July 26, 2024
Whether you're a successful business owner or just starting out, a cash flow analysis is essential to bolster your business.
Having the right amount of money at the right time to pay bills and purchase items can make or break a business. A cashflow analysis gives you the insights you need to make sure your business is always one step ahead. These insights help you anticipate cash shortfalls and wisely invest surpluses.
In this guide, we provide an easy-to-understand outline of cash flow analysis covering the various methods, ratios and metrics you’ll need to assess your business’ liquidity.
We also share strategies for improving cash flow management and explore how cashflow forecasting software can help you save time and gain better insights.
Before we review the various methods and best practices for analysing cash flow, let’s first outline the basics.
Cash flow is the movement of money into and out of a business. It’s a crucial indicator of financial health, revealing how well your business can generate cash to pay debts, fund daily operations and invest in growth initiatives.
Monitoring cash flow requires regularly reviewing your business’ cash flow statement, income statement and balance sheet. These can be used to calculate metrics and ratios that help assess liquidity over a single period or multiple periods.
To gain insights into the future, cash flow forecasting techniques can help you anticipate cash movements and take a more strategic approach to financial decisions.
Business owners are aware of the enormous risk of losing money due to a lack of funds. Cash flow analysis gives you the insights at your fingertips to mitigate that risk.
By providing a detailed understanding of how your business is generating and managing cash, it helps you check that you’ve got sufficient liquidity to meet your short-term debt obligations and operational requirements.
Longer term, analysing where cash is coming from and where it’s going helps you better plan activities, asset purchases and operations that lead to profitability – not to mention avoid potential financial distress.
You can also unearth trends across multiple periods, and spot opportunities to improve inflows, reduce expenses and improve operational efficiency.
So, how do you calculate cash flow? Here we share practical methods to work out if there is more money flowing in or going out of your business for a given period.
Typically generated monthly, quarterly or annually, a cash flow statement allows you to see where your business has spent cash, the source of cash inflows and how much cash is on hand at the end of the period.
It gives you a clear picture of your business’ liquidity and financial health, allowing you to see if sufficient cash is on hand to maintain operations.
A cash flow statement provides a breakdown of cash activities for three key areas:
Operating cash flow covers transactions related to your business’ primary operations. It is calculated by taking cash from customers, dividends, or interest payments and subtracting operational expenses such as rent, salaries, or supplies.
This is the amount of money spent on long-term assets such as property, plants, and equipment, as well as investments in securities.
Financing cash flow encompasses cash raised or spent to fund the business. It covers such activities as borrowing and repaying debt, issuing and repurchasing stocks, and paying dividends.
There are two methods to choose from when preparing your business’ cash flow statement – the direct and indirect. Here we explain the pros and cons of each.
The direct method is the more straightforward of the two. It involves listing all cash transactions in your cash flow statement for the period so you can work out your net cashflow.
This is calculated by subtracting all cash outflows, like payments to suppliers or staff, from cash inflows like cash received from customers, interest or dividends.
While the direct method offers a simpler approach to cash flow analysis, it takes more time to prepare if your business uses the accrual accounting system.
This system involves recording revenue and expenses when they are incurred, rather than when cash is received or paid out. This means you will need to spend time collecting detailed records of all cash transactions for any given period.
This method is slightly more complex than the direct method, however its less time consuming to prepare as it uses the accrual system.
The indirect method does not directly calculate cash flows. Rather, it starts with net income and adjusts for various non-cash items and changes in working capital accounts.
Initially, non-cash expenses such as depreciation and amortisation are added to net income, as these expenses reduce net income but do not involve real cash outflows.
Any non-operating gains or losses, such as those from the sale of assets, are then adjusted—subtracting gains or adding losses—since these are related to investing activities, not operating activities.
Following this, changes in working capital accounts are factored in. This involves adjusting for changes in accounts receivable, inventory, accounts payable and accrued expenses.
Additionally, other non-cash items such as changes in deferred tax liabilities might be adjusted, adding back increases or subtracting decreases as necessary.
Through these adjustments, the indirect method reconciles net income to net cash provided by operating activities. This gives you a clear picture of how changes in balance sheet accounts affect cashflow and provides valuable insights into your business’ operational efficiency and financial health.
Once you have a detailed record of inflows and outflows, you can use a variety of cash flow analysis techniques to assess your business’ financial health.
Here we share five of the most fundamental ratios and metrics to analyse your cash flow statement:
This is the amount of cash you have after deducting operating and capital expenditures. It’s an important metric for assessing your business’ financial flexibility, showing you how much cash is left over to pursue growth opportunities.
Use the below formula to calculate free cash flow:
Free cash flow = operating cash flow −capital expenditures
This liquidity ratio indicates how effective your business is at generating cash from its daily operations. A higher ratio suggests your operations are healthy and generating enough cash to sustain the business.
You can use this formula to calculate operating cash flow:
Operating cash flow = operating cash flow / current liabilities
This determines how effective your business is converting sales into actual cash flow from operations. A higher ratio suggests your business is efficient in its operations and cash management, meaning it can turn a significant portion of its sales into cash.
You can use this formula to calculate cashflow margin:
Cash flow margin = Operating cash flow /sales x 100
This metric measures your business' ability to cover its debt with the cash generated from its core operations. It provides insights into your business’ solvency and financial stability by indicating how effectively you can manage debt obligations using your operating cash flow.
Cash flow to debt ratio can be calculated using the formula below:
Cash flow to debt ratio= total debt /operating cash flow
Working capital assesses your business’ ability to manage short-term financial obligations and operational efficiency. It represents the difference between your current assets and current liabilities, indicating the amount of capital available to fund daily operations.
Use the below formula to calculate working capital:
Working capital = current assets − current liabilities
Comparing your cash flow statements and ratios across multiple periods can provide insight into trends over time.
For instance, you can compare your operating cash flow margin across quarterly or annual periods to see how your cash management and operational efficiency is trending.
If operating cash flow has declined over a yearly period, but you have generated the same amount of revenue, this could mean there’s an opportunity to improve your operations and working capital management.
You could also compare your business’ cashflow against industry averages or competitors to assess relative performance.
Cash flow forecasting provides a snapshot of your business’ future liquidity, allowing you to better predict cash shortfalls, invest expected surpluses and ensure you can honour debts.
Let’s look at how you can project future cash flows and the variables that must be factored in:
This involves estimating how much your business will sell and when by analysing historic sales figures and examining current pipeline opportunities. The current dynamics of the market and your industry, as well as the economy, can also inform sales predictions.
Tracking operating expenses, capital expenditures, debt payments and costs of goods sold provides the historical data needed to help estimate future cash outflows.
Factoring in customer payment terms, supplier agreements and payments owed to your business can help with more accurate cash flow forecasting.
What would your cash flow look like if sales were to drop by 10%? Or if you expanded into a new market? With sensitivity analysis and scenario planning, you can introduce such variables to gain insight into their financial implications.
Testing multiple scenarios by varying assumptions about your sales, expenses, customers or external conditions can help you spot risks, prepare for uncertainties and make more strategic decisions.
A popular way to perform sensitivity analysis is to create best and worst-case scenarios based on your base level cash flow forecast. For example, a best-case scenario could be that your business’s expansion into a new market leads to a 20% increase in sales.
Let's look at how cash flow analysis helps you make better decisions, inform plans and gain visibility of your business’ financial health.
Cash flow analysis provides the visibility needed to see if your business has sufficient cash flowing in to cover short-term expenses and debts, and therefore if there’s enough left over to invest in new assets or initiatives.
It also enables you to assess the viability of potential investments. One way to do this is by calculating its net present value, which represents the difference between the present value of cash inflows and the present value of cash outflows over a given period.
Net present value considers the time value of money, which reflects the principle that a dollar today is worth more than a dollar in the future due to its potential earning capacity.
Knowing how much money your business will spend and receive in a given period allows you to spot potential cash shortfalls or surpluses. This insight means you can better anticipate these outcomes and create more realistic budgets.
Cash flow analysis helps you measure the financial health of your business by providing insights into liquidity, operational efficiency and stability.
Operational efficiency is gauged by examining cash flow from operating activities. Positive cash flow indicates effective management, while negative cash flow may reveal underlying issues. Analysing outflows also helps in identifying cost-saving opportunities.
Financial stability and solvency are assessed through debt management and investment capacity. Ensuring sufficient cash to meet debt obligations reduces default risk, while positive cash flow supports business reinvestment and growth.
Performance evaluation involves comparing actual cash flows with projections, enabling adjustments to strategies. Monitoring trends helps identify patterns and potential issues for proactive management.
Cash flow analysis is crucial to understanding your business’ financial health, yet it presents several challenges that can complicate an accurate assessment.
Analysts and stakeholders might confuse cash flow with profit, leading to incorrect assessments of a business’ financial health. Unlike profit, which includes non-cash items such as depreciation and amortisation, cash flow focuses solely on actual cash transactions.
Another common misinterpretation is overlooking the timing of cash flows. For instance, a business may appear to have healthy cash flow due to a large inflow from a loan, masking underlying operational cash flow issues.
Seasonal variations in cash flow can complicate analysis and forecasting. For example, retail companies often see higher cash inflows during holiday seasons and lower inflows during off-peak periods.
To manage these fluctuations, it’s essential to analyse cash flow on a rolling basis, adjusting for seasonal trends. Developing a cash reserve during peak periods can help cushion the impact of lean times.
Here we explore some practical ways you can improve your business’ working capital and cash flow practices among your staff.
Positive working capital is critical as it represents the cash available to fund your business’ daily operations.
Positive working capital means you have the cash to purchase inventory, pay rent, staff and debts. It also plays a part in qualifying for loans and credit by establishing your credibility with lenders.
If you’re facing cash flow problems, consider the following tips to help maximise your inflows:
So, how can you improve your business’ cashflow more broadly? Let’s look at some practical tips to help you do just that.
If you’re still using spreadsheets to perform cash flow analysis, there is a better way. Let’s look at how the latest cloud-based technology makes it easier.
Cash flow analysis software like Fathom offers advanced functionality to simplify your cash flow analysis.
Fathom’s cash flow analysis tool provides a visual representation of your business’ cash inflows and outflows via an intuitive waterfall chart.
It’s like a statement of cash flows but provides visuals that make it easier to identify large, unexpected outflows and see how cash is flowing through your business.
Via Fathom's waterfall chart, you can quickly determine your operating, free and net cash flow. It helps you understand the quality of cash flow, its sources and whether it’s diminishing, sustainable or subject to fluctuations.
Watch the video below to see Fathom’s cashflow analysis tool in action.
Cash flow analysis software solutions like Fathom also offer features that make forecasting simple.
Fathom brings to life cash flow forecasting with visualisations driven by comprehensive financial modelling. You can forecast up to five years into the future or set up rolling live forecasts that update as often as your financials.
Whether it’s taking on new staff or purchasing equipment, Fathom makes it easy to see the financial impact of new initiatives. Meanwhile, integration with accounting solutions like Sage Business Cloud, Xero, Quickbooks and MYOB means you don't have to spend hours importing data and creating forecasts that are soon out of date.
View the video below to see how you can easily build a cash flow forecast in Fathom.
Cash flow analysis is essential for sustaining business operations and achieving long-term growth. It can inform everything from investment and operational decisions to strategic planning and budgeting.
Let's recap some of the key learnings from this guide:
Try out Fathom’s powerful cash flow analysis and forecasting features for yourself with our free 14-day trial.
Trusted by over 80,000 businesses worldwide, this intuitive cash flow analysis software solution can also help you measure and monitor KPIs, profitability and growth, while making it easy to create customised financial reports.
You can learn more about the benefits of Fathom on our dedicated site or by exploring our blog, which contains a range of tutorial webinars and customer stories.
Kit is the Content Marketing Manager for The Access Group APAC and Fathom. He is a former journalist with extensive experience in content writing and copywriting across various industries, including higher education, not-for-profit, and finance sectors.
