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A Complete Guide to Cash Flow Analysis

A Complete Guide to Cash Flow Analysis

Cash flow refers to how much cash and other liquid assets like shares a business spends and earns over a specific period of time.

The amount of cash on hand establishes how much flexibility a business has; the less cash you spend, the more space you have, and higher the valuation.

It’s different from profit in the sense that, unlike profit, it does not refer to the money that is remaining after subtracting your business expenditure from your total income.

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Understanding Cash Flow Analysis

In order to ascertain how liquid and solvent your business is, you need to track and study three types of cash flow:

  • Cash flow from business operations
  • Cash flow from financing activities
  • Cash flow from investments

All of the above are included in the cash flow statement of an organization.

During a cash flow analysis, companies compare transactions in these three categories to check the revenue and expense sources.

This helps them to establish the status of the company currently.

Remember, however, that spending money is not always bad, and bringing revenues in may not always be good – it depends on the type of cash flow.

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  • Analyzing cash flow aids in understanding the amount of cash earned or spent in a specific financial period by a business
  • To maintain a viable business, it is critical to understand your sources of income and expenses
  • Profitability does not mean you have positive cash flow, and negative cash flow does not mean the business is at the loss.
  • Corollary measurements like unlevered or free cash flow can offer deeper and distinctive insights into the financial health of the business.

Explaining Cash Flow Analysis

Explaining Cash Flow Analysis

We have already seen what cash flow is and how it’s measured from various activities in one cash flow statement.

Apart from measuring the profitability of your business via the P&L statement, this analysis provides vital information about its financial status.

This statement sets out the source of the money: sales, investors, loans, or anything else.

Similarly, it tells you about the cash outflows too.

A temporary negative cash flow is usually not a big problem but if it continues for a long time, most businesses would not be able to sustain it.

A newly established business is likely to spend more on marketing and growth-oriented activities and hence is likely to have negative cash flow.

As long as creditors and investors are ready to provide continued support, it won’t be a problem.

However, it is essential that the cash flow becomes positive to ensure the business stays viable.

It’s only when you review your cash flow statements properly that you can discover if there any problems or if there is a healthy cash flow.

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Additionally, you need to look into different cash flow versions like free cash flow which looks at expenses, not of a cash nature, interest payments, working capital changes, etc. which give you a better picture of your operational cash flows.

Your cash flow before considering your financial obligations is unlevered free cash flow, and levered free cash flow is about cash flow post those obligations.

Assessing and following the different cash flows could be very valuable when it comes to financial planning for future financial periods, and even in preparing for possible economic slumps or low sales.

Cash Flow Analysis Basics

First off you need to generate a cash flow statement about the three types of cash flows.

  • Operating activities cash flow show cash received from sales, after deducting operating expenses including salaries, utilities, rent, and supplies.
  • Investment activities cash flow shows funds spent in acquiring long-term investments like property and other fixed assets, and shares and other financial instruments.
  • Financing activities cash flow shows your borrowings, lending, the money you put in, and so on.

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Importance of Cash Flow Analysis

Now that we have understood what cash flow analysis is in detail, let us look at the importance of cash flow analysis.

A cash flow analysis establishes the working capital of a business.

This is the money that the business has for running everyday operations and completing transactions.

Working capital = current assets – current liabilities. Current assets are liquid assets like cash. Current liabilities are those that are due in the upcoming accounting period.

Analyzing cash flows enable you to see whether your business can pay its dues and earn enough revenue to continue operating for the long term.

When negative cash flows continue for too long, it could potentially mean bankruptcy; positive cash flows indicate good times in the near future.

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Cash flow analysis is one of the best measures of the performance of a business due to these reasons:

It is Measurable and Comparable

Cash can be quantified, and it’s tangible and measurable in standardized units that are universally accepted.

Cash flow is very useful to compare two companies, even if they are in different industries and geo-locations.

It’s Tough to Falsify

Unscrupulous businesses often resort to profit inflation, to make it seem as if the business is doing better than it actually is; this is mainly done by artificial boosting of asset values.

The same is not possible with cash.

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It is a Universally Accepted Tangible Store of Value

You may have to convince people about the value of goodwill, intellectual property, and so on, but not about the value of say SAR 2 million cash.

That everyone knows, and values.

The Benefits of Cash Flow Analysis

The Benefits of Cash Flow Analysis

Short Term Planning

A cash flow statement is an important tool that can be used for planning in the short term, and to control cash.

Every business must have sufficient liquid assets that will allow them to meet the different financial obligations as and when they become due.

Cash flow statements enable the finance department to project the cash flow for the upcoming period, basing it on past cash inflows and outflows.

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Provides the Details of Expense Heads

Certain payments made by the company don’t show up in the profit and loss statement, but they reflect in cash flow statements.

The cash flow statement shows in detail where exactly the business spends its money.

We can understand this better with an example.

Let’s suppose a company has taken a loan and is paying the principal amount off; this will not turn up in the P&L statement, but it will be reflected in the cash flow statement.

Again, a situation where the company is profitable but lacks the liquidity to pay off its dues.

All such issues can be easily detected with the cash flow analysis.

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Creates Additional Cash

The primary aim of any business is to be profitable, and it’s the profit that helps in creating cash.

However, there are other ways in which cash can be created in a business, and these can be identified by analyzing cash flows.

If you depend solely on profit and loss statements, creating additional cash can be very difficult.

For example, more efficient use of your inventory, collecting receivables quicker from your customers, and so on, can help you bring in excess cash – and this information is available in your cash flow statement.

Revealing the Cash Planning Results

Cash flow statements help companies evaluate the success of their cash planning by comparing the actual results with the projections laid out in the cash budget or statement.

These insights will help businesses take better decisions for the future.

Let us suppose that the company predicted an expense of SAR 5000 for acquiring a particular capital asset but the actual amount came to SAR 7500.

The difference between the projected and actual expenditure can be recognized and factored into the projection for the next financial period.

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Long Term Planning

Cash flow analysis and prepared cash flow statements help businesses plan long-term cash requirements.

Business growth depends on the savvy long-term financial planning the company does.

The cash flow statement uncovers the crucial changes a company must make in its financial planning and allows the management to prioritize important activities.

For example, the cash flow projection can help management to determine the ability of the business to repay long-term debts as it depends on cash availability.

Knowing the Optimal Cash Balance

Cash flow statements also help businesses to determine the optimal cash balance level, which helps management to see if there is an excess or shortage of cash and if funds are lying idle.

These factors help businesses to take smart decisions around cash planning.

Let’s say the statement shows a cash surplus, and there are funds lying idle; this money can be invested.

On the other hand, if there’s a deficit, money can be borrowed in time to overcome the deficit.

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Helps in Working Capital Analysis

Working capital refers to the liquid assets like cash that the business has in hand to run its daily operations.

It is important for investors to be aware of the movement of the working capital of a business.

Cash flow can be increased by collecting receivables faster, settling payables later, and so on.

Performing The Cash Flow Analysis

Performing The Cash Flow Analysis

The first step in performing a cash flow analysis is to get the three different cash flow statements ready.

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Generating the Cash Flow Statement

The most commonly included line items in the cash flow statement are:

  • Proceeds of sales of goods and services
  • Payments to employees
  • Payments to vendors for supplies and inventory
  • Rents, lease payments
  • Payments of utility bills
  • Interest on loans or any long-term debt
  • Interest earned on deposits or loans provided
  • Any fines or penalties paid
  • Cash settlement received from lawsuits
  • Payments made for repairs, maintenance, etc.

Two methods are commonly used in the calculation and preparation of the operational activities part of the statements: direct and indirect methods.

In the direct method, all the cash payments from operational activities are deducted from the total cash inflows from operations.

In the indirect method, the non-cash inflow and expenses are deducted from the net income.

Next comes the investment cash flow statement.

Here the end result is arrived at by deducting the amount spent on acquiring stocks and assets, and outstanding loans, from the amount earned through the selling of stock and assets, and loans repaid.

Lastly, financing cash flow refers to the cash that moves between a business and its creditors, investors, and owners.

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The Five Steps Involved in Cash Flow Analysis

The Five Steps Involved in Cash Flow Analysis

When performing the analysis, these are the trends to watch out for:

  • Is the operating cash flow positive? This indicates that the company will be able to stay solvent and attain business growth in a sustainable manner.
  • Negative operational cash flow with positive investment cash flow may mean that the business is selling assets to meet its operational costs – unsustainable in the long run.
  • Negative cash flow is not always an indicator of trouble in investment cash flow as it usually indicates investment in equipment and property for expanding business. Combined with positive operational cash flows, it signifies that the business is in growth mode.
  • Free cash flow is what the business has with it after paying operational and capital expenses, and can be used to pay principal and interest on loans, buy stock, and so on.
  • Cash on hand from operations expressed as a percentage of income from sales in a specific period is the operational cash flow margin. Positive margins indicate profitability and efficiency and build trust among investors.

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Analyze Cash Flow With Software

Calculating free cash flow and analyzing it can be complicated and daunting, especially for large organizations.

But with robust financial accounting software from Tranquil, you can rest easy.

All you need to do is configure your reports and, in a few minutes and with minimal effort, you can get details of cash flows, free cash flows, and more.

With an efficient ERP solution like Tranquil, you can automate all of these activities, and get AI-driven insights, enabling you to work with fewer employees. Do schedule a demo at your convenient time, and we’ll show you how Tranquil Cloud ERP can help your business meet its cash flow requirements efficiently.


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