Cash flow analysis might sound like something only large corporate finance teams would measure, but it’s valuable across businesses of all sizes. It can actually be as simple or complex as you want to make it.
In this article, we dive into why analyzing cash is essential for measuring a healthy business, what role it plays in financial reporting, and how you can use forecasting to anticipate your future cash needs.
Here’s what we’ll cover
How to perform a cash flow analysis in 5 steps
Why cash flow analysis is essential for a healthy business
What is the cash flow statement?
The most important aspects on preparing a cash flow statement
What are the 3 types of cash flow in a company?
Cash flow analysis methodology
How to do a cash flow forecast
What is cash flow?
The term refers to the inflows and outflows of cash within your business during a period, say a quarter or a fiscal year.
It’s important to note this is different from your company’s profit, although both measures are vital in assessing financial performance.
What is cash flow analysis?
Analyzing cash involves an assessment of the timing of cash movements, how much is transferred in and out, and future cash predictions.
Understanding cash flow is one of the main objectives of financial reporting. It allows a company to understand its liquidity and flexibility.
Positive movement shows a company’s liquid assets have increased, meaning it can cover its day-to-day operations, pay creditors, reinvest, and provide a cash buffer for any future financial challenges.
How to perform a cash flow analysis in 5 steps
Performing a cash flow analysis relies on good record-keeping.
Usually this function would be performed by an accountant or accounting software but relies on the business owner keeping accurate and timely records of all cash transactions.
Select the time period you wish to analyze (usually a quarter or annual block). Then calculate:
1. Your opening balance
This is the net value of money in and out less any liability at the date before you are running the cash flow statement, analysis, or forecast for.
2. Cash flow in
This includes the total value of your:
- Customer receipts
- Vendor refunds
- Other income
- Bank transfers and deposits
3. Cash flow out
This includes the total value of your:
- Vendor payments
- Customer refunds
- Other expenses
- Bank transfers
4. Closing balance
The total cash flow in less the total cash flow out.
5. Net balance
The closing balance for this period.
Free cash flow forecast template
Gain cash flow clarity with our free forecast template.
Why cash flow analysis is essential for a healthy business
Analysis provides essential information on your company’s financial health. It tells you where your cash inflows are coming from: Loans, sales, or investors.
It tells you where you are spending your money.
Newer businesses may experience negative operating cash flows to begin with if they’re spending on growth, which is okay if investors and lenders are happy to support the business.
However, a business can’t sustain negative cash flows in the long term, and must be able to operate as a going concern.
Businesses can also use cash flow analysis and forecasting to predict whether they may come into cash flow trouble in the future. Creating a cash flow forecast will help manage the timing of cash inflows and outflows.
What is the cash flow statement?
The cash flow statement is one of the 3 main financial statements and is generally used alongside the balance sheet and the profit and loss statement (also known as the income statement).
To analyze your company’s cash flow, you need a cash flow statement, as the profit and loss statement includes non-cash transactions as well as accruals.
It’s the cash flow statement’s role to show pure cash movements for the period.
The cash flow statement allows you to get a picture of how your business manages its cash position because you can see both the sources and uses of cash.
Being able to see not only how much cash was spent, but also where, gives you contextual information you won’t receive from other financial statements.
The most important aspects on preparing a cash flow statement
Cash flow analysis provides you with the current status of your business in terms of cash availability.
It also helps you plan for the future by seeing what funds are available, so you can decide where best to spend your money.
When calculating cash flow, don’t forget to adjust for non-cash expenditures like depreciation, as well as changes in working capital.
Include changes from things like payable loans or dividends from investments. After detailing the operating, investing, and financing activities, you’ll arrive at the net change in cash.
This is the key to your cash flow analysis over the time period you set.
What are the 3 types of cash flow in a company?
There are 3 sections included on the cash flow statement: Cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities (this is the order they appear on the statement).
Operating cash flow
Cash flow from operating activities, or operating cash flow, describes the movements of cash used in your everyday business operations. So, it tells you how much cash was generated in sales of your products or services.
Operating income
Cash receipts also include other operating income like commissions and interest received. Cash payments include the costs of running the business, like salaries, rent, and office equipment.
Investing cash flow
Cash flow from investing activities, or investing cash flow, describes the cash spent on growing your business through capital investment.
This includes physical assets and non-physical assets like patents, as well as the cash you receive from selling those investments.
Negative cash flow from investing activities might indicate a focus on investing in long-term growth such as research and development, so is not necessarily an indicator of poor health.
Financing cash flow
Cash flow from financing activities, or financing cash flow, shows the cash used to fund the business from the owner(s), investors, or creditors.
Receipts can include business loans from banks, mortgages, and other borrowed funds. Cash payments include dividends paid to shareholders.
Cash flow analysis methodology
When you review a cash flow statement, first check the number at the bottom telling you the net cash movement for the period.
If it’s a positive number, cash increased over the period and if it’s negative, then the business spent more than it received.
For example, Google’s company, Alphabet Inc, reported a negative net cash flow for the period ending December 2021 of $5.2 billion. The company had positive cash flow from operating activities of $91.7 billion, but negative financing cash flow from investing activities of $35.5 billion and negative cash flow from financing activities of $61.4 billion.
Then you can do further analysis by reviewing the three sections above and seeing where the cash inflows and outflows occurred.
It’s also helpful to look at trends over time across multiple statements, so you can identify areas of strength and opportunities for improvement.
If your operating cash flow is negative, then you can start to investigate areas of the business where you may potentially have a cash flow issue.
Ideally, your cash from operating activities will always be positive so not only can the business remain solvent, but you can continue to grow operations.
How to do a cash flow forecast
A cash flow forecast will give you a view of your company’s upcoming cash requirements and therefore help manage liquidity.
A simple cash flow forecast indicates where your cash balances will be at certain dates in the future.
This information can assist you to decide when you need cash available and when you can take advantage of excess funds.
A more comprehensive cash flow forecast will start with an opening balance and track what payments and receipts will occur from now until a future date.
Free cash flow forecast template
Gain cash flow clarity with our free forecast template.
5 steps to cash flow analysis
1. Net income
Calculate your net income. This is derived from your income statement:
Net Income = Revenues – Expenses
2. Adjust for non-cash transactions
Take into account transactions that affect the income statement but do not affect your cash. This can include depreciation, stock-based compensation, and deferred taxes.
Add or subtract these figures from your net income.
3. Account for changes in operating working capital
Operating working capital refers to current assets and liabilities related to your operations. Consider changes in accounts receivable, inventory, accounts payable, and accrued expenses.
If assets increase, cash flow decreases, and vice versa. Similarly, if liabilities increase, cash flow increases, and vice versa. This can be explained by the formula:
Change in cash flow from operations = Net income + Depreciation – Δ Working capital
4. Calculate cash flow from investing and financing activities
Closely review your investments (like purchase or sale of assets) and financing activities (like loans taken or repaid, stock issued or bought back, and dividends payments).
This formula explains the calculations you will need to make:
Cash flow from investments = Cash received from sales of assets – Cash spent on asset purchases
Cash flow from financing = Cash from issuing shares or loans – Cash paid back or used to repurchase shares or loans, or paid as dividends
5. Arrival at net cash flow
The previous calculations will give you your net cash flow. It is the sum of cash flows from operations, investments, and financing activities. Add this figure to your initial cash balance to reveal your final cash balance, calculated by the formula:
Net cash flow = Cash flow from operations + Cash flow from investments + Cash flow from financing
Final cash balance = Initial cash balance + Net cash flow
Cash flow analysis example
Sarah decides to start a new e-commerce business selling homemade products called Scentsational Gifts, so she creates a simple cashflow analysis forecast for the first 6 months of operation.
In the cash inflows section, she includes the one-off cash investment she will put in to start the business, plus the forecasted sales she expects to make each month.
In the cash outflows section, she includes the cost of equipment she needs to set up the business, plus an estimate of the monthly outgoings like materials and marketing costs for paid advertising.
As you can see by the net cash flow, there’s a small cash inflow each month, except for March when there is a cash outflow of $2,800 thanks to a one-off expense.
After taking into account the inflows and outflows each month, she expects the closing cash balance at the end of June will be $9,200.
Final thoughts
To make the best business decisions possible, you need the right information at your fingertips.
Cash flow affects every area of decision-making, from whether you need to chase outstanding debtors to whether you can afford to expand operations.
This makes cash flow analysis, statements, and forecasts vital tools for ensuring your business flourishes.
FAQs
Q. What is a cash flow analysis?
A. Cash flow analysis gives you an idea of the financial health of your business. It assesses how money flows in and out of the business to help you understand its liquidity.
Q. Why is a cash flow statement important?
A. A cash flow statement is the first step in performing successful cash flow analysis.
It gives you an idea of the financial health of your company.
Unlike an income statement (which is like a photo snapshot), a cash flow statement offers a moving picture, highlighting how your cash position changes over time.
Q. Who requires a cash flow statement in Canada?
A. In Canada, any business adhering to generally accepted accounting principles (GAAP) must prepare a cash flow statement.
This includes both public and private companies. Canada’s Accounting Standards for Private Enterprises (ASPE) and International Financial Reporting Standards (IFRS) require the inclusion of a cash flow statement as part of a complete set of financial statements.
Q. How is the cash flow statement structured?
A. The cash flow statement follows a structured format:
- Cash flow from operating activities that highlight the cash generated or consumed in the course of regular business operations.
- Cash flow from investing activities showing the cash used or received from the acquisition or disposal of long-term assets and investment securities.
- Cash flow from financing activities reveals cash from loans, issuing shares, or payment of dividends and reflects how your activities are financed.
- Net increase or decrease in cash. This shows the ripple effect of all these cash flows on the company’s cash reserves over the period.
Q. What does a negative cash flow indicate?
A. While a negative cash flow might initially cause alarm, it doesn’t necessarily mean trouble. It could indicate a strategic investment in growth opportunities.
However, your cash flow analysis regularly reveals negative cash flow, there could be issues that need investigation.
Q. What is a cash flow forecast, and how is it useful?
A. A cash flow forecast predicts the cash coming into and going out of your business over a future period.
It helps you see if you’ll have enough liquidity to cover upcoming expenses or seize new business opportunities.
Editor’s note: This article was originally published in January 2023 and has been updated for relevance.
Subscribe to the Sage Advice Newsletter
Get a roundup of our best business advice in your inbox every month.
Ask the author a question or share your advice