Cash Flow Analysis

A cash flow analysis is a financial evaluation tool that lets companies measure the financial strength of their businesses. With this type of analysis, you can follow line items in three cash flow categories to see where money is coming in and going out. This information is obtained from cash flow statements calculated at the beginning and end of an accounting period. In this article, we discuss what a cash flow analysis is, how to create one and give examples of its use.

What is Cash Flow Analysis?

Cash flow analysis is the evaluation of a company’s cash inflows and outflows from operations, financing activities, and investing activities. In other words, this is an examination of how the company is generating its money, where it is coming from, and what it means about the value of the overall company.

Cash flow analysis is the examination of a company’s different cash inflows and outflows during a specific accounting period. This important financial statement can be a simple one-page document or a complex statement with several schedules. It lists all the cash that flows in and out of a company or project. In addition to the amount of cash flowing in and out, a cash flow analysis also examines the timing of cash inflow and outflow with monthly or yearly cash flow statements.

To better understand a cash flow analysis, a simplified comparison would be a personal checking account. The deposits into the checking account are the inflow of cash (how a company receives its money) and withdrawals from the checking account are the outflow of cash (how a company spends its money). The checking account balance is comparable to the net income amount on a company’s income statement.

What Does Cash Flow Analysis Mean?

A cash flow statement is one of the most important financial statements for a project or business. The statement can be as simple as a one page analysis or may involve several schedules that feed information into a central statement.

A cash flow statement is a listing of the flows of cash into and out of the business or project. Think of it as your checking account at the bank. Deposits are the cash inflow and withdrawals (checks) are the cash outflows. The balance in your checking account is your net cash flow at a specific point in time.

A cash flow statement is a listing of cash flows that occurred during the past accounting period. A projection of future flows of cash is called a cash flow budget. You can think of a cash flow budget as a projection of the future deposits and withdrawals to your checking account.

A cash flow statement is not only concerned with the amount of the cash flows but also the timing of the flows. Many cash flows are constructed with multiple time periods. For example, it may list monthly cash inflows and outflows over a year’s time. It not only projects the cash balance remaining at the end of the year but also the cash balance for each month.

Working capital is an important part of a cash flow analysis. It is defined as the amount of money needed to facilitate business operations and transactions, and is calculated as current assets (cash or near cash assets) less current liabilities (liabilities due during the upcoming accounting period). Computing the amount of working capital gives you a quick analysis of the liquidity of the business over the future accounting period. If working capital appears to be sufficient, developing a cash flow budget may not be critical. But if working capital appears to be insufficient, a cash flow budget may highlight liquidity problems that may occur during the coming year.

Most statements are constructed so that you can identify each individual inflow or outflow item with a place for a description of the item. Statements like Decision Tool Cash Flow Budget (12 periods) provides a flexible tool for simple cash flow projections. A more comprehensive tool for a Farm Cash Flow (Decision Tool) is also available. A more in-depth discussion of creating a cash flow budget is Twelve Steps to Cash Flow Budgeting.

Some cash flow budgets are constructed so that you can monitor the accuracy of your projections. These budgets allow you to make monthly cash flow projections for the coming year and also enter actual inflows and outflows as you progress through the year. This will allow you to compare your projections to your actual cash flows and make adjustments to the projections for the remainder of the year.

Cash flow budget
Cash flow budget

Reasons for Creating a Cash Flow Budget

Think of cash as the ingredient that makes the business operate smoothly just as grease is the ingredient that makes a machine function smoothly. Without adequate cash a business cannot function because many of the transactions require cash to complete them.

By creating a cash flow budget you can project sources and applications of funds for the upcoming time periods. You will identify any cash deficit periods in advance so you can take corrective actions now to alleviate the deficit. This may involve shifting the timing of certain transactions. It may also determine when money will be borrowed. If borrowing is involved, it will also determine the amount of cash that needs to be borrowed.

Periods of excess cash can also be identified. This information can be used to direct excess cash into interest bearing assets where additional revenue can be generated or to scheduled loan payments.

Cash Flow is not Profitability

People often mistakenly believe that a cash flow statement will show the profitability of a business or project. Although closely related, cash flow and profitability are different. A cash flow statement lists cash inflows and cash outflows while the income statement lists income and expenses. A cash flow statement shows liquidity while an income statement shows profitability.

Many income items are also cash inflows. The sales of crops and livestock are usually both income and cash inflows. The timing is also usually the same as long as a check is received and deposited in your account at the time of the sale. Many expense items are also cash outflow items. The purchase of livestock feed (cash method of accounting) is both an expense and a cash outflow item. The timing is also the same if a check is written at the time of purchase.

However, there are many cash items that are not income and expense items, and vice versa. For example, the purchase of a tractor is a cash outflow if you pay cash at the time of purchase as shown in the example in Table 1. If money is borrowed for the purchase using a term loan, the down payment is a cash outflow at the time of purchase and the annual principal and interest payments are cash outflows each year as shown in Table 2.

The tractor is a capital asset and has a life of more than one year. It is included as an expense item in an income statement by the amount it declines in value due to wear and obsolescence. This is called “depreciation”. The cost of depreciation is listed every year. In the tables below a $70,000 tractor is depreciated over seven years at the rate of $10,000 per year.

Depreciation calculated for income tax purposes can be used. However, to more accurately calculate net income, a realistic depreciation amount should be used to approximate the actual decline in the value of the machine during the year.

In Table 2, where the purchase is financed, the amount of interest paid on the loan is included as an expense, along with depreciation, because interest is the cost of borrowing money. However, principal payments are not an expense but merely a cash transfer between you and your lender.

Cash Flow Analysis
Cash Flow Analysis

Cash Flow Analysis Components

A cash flow analysis is divided into three parts, including:

Cash flow from operations

Cash flow from operations considers the normal business operations that create cash inflows and the corresponding outflows. You can calculate cash flow from operations in two ways, directly and indirectly. The indirect method is much more common and gets used in the majority of cases. Cash flow from operations shows how much of the cash from the income statement is on an accrual basis, including accounts payable, account receivable and payable income taxes.

Cash flow from investments

In addition to normal business operations, investments can create cash inflows and outflows. You can calculate cash flow from investments by finding the number of cashless activities, losses or gains, that happened over a specific period of time. This includes activities such as purchasing or selling securities, long-term assets or loans. Cash flow from investments shows how much cash comes from sales and purchases, including fixed assets and investment transactions like property, vehicles, capital expenditures or investment securities.

Cash flow from financing

In addition to normal business operations and investments, financing activities can create cash inflows and outflows. You can calculate cash flow from investments by finding the amount of funds moved between the company, its owners, its investors and creditors. This includes activities such as repaying or borrowing money for loans and buying or selling stocks. Cash flow from financing shows how much cash is from equity and debt transactions, including dividend payments and bonds.

Why Create a Cash Flow Analysis?

A company can only function properly if it has an adequate cash flow, since without sufficient cash flow it can’t complete necessary transactions. By creating a cash flow analysis, a company can examine and project sources of cash and applications of cash for a specific time period. Periods of cash deficit can get identified and preventative actions can alleviate the deficit problem, such as adjusting the timing of transactions or borrowing money. Periods of cash excess can get identified and used for purchasing investments, creating additional revenue or making additional loan payments.

Uses of Cash Flow

Cash Flow has many uses in both operating a business and in performing financial analysis. In fact, it’s one of the most important metrics in all of finance and accounting.

The most common cash metrics and uses of CF are the following:

  • Net Present Value – calculating the value of a business by building a DCF Model and calculating the net present value (NPV)
  • Internal Rate of Return – determining the IRR an investor achieves for making an investment
  • Liquidity – assessing how well a company can meet its short-term financial obligations
  • Cash Flow Yield – measuring how much cash a business generates per share, relative to its share price, expressed as a percentage
  • Cash Flow Per Share (CFPS) – cash from operating activities divided by the number of shares outstanding
  • P/CF Ratio – the price of a stock divided by the CFPS (see above), sometimes used as an alternative to the Price-Earnings, or P/E, ratio
  • Cash Conversion Ratio – the amount of time between when a business pays for its inventory (cost of goods sold) and receives payment from its customers is the cash conversion ratio
  • Funding Gap – a measure of the shortfall a company has to overcome (how much more cash it needs)
  • Dividend Payments – CF can be used to fund dividend payments to investors
  • Capital Expenditures – CF can also be used to fund reinvestment and growth in the business

Cash Flow vs. Profitability

While cash flow and profitability have a close relationship, they are two different things. A cash flow statement shows liquidity by listing cash inflows and cash outflows. An income statement shows profitability by listing income and expenses. Sometimes income and cash inflows are the same, such as the sale of products or services where the money gets received and deposited at the same time as the sale. Sometimes expenses and cash outflows are the same, such as the purchase of products or services where the money gets spent at the same time as the purchase.

However, this is not always the case. For example, if a company borrows money to purchase a large piece of machinery, the down payment at the time of purchase would be a cash outflow along with the annual principle and interest payments. The piece of machinery would be a capital asset and its depreciation would get listed as an expense line time on an income statement.

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