Success in business can have various definitions, but one common benchmark for all kinds of companies is cash flow – the movement of money into and out of the business. Cash flow stems from a company’s operations, investments, and financing activities. Pinning down these inflows and outflows of cash can be challenging, but it’s necessary to ensure the business will always have enough money to manage its operations, cover its expenses and fund growth. Cash-flow analysis is vital for this purpose.
What Is Cash-Flow Analysis?
Cash-flow analysis is a measure of how much cash a business generates and spends during a set financial period. Cash-flow analysis typically begins with the cash-flow statement, a core financial statement that itemizes every cash exchange from operating, investing, and financing activities. The cash-flow statement can then be analyzed to spot trends, pinpoint strengths, and identify areas for improvement.
The Significance of the Cash-Flow Statement
The cash-flow statement reveals a business’s cash inflows and outflows within a period. More specifically, it can show whether a company has added to or depleted its cash balances over a period and how. The cash-flow statement is one of the three major financial statements, all of which can work together to help reveal a business’s financial health. The other two are the income statement, which records net profit and loss, and the balance sheet, which displays assets, liabilities, and equity positions at a point in time.
For example, the balance sheet might show you have a loan liability, and the income statement might show the interest expense on that loan. But the cash-flow statement will reveal how much cash was actually used during the period to pay down the loan principal or how much interest was paid.
The cash-flow statement is one of the three major financial statements, all of which can work together to help reveal a business’s financial health.
Why Is Cash-Flow Analysis Important?
Cash-flow analysis can be a useful way to track how well a company manages its cash inflows and outflows. It also can demonstrate its ability to meet its financial obligations and invest back in the business. Cash flow can be a trusted indicator of performance since it can be measured and compared, is difficult to manipulate, and is a clear indicator of value.
Cash flow can be measured and compared.
Cash is tangible, quantifiable, and can be measured in standard units. When comparing two companies in the same industry, cash flow can provide a reputable “apples to apples” comparison. Still, cash flow isn’t the be-all and end-all. Because businesses generate and spend cash differently, direct comparisons can benefit from additional context. A new company may spend money at a faster rate than an established business, so periods of negative cash flow don’t necessarily point to danger.
Cash flow is difficult to manipulate.
While a business can inflate profits or artificially increase the value of its assets, cash can provide a more transparent story. A company might show record-high sales and profits, but if those sales are on made credit or have slow collections, the actual cash might not be available for months. A business with lower sales and a healthy cash flow may be in a better position to pay expenses, reduce debt, and reinvest funds for growth.
Cash flow is a clear indicator of value.
Most people can understand the value of $1 million in cash. The same cannot be said for other assets, such as intellectual property, good will, or depreciated equipment – the value of which can vary by perspective. For example, a used forklift may be worthless to a writer but a valuable asset for a warehouse owner. Cash flow can reveal both the amount and the effective use of cash in a business.
Cash-Flow Sources to Analyze
There are three primary sources of cash flow: operating activities, investment activities, and financing activities, all of which are itemized on a business’s cash-flow statement. This document allows a business to analyze its cash-flow patterns and ultimately improve or optimize its cash management.
Operations
Cash flow from operations represents a business’s primary cash movements in and out of the organization. Cash comes in from customers and goes out to cover expenses to deliver those goods or services. Expenses include wages, selling and marketing expenses, raw materials, and inventory. However, revenue doesn’t always equal immediate cash. In one month a company might make $1 million in sales on 60-day credit terms, effectively bringing in no cash for that period. Conversely, cash could come in from past credit sales, creating a positive cash flow even if sales have declined for the current period.
A business can use its operating cash-flow trends to represent the “bread and butter” of the business. Operating activities are what the organization is in business to do – so it’s important that over time, they generate positive cash flow. Successful companies can weather intermittent periods where cash flow is negative, but very few can withstand this over the long run.
Investment Activities
Cash flow from investment activities mainly involves the buying or selling of fixed assets. This includes property, plant, and equipment (PP&E), such as machinery, land, furniture, and vehicles, as well as proceeds from other investment-related activities, such as a merger or acquisition. Investment activity cash flow is typically kept separate from operations because it tends to be non-recurring and focused on long-term growth, not day-to-day activities.
For example, the purchase of a new forklift can be considered an investment activity, but the monthly depreciation expense of the forklift over its useful life can be captured within operating activities. Usually, a company spending extra cash on investments may be planning for the future. But if its operating cash can’t cover these investments, the business may be at risk of overextending itself and might struggle to meet financial obligations.
Financing Activities
Cash flow from financing activities can show cash transactions with financial backers such as lenders and investors. It can include cash inflows from borrowing and share sales, as well as cash spent on loan payments and share dividends. Cash flow from financing activities can be used to compare how much cash the company generates from external sources versus its operations. While external funding can help support business growth or benefit cash flow during a crunch, businesses should try to make sure they don’t borrow more than they can realistically repay.
How to Perform a Cash-Flow Analysis
To perform a cash-flow analysis, you can start by identifying all sources of business income, including financing funding. Next, you can pin down all business expenses, including inventory purchases, accounts payable, payroll, advertising, taxes, and insurance. Then, you can create your cash-flow statement, either manually or with accounting software, taking care to categorize income and expenses as an operating activity, investing activity, or financing activity.
To conduct the analysis, you can start by looking at the total cash flow. What is the net increase or decrease in cash at the end of the period? This can give you a general idea of whether your business has a positive or negative cash flow for that period. Then, you can go deeper by examining each of these three main activities:
- Whether the core business has positive cash flow from operations.
- Where funds have been invested, such as equipment or property purchases. Large outflows here can be a sign of growth. Large inflows could be strategic, or they could be helping the company compensate for weak operating cash flow.
- How much money is being borrowed or repaid, whether new equity is being introduced, or whether dividends are being paid. This can offer a look into how the business is being financed.
Next, you can start to identify any patterns. You can compare multiple cash-flow statements over consecutive periods. Does seasonality affect operating cash flows? Is positive cash flow for a period simply due to mounting unpaid obligations or because customers paid quicker than usual? Are there regular outflows in the investing section that could be signaling growth? Is debt creeping up? These high-level findings may help you gauge how well your company manages cash. If the analysis reveals a consistent negative cash flow from operations, it might be a sign to reassess your business model. If there's a trend of increased borrowing, consider whether it's sustainable.
Remember, occasional negative cash flow typically may not be cause for alarm, but consistent negative flows or downward trends can prompt deeper investigation. Regularly analyzing cash-flow statements can be a proactive way to keep your business financially healthy. It’s also important to note that cash is not the same as profit. A company can be profitable on its income statement but be cash-flow negative and unable to pay employees, buy inventory, or keep the lights on. Profitability can be closely tracked alongside cash flow.
The Takeaway
Everything a business does depends on cash, from paying employees and producing goods to investing in its future. By prioritizing cash-flow analysis, businesses can help ensure their obligations are met, orders are fulfilled, and there’s enough cash left over to build long-term success.
A version of this article was originally published on January 13, 2020.
Photo: Getty Images
