Cash Flow Analysis: Calculation, Prep & Limitations

Ever wondered, “What is cash flow analysis?” Think of a crystal ball that gives you a view into where money is flowing both in and out of your business—your means of predicting future financial well-being with such uncanny accuracy. It is one of the major financial tools a business should possess and maintain to stay afloat and thrive. 

We are going to dig into the meaning of cash flow, purpose of cash flow statement, components of cash flow statement, analysis of the statement, and more in this blog and understand why smart analysis of a cash flow statement can make all the difference in your financial strategy!

What Is Cash Flow Analysis?

Finances are characterized by cash flow analysis, which documents money inflow and outflow from the company. It represents cash inflows like sales income, investment gain, loans, and outflows such as expenses or capital expenditure plus loan repayment. A firm’s financial condition and efficiency can be assessed through this data.

Cash flow analysis helps to assess the liquidity and operational efficacy of a company. Companies that receive money over their needs are in a better position to meet short-term obligations without externally sourced finances along with effectiveness in resource management. In other words, it implies that core operations are generating enough money to sustain and expand business activities.

Furthermore, cash flow analysis gives insight into the firms’ capacity to take advantage of growth opportunities while maintaining solvency & liquidity. The process of projecting future shortages or surpluses for budgeting purposes, financing arrangements, and other strategic decisions is therefore facilitated by cash flow analysis for forecasting purposes, etc.

Basics of Cash Flow Analysis

Cash flow analysis is based on three major elements: operating activities, investing activities, and financing activities. Analysis involves studying the cash flow statement to assess the sources of cash inflows and how it is used in these areas. This study is undertaken to ascertain liquidity, operational efficiency, and financial health. 

Preparation of a Cash Flow Statement

There are two ways of preparing a cash flow statement: the Direct Method and the Indirect Method. Both methods yield identical results for cash inflows from operating activities but differ in approach.

Direct Method

Under this method, all the cash receipts and cash payments made during a period are recorded to arrive at the net cash provided by operating activities. The following is how it works:

Cash Inflows: List all of the cash received from customers.

Add other cash receipts resulting from operating activities, including interest or dividends received.

Cash Payments: Deduct all of the cash paid to suppliers and employees.

Deduct cash paid to operating expenses such as rent, utilities, and taxes.

Add other cash payments related to operating activities, including interest paid or income taxes paid.

Net Cash Provided by Operating Activities: The difference between cash receipts and cash payments provides the net cash provided by (or used in) operating activities.

Indirect Method

The Indirect Method begins with net income from the income statement and proper adjustments are made for non-cash transactions and working capital changes so that it derives the net cash provided by operating activities. Here’s how it works:

Begin with Net Income: In the journal entry, start with the net income amount of a given period from the income statement.

Adjust for Non-Cash Items: Add the depreciation and amortization, which is a non-cash item or expense. Deduct non-cash gains, such as gains on the sale of assets.

Accounting for Changes in Working Capital: Accounting for changes in accounts receivables, inventories, and accounts payables. An increase in accounts receivables or inventories is subtracted. An increase in accounts payables is added.

Net Cash Provided by Operating Activities: After these adjustments, you have the net cash provided by (or used in) operating activities.

Maintain Positive Cash Flow

Positive cash flow is a situation where a business has high cash inflows that can meet its short-term obligations. A business enjoying positive cash flow will be able to pay off its current liabilities and grab investment opportunities. The proper monitoring and management of cash flow will keep the business free from liquidity problems and result in continuous operations.

Treat Positive Cash Flows with Caution

Even though positive cash flow is an excellent indicator, always treat it with skepticism. Separate excess cash flows that are temporary surpluses from those created due to authentic, viable enhancements. The sources and sustainability of positive cash flow have to be analyzed to make sure it is representative of actual good financial health.

Identify Negative Cash Flow and Analyze It

You can view this in the context of learning from the underlying problems affecting financial performance. That means seeing exactly what’s causing cash outflows, such as increased expenditure or declining revenues, and working out strategies to address these challenges.

Find Out How Much Free Cash Flow You Have

Free cash flow is the money available after capital expenditures, and it is a key indicator of financial flexibility. Free cash flow helps estimate the amount of cash that would be at one’s disposal for dividends, debt repayment, or even reinvested in the business.

Operating Cash Flow Margin Builds Trust

A healthy margin of operating cash flow is an indication of effective business operations and financial stability. It builds trust with investors, creditors, and stakeholders by showing that the company generates enough cash from its core operations to keep up and grow its business.

Cash Flow Statement

The statement of cash flow is one of the financial documents giving detail on cash inflows and outflows that a business experiences over some time. It has three major divisions: operational, investment, and financing cash flow, all describing the different areas of financial activities of the company.

Operational Cash Flow

Operational cash flow depicts cash that is created or consumed due to a company’s core business activities. Activities in this category include sales revenue, cash payments to suppliers, and payroll. This category of the cash flow statement thus shows if a company can generate cash through regular business activities that hold the key to running daily operations.

Investment Cash Flow

Investment cash flow includes cash used for or generated from investment activities, such as the purchase or sale of property, equipment, or securities. It gives insight into the company’s strategies in terms of investment and its long-term growth prospects since this shows money given toward future growth.

Financing Cash Flow

Financing cash flow refers to the cash exchanged between a business and its investors or creditors. This may comprise issuing or repurchasing stock, loaning, repayment of loans, or paying dividends. It measures how a business funds its ongoing activities and growth and how it returns value to shareholders.

Cash Flow Statement Analysis

Cash flow statement analysis involves the examination of the different components of cash flow statements, which indicate the financial health and performance of a business.  

Cash Flow from Operations/Net Sales

It measures the ratio of cash flow from operations to net sales, which describes how much cash a company generates from its sales. The higher the ratio, the more efficiently the company turns its sales into cash. This consideration is of extraordinary importance for the sustenance of operative activity and financing future growth.

Free Cash Flow

Free cash flow refers to the cash left in a company after accounting for capital expenditure. It is a critical measure of financial flexibility and shows money that can be used to pay dividends, reduce debt, or be available for reinvestment. In most cases, a strong FCF is considered an indicator of a company’s ability to create value for shareholders.

A Thorough Coverage of Free Cash Flow

Free cash flow is an all-inclusive measure of a company’s well-being indicating the final amount of money that one can spend at their wish after meeting all the necessary costs. This is among major indicators that investors and analysts look forward to as it predicts the growth, stability, and returns to shareholders of a company.

Analyzing Cash Flows with Examples

Mahek’s Milkshakes: Cash Flow Statement for the Month Ended April 2024

The cash flow increase for the month, as captured in the financial report of Mahek’s Milkshakes, is $38,000. Operationally, the company performed very well, returning a healthy inflow of $48,000, which depicts its efficiency in running core business activities profitably. Even with a net outflow in investing activities due to equipment upgrades, the focus remains on enhancing long-term operational capacity. This net inflow from financing reflects a very balanced strategy, taking on debt and issuing bonds for the company’s growth. 

From an overall perspective, Mahek’s Milkshake is doing everything right: mapping out its financial strategy for growth that is sustainable, will maintain liquidity, and has reward potential for shareholders—all factors pointing toward a successful future.

What Analysis of Cash Flows Can Tell You 

Analyzing cash flows provides valuable insights into a company’s financial health and operational efficiency. By examining cash inflows and outflows, businesses can assess their ability to generate cash, sustain operations, and fund growth. This analysis helps in understanding how well a company manages its cash resources and whether it is financially stable.

Positive Cash Flow

Positive cash flow indicates that the company receives more cash than it spends. This can be interpreted as a leading sign of a sound financial state since it indicates that the company can meet its liabilities, has room for growth and investment, pays off its debt, and yields profits for its shareholders. Positive cash flow is needed to maintain liquidity and secure long-term survival.

Negative Cash Flow

Negative cash flow simply indicates that a company has more cash outflows than inflows. While this can be a red flag, it does not necessarily indicate that trouble is lurking—especially not if the negative cash flow is due to enormous investments in growth. In general, though, very prolonged periods of negative cash flow might be a sign of fundamental financial instability, signaling corrective measures by way of fine-tuning the company’s cash management.

Free Cash Flow

FCF refers to the cash that remains within a company after covering capital expenditures. It is one major measure of a company’s financial flexibility and its ability to generate cash, which can be used for dividends, debt repayment, or reinvestment. A high FCF shows that the firm is not only able to generate cash but is also efficiently managing investments.

Operating Cash Flow Margin

The operating cash flow margin is a metric that measures the proportion of cash flow from operations relative to a company’s net sales. The higher the margin, the more effectively a firm converts its sales to cash to run day-to-day operations and finance growth. It is one of the key indicators of operational efficiency and financial stability. 

Limitations of Cash Flow Analysis 

The following are some of the limitations of cash flow analysis:

Ignores Non-Cash Transactions: Cash flow analysis does not account for non-cash items like depreciation or changes in working capital, which can affect overall financial performance.

Short-Term Focus: The analysis of cash flow is oriented more toward short-term liquidity and might consequently give less attention to the long-term state of financial health or profitability.

Timing Problems: The inflows and outflows of cash might be at different times, and meaningless conclusions might be drawn if the exercise is not done with an appropriate perspective.

Doesn’t Reflect Profitability: A positive cash flow does not indicate that the business is profitable because it does not adjust for non-cash expenses, including accrued liabilities.

Subject to Manipulation: Cash flows can be influenced by the timing of payments or receipts, which again may be manipulated to project a better financial picture.

How Cash Flow is Calculated?

It is essential to understand how cash flow is calculated to be able to assess the financial state of a company. There are two major accounting methods used to track and report cash flow on the financial statements. These two major methods are accrual accounting and cash accounting. 

Each of these methods presents a different perspective on how financial activities are recorded and can substantially alter the meaning of financial reports concerning the financial standing of the organization under consideration.

Accrual Accounting

Most public companies prefer accrual accounting since it provides maximum scope to investigate the financial activities of the company. Under this approach, revenues are recorded as income when it was earned and not when it is actually received. The same holds good for expenses also, where they get accounted for at the time they actually occur, irrespective of whether or not cash has yet been paid out for the same. 

For example, the revenues from a sale are recognized immediately on an income statement when the sale is made, even though payment won’t be received until sometime in the future. This method allows companies to match revenues with the expenses incurred in generating those revenues and therefore provides a clearer picture regarding profitability.

However, it could also give rise to a situation wherein the reported profits are not matched with a similar level of cash on hand. For instance, in the case wherein a firm can indicate a profit in the income statement as a result of recorded sales, but if the sales were credit sales and the money has not yet been collected, then the firm can still be confronted with cash shortages. This kind of situation can be very dangerous, especially when the company has large expenses to be paid out, such as payments to suppliers or employees. Accounts receivables, which represent credit sales, will only affect cash flow once the payments are collected.

Cash Accounting

In sharp contrast to this, cash accounting is a very simple method under which financial transactions are recorded only when there is actual exchange of cash. In other words, revenues are recorded when cash is actually received and expenses are recorded when they are actually paid for. This approach clearly and immediately describes a company’s cash position, thereby making the assessment of its short-term liquidity and the possibility of its meeting its financial obligations easier.

Though it is considered to be an accurate mode of describing the cash inflow and outflow, cash accounting may not always reflect the actual situation or performance of the company. For instance, a company selling heavily during a period but remaining unpaid by its customers could appear less profitable. 

On the other hand, it may appear more profitable in a period where it recovers dues of past sales though the actual sales may be less during that period. This may be beneficial for small businesses or businesses with less complex financial transactions but may end up being very restrictive for big companies whose nature of business may involve financial transactions of great complexity.

Conclusion 

As we complete this journey of understanding and learning about cash flow it’s clear that mastering cash flow statement analysis is more than just a number-crunching exercise—it’s your gateway to financial clarity and control. Be it for an understanding of what a cash flow statement is or its limitations, always remember that timing is everything when you know there’s more or less cash coming and going. Keep the statement in front of you at all times and never be caught off guard. Here’s to making informed financial moves and turning those insights into action!

FAQs

In cash flow analysis, which technique is used?

The two most essential techniques that could be employed in cash flow statement analysis are the Direct and Indirect methods. However, the indirect method is mainly preferred because it deals with the reconciliation of net income with cash flow. 

Cash flow ratio calculation – how to do it?

To calculate the cash flow ratio, divide Operating Cash Flow by Current Liabilities. This ratio measures a company’s ability to cover its short-term obligations with the cash generated from operations. 

Does cash flow analysis have a formula?

Yes, there are many formulas involved in cash flow analysis: Free Cash Flow = (Operating Cash Flow – Capital Expenditures), and Cash Flow from Operations = (Net Income + Non-Cash Expenses + Changes in Working Capital).

What defines a healthy cash flow?

A healthy cash flow is characterized by positive operating cash flow that consistently exceeds outflows, ensuring the company can meet its obligations, reinvest in growth, and distribute returns to shareholders. 

Partham Barot is an ACCA-certified professional. showcasing his expertise in finance and accountancy. he’s revolutionising education by focusing on practical, real-world skills. Partham’s achievements underscore his commitment to elevating educational standards and empowering the next generation of professionals.