort to boost profits. A company must weigh the cost of borrowing against the expected return. Also, if a company receives cash from a stock sale, it must reward shareholders by generating higher profits or paying dividends.
How to do a cash flow analysis
Most of the analysis of a company’s cash flows is focused on cash from operations. That’s because the business is operating every day, whereas investing and financing activity happens intermittently or as needed.
The analysis of operating cash flow can be done in either of two ways: the direct method or the indirect method. The direct method, like checkbook balancing, only considers cash transactions. The indirect method is a roundabout way of determining operating cash flow, but it’s more informative because it shows the relationship among a company’s income statement, balance sheet, and cash flow statement. It also shows the effect of accrual accounting for any income or expenses that haven’t yet been received or paid.
The direct method formula, like toting up a checkbook balance, is simply:
Cash flow from operations = cash revenue - cash expenses
When using the indirect method for calculating cash from operations, you start with net income and then add back any noncash items such as depreciation and amortization expense. Then, in the balance sheet, you calculate the company’s change in working capital—its current assets minus current liabilities. The basic formula is:
Cash flow from operations = net income + depreciation and amortization - change in net working capital (current assets - current liabilities)
The change in working capital is important to cash flow because an increase in working capital means a decrease in operating cash, as more cash is spent on assets such as inventory or tied up in accounts receivable.
Cash flow analysis FAQ
What is a cash flow analysis?
A basic cash flow analysis example examines the difference between recorded sales for a given period and the amount of those sales awaiting payment from customers, known as accounts receivable. The analysis would conclude either that the accounts receivable won’t cause a cash crunch, or that they might lead to a crunch and the company should take steps to avert any cash shortage.
Why is doing a cash flow analysis important?
An analysis helps a business to see whether its cash balance is coming mainly from sales growth, which is ideal, or from cost cutting, or from the proceeds from borrowing or stock issuance. Declining cash flow may signal distress and the need for outside funding. Expanding cash flow, on the other hand, gives the company room to consider expansion, acquisitions, paying dividends, or paying down any debt.The company can also size up its working capital, which shows its degree of liquidity and whether it has enough money to pay bills, salaries, taxes, and any other costs from period to period.
What are three examples of cash inflow?
Some examples of cash inflows are cash sales, where customers pay immediately; proceeds from the sale of fixed assets such as equipment, or sale of securities the company held for investment; and proceeds of a loan or a sale of bonds or shares.