Cash flow analysis plays an important role in a company’s financial management because it shows how much cash a company has to pay its bills and reinvest in the business.
This analysis goes beyond accounting profits. Accounting profits can be influenced by non-cash items such as depreciation or goodwill write-offs.
Instead of focusing on cash, cash flow analysis focuses on the cash that a company actually has available to pay its operating expenses, pay off debt, and reinvest in growth.
Investors can do this analysis by looking at a company’s cash flow statement. This statement details how cash came in and went out during a given period.
Companies, Investors and analysts examine cash flow to determine the financial stability and health of a company and to make investment decisions.
Ultimately, investors are more interested in businesses that can generate consistent positive cash flow. This is because such businesses are better equipped to expand their businesses or withstand market shocks!
Why is cash flow analysis important?
As the saying goes, “cash is king.” Having enough cash to pay bills, buy assets, and operate profitably is critical to a company’s long-term success.
Furthermore, even if a company appears to be making a profit based on net profits, cash flow provides a more accurate picture of its current liquidity. Cash flow shows whether it has enough cash to cover expenses, replenish inventory, or invest in growth.
It is also important to understand how well a company is generating its cash. By tracking cash inflows and outflows, businesses can better plan for activities and activities that will drive profitability and growth.
What is a Cash Flow Statement?
Before a company can analyze its cash flow, it must first prepare a “cash flow statement.” This statement shows all cash inflows (inflows) from operating activities and external investments during a given quarter.
It also shows all cash outflows (outflows) from operating activities and investments.
The cash flow statement has three separate sections:
- Cash Flow from Operating Activities (CFO): Cash generated from regular business operations.
- Cash Flow from Investing (CFI): Cash generated from buying/selling assets.
- Cash Flow from Financing (CFF): Cash generated from borrowing/repaying debt, Cash from share issuance.
Cash Flow From Operations
This section shows the actual cash flow from the company’s income statement, compared to the amount originally recorded on an accrual basis.
Some items included in this section are Accounts Receivable, Accounts Payable, and Income Taxes Payable.
For example, if a customer pays a receivable, it is recorded as cash from operations.
Changes in Current Assets or Current Liabilities (things due within one year or less) are recorded as cash flows from operations.
Cash Flow From Investing
This section records the cash flow from capital expenditures and the sale of long-term investments such as plant, property, and equipment (PPE). Items included here include vehicles, furniture, buildings, or land.
- Outflows: These are cash outflows, such as the purchase of businesses or investment securities.
- Inflows: These are cash inflows from the sale of assets, businesses, and investment securities.
Investors primarily monitor capital expenditures, which are used to maintain and expand physical assets to support the company’s operations and competitiveness. In short, investors want to know how the company is investing in itself.
Cash Flow From Financing
This section shows the cash flows that arise from debt and equity issues.
- Cash flows from paying dividends, or buying back or selling stocks and bonds are all considered cash flows from financing activities.
- Cash received from borrowings or cash used to pay down long-term debt is also recorded in this section.
This section is important for investors who like companies that pay dividends because it shows the amount of profit that is paid out. This is important because it uses actual cash, not net income, to pay dividends to shareholders.
Cash Flow Analysis
Cash Flow is the number that appears at the bottom of a cash flow statement. It may be called the “ending cash balance” or the “net change in cash account.” It is the sum of the net cash from all three categories (operating, investing, and financing).
Fundamental analysis can be performed by examining the cash flow statement. It determines whether the net cash flow is positive or negative, and it can be used to determine how the cash flow compares to the cash flow.
However, there is no universally agreed-upon definition of cash flow. For example, many financial experts consider a company’s net operating cash flow to be the sum of net income, depreciation, and other non-cash expenses (amortization).
This definition is close to net operating cash flow, but it is not exact. Therefore, investors should only use the actual net operating cash flow figure from the cash flow statement.
While cash flow analysis can involve many ratios, there are a few key indicators that are essential for assessing the quality of a company’s cash flow.
Operating Cash Flow to Net Sales Ratio
This ratio is expressed as a percentage of a company’s net operating cash flow to net sales (or revenue). This ratio indicates how many dollars of cash are generated for every dollar of sales.
There is no set percentage. But the higher the percentage, the better. Ratios can vary greatly by industry and company.
Investors should track this ratio’s historical performance. This will help them see if there is a significant difference between the company’s average cash flow to sales ratio and that of other companies in the industry.
It is also important to watch to see if cash flow is keeping pace with sales growth. A business whose sales are growing faster than cash flow may face short-term liquidity issues.
Free Cash Flow (FCF)
Free Cash Flow (FCF) is typically defined as net operating cash flow minus capital expenditures. It is an important measure of how efficiently a company generates cash.
Investors rely on FCF to determine whether there is enough cash left over after paying operating expenses and capital expenditures to pay dividends to shareholders and repurchase shares.
To calculate FCF from the Cash Flow Statement, take “Cash from Operating Operations” (or “Net Operating Cash”) and subtract capital expenditures. If you want a more complete FCF, you can subtract additional cash flows, such as dividends.
Companies that pay dividends are not likely to upset shareholders, and it is not easy to suddenly stop or eliminate these dividends.
Even a reduction in dividends can be a problem for many shareholders. In some industries, investors consider dividends as a necessary cash flow, such as capital expenditure.
It is important to monitor FCF over time and compare it to other competitors. A positive FCF indicates that the company can meet its operating expenses and liabilities.
In industries where dividends are considered essential, having consistent FCF is key to maintaining shareholder confidence!
Calculating Free Cash Flow Coverage
The Comprehensive Free Cash Flow Ratio can be calculated. It is simply expressed as a percentage of free cash flow (FCF) divided by net operating cash flow.
The higher this ratio, the better:
- A higher ratio indicates that a company is generating free cash flow more efficiently compared to its operating activities.
- This is generally a positive sign of financial strength.
Cash Flow Analysis Example
Let’s look at Acme Company’s cash flow statement and do a basic analysis. Here’s a summary of their cash flows for a fiscal period. (It’s presented in terms of interest and profit).
- Cash Flow from Operating Activities: After deducting net income, payroll, depreciation, and office rent, we have a net cash flow of $315,000. (This is the best possible result.)
- Cash Flow from Investing: After deducting the proceeds from the sale of equipment and the purchase of property, we have a net cash flow of $25,000. (There are more sales than purchases.)
- Cash Flow from Financing: Net cash flow ($20,000) is reduced by paying down debt. (The negative number is a debt payment.)
A look at Acme’s cash flow statement indicates that the net cash flow for the period was $320,000. Most of this positive cash flow came from operating activities.
This means that Acme is able to generate a lot of cash from its regular operations. The statement also shows that Acme is investing in assets while paying down debt.
This indicates that the company is preparing itself for growth and is working to improve its financial health. Investors will likely like this situation.
What can cash flow analysis tell you?
Cash flow analysis can provide insight into a company’s financial activity or financial volatility, and can also help you determine whether it is a good investment. Keep these points in mind when analyzing cash flow:
Positive Cash Flow
Positive cash flow is the goal of most businesses, and if it is consistently generated, it indicates that the company is operating efficiently and has the potential to grow.
However, be careful if the cash flow from investing is positive and the cash flow from operating is negative. This situation could indicate a problem. This is because it could mean that the company is selling assets or investments to cover operating expenses, which is not sustainable in the long run.
Negative Cash Flow
A negative cash flow does not always indicate financial distress. For example, a company may have negative cash flow from investments because it is spending money to buy assets that will improve its operations and products. Similarly, a startup may have negative cash flow because it is investing heavily in future growth and profitability, receiving money from investors.
Free Cash Flow
A positive free cash flow (FCF) is a big advantage. It is the cash left over after paying operating expenses and purchasing necessary assets. The company can use this FCF to pay down debt, pay dividends and interest to shareholders, or reinvest in the business for growth.
Operating Cash Flow Margin
The operating cash flow margin is the ratio of cash generated from operating activities to sales revenue during a given period. A positive percentage shows that the company is able to convert sales into cash, indicating the profitability and quality of earnings.
Limitations of Cash Flow Analysis
The cash flow statement only shows past data. As a result, it may not be very helpful to analysts and investors who want to evaluate investments in detail.
For example, showing cash outflows from investments on the statement may result in negative cash flow in the short term, but those investments may drive future growth, profitability, and positive cash flow.
This analysis does not include non-cash items, so it cannot show the company’s net income. You must also check the income statement to find this information.
Finally, Cash flow analysis is only a snapshot of the cash available at the end of a period and does not provide a complete picture of the company’s overall liquidity.
Accounting for Cash Flow
There are two accounting methods that determine how cash flows in a company’s financial statements. These are accrual accounting and cash accounting.
- Accrual Accounting
Most public companies use this accounting system.
- This system records revenue when the cash is earned, not when the cash is actually received.
- Expenses are also recorded when they are incurred, even if the cash has not been paid.
For example, if a company records a transaction, the revenue is recognized on the income statement, but the cash is not received until later.
From an accounting perspective, the company is making a profit and paying income taxes, but no actual cash has been exchanged. In reality, there is an initial cash outflow because the cash is used to purchase or produce goods to sell.
A customer is billed 30 days, Payment terms of 60 or 90 days are common in businesses. These transactions are treated as accounts receivable and do not affect cash until the money is actually collected.
- Cash Accounting
The cash accounting system is an accounting method that records revenue in the period in which payment is received and expenses in the period in which payment is made.
In other words, revenue is recorded when cash is received and expenses are recorded when cash is paid.
A company’s profit is shown on the income statement as net income, which is also the company’s bottom line.
However, because of the general ledger system, net income does not necessarily mean that all of the money owed to customers has been collected.
From an accounting perspective, a company may be making a profit, but if the money it owes is late or not collected at all, the company may face financial problems.
So even profitable companies can fail to adequately manage their cash flow. That’s why the cash flow statement is such an important tool for analysts and investors!
What is Cash Flow Analysis?
Cash flow analysis is the process of systematically examining the amount of cash coming in and going out of a company and determining the amount of net cash left.
Once you know whether cash flow is positive or negative, company managers can look for opportunities to change the business for the better.
What are the 3 types of cash flows?
There are three main types of cash flows. These are:
- Cash Flows from Operations: This is the cash generated by a company’s main activities (such as sales or payments for goods/services).
- Cash Flows from Investing: This is the cash received or used from the purchase or sale of long-term assets (such as plant, land, and equipment).
- Cash Flows from Financing: This is the cash received from or paid back to investors and lenders. For example, it includes issuing shares, paying dividends, or repaying loans.
How to Calculate Cash Flow?
The simplest way to calculate cash flow is to:
- Add up all the total cash inflows and
- Subtract all the total cash outflows.
Cash flow = Total revenue flow – Total cash flow
Once you have this cash flow figure, you can use it to calculate various ratios (e.g. operating cash flow / net sales) for more in-depth cash flow analysis.
The Bottom Line
If a company’s cash flow is consistently positive, it is a strong indication that the company is in a good position to meet all of its obligations, support growth, pay dividends, and weather economic downturns without taking on too much debt.
Also Read: 10 Ways to Improve Cash Flow and Grow Your Profits
Most investors closely analyze free cash flow (FCF). This is because FCF not only directly reflects a company’s ability to generate cash internally, but also how wisely it is reinvesting that cash or providing it to shareholders. This makes FCF an essential indicator of a company’s long-term health and growth potential.
