If you have a checking account, you’re probably familiar with the task of balancing your checkbook. Balancing (or reconciling) your checkbook lets you see how much money is coming in through deposits and how much is going out through checks or online payments. You can also balance your checkbook by looking at deposits and payments that haven’t yet been reflected on your last bank statement. This lets you know how much money you actually have so you can top up your account as needed and avoid bounced checks.
Businesses also need to look at their checking accounts to figure out how much money they have. Small businesses might do the same as a home would, comparing their checkbook with their most recent bank statements. Larger businesses do this with a more formal process called a cash flow analysis.
What is Cash Flow Analysis?
A cash flow analysis is a regular review of the money a business receives from all sources and pays out for all purposes. Businesses might look at the flow of cash through their operations monthly, as many do with a checkbook, but most businesses also perform quarterly and annual analyses.
Just like we reconcile our checkbook balance with our bank statement, businesses use cash flow analysis to compare their cash flow statement with their income statement, which records revenues, expenses, and net income (or profit). Businesses do this so they can explain the differences between their cash flows and profits; this process is called reconciliation.
Analyzing cash flow is essential because many businesses, especially small and medium-sized businesses, struggle to generate enough cash even when they’re profitable. Businesses want to find ways to consistently generate positive cash flow and keep their checkbooks balanced.
What are the benefits of cash flow analysis?
The main purpose of a cash flow analysis is to give business owners a comprehensive understanding of their business so they can plan ahead to meet challenges and take advantage of opportunities.
For example, if the analysis shows that cash flow is positive or increasing, a company can consider how to use the excess cash in a profitable way. On the other hand, if cash flow is decreasing, the company has time to take measures such as increasing sales, reducing expenses, or arranging for short-term borrowings to make up for the temporary shortage of funds.
Examining the timing of cash flows also allows a company to make adjustments. For example, if a company pays its invoices (accounts payable) within 30 days but its customers take 90 days to pay (accounts receivable), it may decide to postpone invoice payments and tighten collections from customers. This is important in managing a company’s working capital, which is current assets minus current liabilities. Working capital, which is part of operating cash flow, determines a company’s ability to pay its expenses in the current operating cycle for a quarter or year.
Three types of cash flows
Cash flows are split into three categories:
1. Operating Cash Flow
This is the money received and paid out from the normal business operations of a company. This is the most important of the three cash flows because it indicates whether the company is self-sustaining, generating enough money to pay all expenses and pursue other opportunities without needing outside funding. The primary objective of any business is to generate a consistent, strong positive cash flow.
Operating cash flow does not include capital expenditures, that is, money spent to renew and maintain the operating efficiency of a 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, especially its ability to make expansions, make acquisitions, and pay dividends.
2. Cash flow from investments
This is money spent to buy assets (commonly known as capital expenditures) and money earned from selling assets. These assets include fixed tangible assets (PPE), as well as trademarks, brand names, patents, and other intellectual property (commonly known as intangible assets).
Cash from investments includes money received from purchasing securities held for investment purposes and money received from selling such securities. The objective of investing cash flows is to purchase the most productive assets, those assets that have the highest potential for generating the highest return on investment, and to sell the less productive assets.
3. Cash flow from financing
This is money received from outside sources and money paid out on such money. Money received includes proceeds from loans, bond issues, or stock sales, while money paid out includes repayments of principal on loans or bonds, stock dividends, or stock repurchases. Interest paid on loans and bonds is treated as a cash flow from operating activities.
Cash flow from financing is important if a company uses debt or leverage to increase profits. Companies must weigh the cost of borrowing against the expected returns. Also, if a company receives cash from selling stock, it must reward shareholders by generating higher profits or paying dividends.
How to perform a cash flow analysis
Most analyses of a company’s cash flows focus on operating cash flows because a business operates on a day-to-day basis, whereas investing and financing activities occur intermittently or on an as-needed basis.
Analysis of Operating Cash Flow It can be done in one of two ways: direct or indirect. The direct method considers only cash transactions, similar to balancing a checkbook. The indirect method is a roundabout way to determine operating cash flow, but it is more useful because it shows the relationship between a company’s income statement, balance sheet, and cash flow statement. It also shows the impact of accrual accounting for revenues or expenses that have not yet been received or paid.
Direct Method
The formula for the direct method is similar to balancing a checkbook and is as follows:
Operating cash flow = cash inflows – cash outflows
Indirect methods
When calculating operating cash flow using the indirect method, you start with net income and add non-cash items such as depreciation and amortization. Then you calculate the change in the company’s working capital (current assets minus current liabilities) on the balance sheet. The basic formula is:
Operating Cash Flow = Net Income + Depreciation and Amortization – Change in Net Working Capital (Current Assets – Current Liabilities)
Changes in working capital are important to cash flow: an increase in working capital means less operating cash because more cash is spent on assets like inventory and tied up in accounts receivable.
Cash Flow Analysis FAQs
What is Cash Flow Analysis?
An example of a basic cash flow analysis would look at the difference between sales recorded during a particular period and sales waiting to be paid by customers (accounts receivable). accounts receivable A company should take steps to avoid a cash shortage as it may not or may not cause a cash shortage.
Why is it important to perform a cash flow analysis?
The analysis helps a company understand whether its cash balance is coming primarily from increasing sales (ideally), cost cutting, or proceeds from borrowing or issuing equity. A decline in cash flow can indicate distress and a need for outside financing. On the other hand, an expanding cash flow gives a company room to consider expansion, acquisitions, dividend payments, and debt repayment.
A business can also estimate its working capital, which indicates the degree of liquidity and whether the business has enough money to pay bills, payroll, taxes, and other expenses from period to period.
Give three examples of cash inflows.
Examples of cash inflows include cash sales paid immediately by customers, proceeds from the sale of fixed assets such as equipment, proceeds from the sale of securities held by the company for investment purposes, and proceeds from the sale of loans, bonds, or stocks.
