Cash Flow Analysis: What It Is & How To Prepare It

The Statement of Cash Flows is one of the main three financial statements for a business. The other two documents are the income statement and balance sheet.

All three of these are helpful in determining the health of a company. While these two statements provide a snapshot of the business finances, the Statement of Cash Flows shows how a company receives and spends cash.

It’s a determining factor in how a company is valued and closely viewed by investors and shareholders. But even if you don’t have investors, a cash flow analysis is a perfect way to understand the inflows and outflows of your finances.

Cash Flow Analysis Explained

Over time, a company brings in money from sales, services, and investments and spends money on inventory, interest, and salaries. This inflow and outflow of funds are called your cash flow. 

Cash flow comes from three sources—operating activities, investing activities, and financing activities. It’s important to look at each of these areas individually and as a whole when looking at the health of a business. 

Cash inflows can be negative or positive depending on whether the company has more money flowing in or out. A cash flow statement shows the source of the inflows and outflows.

A positive or negative cash flow doesn’t necessarily indicate whether a company is profitable (that’s the purpose of the income statement). Still, a positive cash flow is a good indication of a healthy company. Conversely, sustained negative cash flow is not a good sign that a business will thrive.

There are different ways to calculate and look at cash flow:

  • Operating Cash Flow is a picture of how the company operates its business on a daily basis. It includes the inflows and outflows that come from normal daily operations. Are you earning more than you are spending?
  • Free Cash Flow is another way of seeing how a company operates but is calculated before interest payments and does not include capital expenditures. This is valuable as it shows performance and how cash is affected by the expenses of assets. Free cash flow is used to decide how much to pay investors and is a key indicator when applying for a loan.

Why is Cash Flow Analysis Important?

As we mentioned, cash flow analysis can tell you where your cash is coming from or going. Cash inflow (the money coming into your business) can originate from sales, loans, depreciation, or other financings. Cash outflows can stem from interest payments and capital investments.

Cash flow analysis will indicate whether a company is able to pay its bills. Positive cash flow, especially when repeated over several reporting cycles, exudes confidence in the company’s management structure.

It shows investors that the company knows how to manage its finances. Conversely, repeated negative cash flow indicates that things are not going well and, if not corrected, could be headed toward bankruptcy.

While an income statement shows a company’s profitability, the cash flow statement goes a step further and shows where specifically a business is thriving or not.

Preparing a Cash Flow Statement

A cash flow statement has three sections—cash from operating activities, cash from investing activities, and cash from financing activities. Each one of these contributes to the bottom line.

Cash Flow From Operations

The first section of the cash flow statement reports cash from operating activities.

There are two ways of reporting cash flow from operations. The direct method uses the income statement prepared using the cash method. The core activities include cash received from customers, cash paid to suppliers and employees, interest paid, and taxes paid.

If using the indirect method, core activities originate from an income statement that uses the accrual method. You start with the net profit or loss, add back non-cash expenses, and adjust for the movement of working capital.

Net profit or loss is the number to look at to see if a company is profitable. A positive cash flow is the cash available to spend growing the business or paying shareholders. A company could have a negative cash flow and still be profitable, or have a positive cash flow and not bring in a profit.

Non-cash expenses include depreciation, amortization, unrealized gains or losses, asset write-downs, provisions for future losses or discount expenses, and stock-based compensation. These items are included in the income statement but do not involve an actual cash transaction. 

Working capital is calculated from the balance sheet. Take the current liabilities and subtract current assets. Working capital represents operating liquidity available to a business. Positive working capital means the company can pay its bills and spend money on growing the business.

We mentioned the cash method versus the accrual method when preparing the income statement and statement of cash flows. The cash method records income and expenses when money is received.

The accrual method records revenue and expenses when they are earned. Expenses are recorded when a transaction occurs, whether or not money is exchanged simultaneously. 

Small businesses that use the cash method can use the income statement instead of a cash flow statement, as they show the same information.

It’s important to note that if you follow Generally Accepted Accounting Principles or IFRS, you must use the accrual method to prepare both. A separate cash flow statement is required. 

Cash Flow From Investing

This section details the investments in long-term assets. A company may buy or sell capital expenditures, which creates an inflow or outflow of cash. These expenses are outside the core activities of the business and are usually one-time entries. 

Capital expenditure is money a company uses to purchase, maintain, or upgrade fixed assets. These include buildings, vehicles, equipment, or land. An increase in these items shows that the company is investing in its infrastructure.

These expenses will affect cash flow during the period they were purchased, so it’s significant to note that while this lowers the overall cash flow, it shows potential future growth.

Cash Flow From Financing

Funding from a company’s investors, creditors, or owners will cause an influx of cash flow. This is reported in the third section of the cash flow statement.

It’s important to note that this is often a one-time entry, so while it influences the cash flow total during one particular time period, it’s not sustainable over the long term.

Prepare Your Cash Flow Analysis: Step By Step

Cash flow analysis starts with identifying your sources of income and expenses. As a reminder, there are two methods of preparing a cash flow statement—the direct method and the indirect method. The method you choose depends on which method was used to track your finances and prepare your income statement.

The direct method adds all the cash collected from operating activities and subtracts cash paid in pursuit of those activities. Each income and expense is identified separately on the cash flow statement.

The advantage of this method is that it’s much easier to see where you might be overspending or where you need to spend time generating income.

The indirect method is much simpler to calculate. You start with the net income from the income statement and add or deduct non-cash revenue and expense items.

In addition to gathering all cash related to incomes and expenses, identify cash from investing and financing activities. 

Identify All Sources Of Income

Before preparing a cash flow statement, gather all of your sources of income, or money coming into the business. This not only includes cash and cash equivalents, but cash from other sources such as investments, financing, and loans. Here are some of the items that may increase cash flow:

  • Cash received from the sale of goods and services
  • Cash settlements from lawsuits
  • Proceeds from Loans
  • Cash received from the sale of long-term assets
  • Issuance of Common Stock
  • Depreciation or Amortization

Identify All Business Expenses

Business expenses range from paper for the printer to inventory for your high-tech product to payments on your loans. Here are expenses and outflows that reduce cash flow:

  • Inventory and supplies purchased to make those goods and services
  • Increase to Accounts Receivable
  • Decrease in Accounts Payable
  • Cash paid out to suppliers to employees
  • Dividends paid to investors
  • Long-term debt repayments

Create Your Cash Flow Statement

Once you have gathered your income and expenses, you can create a cash flow statement.

The cash flow statement starts with cash on hand at the beginning of the time period and cash on hand at the end of the time period. These numbers come from the balance sheet. Then the details are added explaining the difference between the two. 

You can create a cash flow statement on paper, on your computer in an Excel spreadsheet, or plug the numbers into one of many free templates available on the internet.

Here is a fictitious cash flow statement using the indirect method:

Cash Flow Statement

My Company

Year Ending December 31st, 2021

Cash Flow from Operations

Net Income                                                                                  $50,000

Additions to Cash

Depreciation                                                                                $10,000

Increase in Accounts Payable                                                   $10,000

Subtractions from Cash

Increase in Accounts Receivable                                           ($15,000)

Increase in Inventory                                                                ($10,000)

Net Cash from Operations                                                        $45,000

Cash Flow from Investing

Purchase of Equipment                                                             ($6,000)

Cash Flow from Financing

Notes Payable                                                                                $6,500

Cash Flow for Year ended December 31st, 2021         $45,500

Analyze Your Cash Flow Statement

Now that you’ve created your cash flow statement, it’s time to take a deep look at each line item. Here are some things to consider and actions you can take:

  1. A cash flow statement can help you budget for larger expenses. If you know that you bring in more sales during specific periods of the year, you can plan an inventory purchase for that period as well. Note predictable and steady expenses, such as payroll and insurance bills, and concentrate on the ones that will positively affect cash flow. Cutting expenses equals an increase in cash flow, but before you decide to cut your workforce, consider how it will impact the rest of the numbers.
  2. If your expenses are close to or greater than your income from sales, this may be a time to focus on productivity. Consider launching a new product line or expanding your business model. Crunch the numbers to see if hiring a new employee will increase sales or whether the market can handle a price increase. Check out each expense line and see if the value is worth the cost. Negotiate with suppliers for better rates and evaluate expenses that aren’t absolutely necessary.
  3. See if you can adjust your payments to your creditors. Paying over a more extended period of time will reduce a monthly expense. On the other hand, paying early might reduce interest payments. If it’s possible to plan when expenses hit your account, you can sometimes avoid a negative cash flow.
  4. If a company has a high positive cash flow and low investments, one might question whether they are committed to growing the business. Investing in people, inventory, or equipment is necessary to take a business to the next level. Also, If the company has a lot of financing on a regular basis, one might question whether that can be sustained.
  5. Compare cash flow statements for several periods. Look for exceptions to the norm. Discover areas for improvement. Use the cash flow statement as a launching point for brainstorming sessions on increasing income and reducing expenses.

While small businesses can get by with spreadsheets and simple accounting software, medium to larger companies will want to look into software that will put each of these numbers at their fingertips. 

Investors look at the cash flow statement to determine whether a company is a good investment opportunity. You can do the same thing. 

The Bottom Line

Knowing current cash flow numbers is critical for any business. It allows a company to set goals and evaluate whether they meet them. It shows trends and points out problems.

It’s crucial to know where you stand financially at any given period and take steps to improve. A cash flow statement is a perfect tool to start your analysis. 

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