A cash flow analysis is a crucial part of a business’s financial management as it indicates how much cash is available to settle bills and invest in the business. The analysis is more than accounting profit, which can be affected by items that are not cash expenses like depreciation expenses or goodwill write-off.
Rather, cash flow analysis is on the cash that a company has to cover its operating costs, repay the debt, and invest in growth.
A company’s cash flow statement details the ways in which cash has flowed in and out of the business over a specific time period, by which investors can analyze the cash flow.
There are many different reasons that businesses, investors, or analysts may look at cash flow statements, such as to assess a company’s financial stability and health, or to make a decision about whether they plan to invest in a company. In the end, investors are interested in companies that can produce steady and positive cash flow – companies that have this are more likely to be able to grow and survive if there is a downturn in the market.
Importance of Cash Flow Analysis
“Cash is King” as they say. A company’s success will depend largely upon its ability to pay its bills, buy its assets and maintain a profitable business.
In addition, cash flow is a better indicator of a company’s liquidity than net profits because cash flow shows how much cash a company has on hand to pay its bills, replenish its inventory, and invest in its growth.
The company also should have a knowledge of its cash generating ability. Knowing how to track cash inflows and outflows will enable businesses to plan their operations and activities for increased profits and growth.
Cash flow analysis looks at cash that enters and leaves a business, how it comes from the business, where it goes, and the cash that remains. Positive cash flow is a sign of financial stability, and if the cash flow is constantly negative, it may mean financial difficulties. The cash flow of a company is recorded in the company’s statement of cash flows.
The Cash Flow Statement
A company can’t analyze cash flow until it creates a cash flow statement that includes all cash inflow it receives as a result of its current business operations and other investment sources, and all cash outflow that is used to pay for business activities and investments during a specific quarter.
The cash flow statement has three sections: cash flows from operating activities (CFO), cash flows from investing activities (CFI), and cash flows from financing activities (CFF).
Cash Flow From Operations
This is the cash that is the equivalent of an accrual basis item on the income statement. Accounts receivable, accounts payable, and income taxes payable are some of the items included in this section.
In case of cash receipt on a receivable, it would be cash from operations. If there is a change in current assets or current liabilities (those payable within one year) it is classified as cash flow from operations.
Cash Flow From Investing
This section shows cash flows resulting from long-term investments such as plant, property and equipment (PPE) purchased and sold. They could be a vehicle, furniture, buildings or land.
Other expenses that can be cash outflows can be business acquisition or investment securities. Cash inflows are realized from the sale of assets and businesses and securities.
The periodic tracking of capital expenditures—incurred to sustain or enhance a business’s tangible assets, such as labor-intensive equipment, buildings, and land—is one of the most common ways to gauge a company’s investments. Bottom line: investors are looking to see if and how a company is investing in itself.
Cash Flow From Financing
Debt and equity transactions are included in this section. Cash flows involving repurchasing or selling stocks and bonds, as well as cash flows involving dividends paid would be considered financing cash flows. Any cash received from a loan or cash used to pay off long-term debt would show here as well.
The section is significant for investors who like companies that pay dividends since, like said, it displays cash dividends paid. Cash, not net income, is used to pay dividends to shareholders.
Analyzing Cash Flow
The number that is at the bottom of a cash flow statement is a company’s cash flow. It may be referred to as “ending cash balance” or “net change in cash account. Cash flow is also considered the net cash amounts from each of the three sections (operations, investing, financing).
The following is a simple cash flow analysis that can be done by reviewing the Cash Flow Statement and determining if there is a net negative or positive cash flow, which variables are greater than the other, and making a conclusion about that.
However, there’s no universally accepted definition of cash flow. When net operating cash flow is used, for example, many financial experts will add a company’s net income, depreciation, and amortization (non-cash charges in the income statement) to their calculations.
This definition is similar to net operating cash flow but can be misleading, and investors will likely want to use the net operating cash flow figure found on the cash flow statement.
While there will be a few ratios that can be used in cash flow analysis, some are very important to consider when determining the quality of a company’s cash flow.
Return on Operating Cash Flow to Net Sales
This ratio is calculated as a percentage of a company’s net operating cash flow and net sales or net revenue (from the income statement). It indicates how many dollars of cash are generated for every dollar of sales.
There’s no exact percentage to look for, but the higher the percentage, the better. There will be significant differences in industry and company ratios too. Investors should track this indicator’s performance historically to detect significant variances from the company’s average cash flow/sales relationship and how the company’s ratio compares to its peers.
Also, it is important to keep track of the enterprise’s cash flow as sales rise to ensure that the cash flow matches the rise in sales. A company with expanding sales as compared to cash flow may experience cash flow problems.
Free Cash Flow
Net operating cash flow (NOCF) minus capital expenditures is a common method for determining free cash flow (FCF). It is a crucial indicator as it reflects a company’s cash generating efficiency. FCF is important because it allows investors to see whether a company has sufficient cash on hand to pay their investors dividends and/or repurchase stock.
The cash flow statement can be used to calculate FCF; simply subtract capital expenditures from cash flow from operations, or “operating cash” or “net cash from operating activities. This number can be further adjusted by removing other cash expenses like dividends to get a more complete Free Cash Flow number.
If a company pays dividends, it is not going to be able to suspend or cancel them with ease without inflicting hardship on its shareholders. Reduced dividends – although less harmful – are an issue for many stockholders.
For some industries, investors consider dividend payments as necessary cash outlays similar to capital expenditures.
It is crucial to keep track of the FCF over the years and make comparisons with other companies in the industry. Positive FCF indicates that the company has sufficient cash to fund its operations and pay its debt obligations, such as paying dividends. If dividends are regarded as essential in industries, then an uninterrupted FCF is important to build the trust of shareholders.
It’s time to take a closer look at how well a company is covering its free cash flow.
One way to determine a complete FCF ratio is to divide the FCF by the net operating cash flow to obtain a percentage ratio. The higher the %, the better the company is at creating free cash flow from its business operations, generally a good sign of financial strength.
Insights from Cash Flow Analysis
Cash flow analysis can lend insight into the financial vibrancy or financial instability of a company and its prospect as a good investment. Bear in mind these points when analyzing cash flow:
Positive Cash Flow
Positive cash flow is generally a desired outcome for most businesses, and a positive cash flow in several consecutive quarters is seen as a sign that the business is operating efficiently and has growth prospects to look forward to.
But look out for positive investing cash flow and negative operating cash flow. This may indicate trouble, and could mean that the company is selling assets or investments to meet its operating costs, which is not sustainable in the long run.
Negative Cash Flow
Negative cash flow doesn’t always mean that there is a financial problem. For example, cash flow could be negative if an enterprise invests in an asset that enhances operations and the products it sells. Likewise, a startup could experience negative cash flow as it has been receiving capital from investors and is putting money into business development and profitability in the future.
Free Cash Flow
Having positive free cash flow is a great advantage. It’s the cash available after paying operating expenses and purchasing needed capital assets. A company can use its free cash flow to pay off debt, pay dividends and interest to investors, or re-invest in the business for growth.
Operating Cash Flow Margin
Operating cash flow margin ratio is the ratio of cash generated from operating activities to sales during a specific period. A positive margin means that a business can turn sales into cash and can mean it is profitable and that its earnings quality is good.
Cash Flow Analysis: Limitations
The cash flow statement reports facts about the company’s cash flows that have already happened. It may not be very helpful for analysts and investors who want to have a proper evaluation of an investment. For instance, cash flow from investments may be in the red in the short term but positive cash flow may result in future growth, profits and positive cash flow.
It does not necessarily represent the net income of a company since it doesn’t include non-cash items. The income statement must be examined to determine these.
Lastly, cash flow analysis presents a picture of cash on hand at the end of a period, but cannot give a full picture of the company’s overall liquidity.
Accounting for Cash Flow
There are two types of accounting which govern the flow of cash in and out of a business’s financial statements. They are accrual accounting and cash accounting.
Accrual Accounting
Accrual accounting is the typical method of accounting for most public companies. It considers revenue to be income when it is generated, not when it is paid by the company. Expenses are reported when incurred, even though no cash payments have been made.
For instance, a business may make a sale then not collect the cash until later in the period. On an accounting basis, the company will be making a profit and will have to pay income taxes on that profit, but no cash will have changed hands.
The transaction would most likely be a cash outflow first, because the company would have to spend money to purchase inventory, and then produce the product to sell.
It is a common practice for businesses to offer terms of 30, 60 or even 90 days to a customer for the payment of the invoice. This sale would be an accounts receivable, and would not affect cash until collected.
Cash Accounting
Cash accounting is an accounting system where cash received is reported in the same period as cash received, and the cash paid is reported in the same period as cash paid. That is, revenues and costs are matched when cash is collected and paid, respectively.
Net income on income statement represents a company’s profit. The company’s net income is the bottom line of the company. But, due to accrual accounting, net income does not necessarily equate with all of the collected revenues from customers.
The company can be profitable at an accounting level, but if the receivables become past due or uncollected, then problems can arise for the company financially. As such, a cash flow statement is a key instrument for analysts and investors, even for profitable companies that may not be managing cash flow well.
What Is Cash Flow Analysis?
Cash flow analysis is an examination of cash that enters a company and cash that leaves the company to determine the net amount of cash within the company. If it is established that cash is flowing in or out, the company management can search for ways to change it to boost the company’s position.
What Are the 3 Types of Cash Flows?
The three categories of cash flow are cash flows from operations (cash generated by the company’s core business activities, like sales and payments for goods and services), cash flows from investing (cash used in or generated from the purchase and sale of long-term assets), and cash flows from financing activities (cash received from or paid to investors and lenders, like the sale of stock, the payment of dividends, or the repayment of loans).
How can Cash Flow Calculations be Made?
One of the easiest methods of cash flow calculation is to add all of the cash inflows to the total and then subtract total cash outflows from that total. After determining a cash flow number, you can determine other ratios (such as operating cash flow/net sales) for a more thorough cash flow analysis.
The Bottom Line
When a company maintains a positive cash flow on a regular basis, it’s a positive sign that the company is in a good position to pay obligations with minimal borrowing, expand the business, pay dividends and survive economic downturns.
Free cash flow is a metric that is closely examined by most investors because it provides information on how effectively a company is using its cash and whether, or not, it is generating it. This is why free cash flow is a key metric of a company’s long-term health and growth potential.
