Cash Flow Analysis: The Basics (2024)

Cash flow analysis is an important aspect of a company's financial management because it underscores the cash that's available to pay bills and make purchases—generally, money it needs to run and grow the business.

Companies, investors, and analysts examine cash flow for various reasons, including for insight into a company's financial stability and health and to inform decisions about possibly investing in a company.

Why Cash Flow Analysis Is Important

Cash is important to every business. Having enough money to pay the bills, purchase needed assets, and operate a business to make a profit is vital to a company's success and longevity.

A company must understand how well it is generating cash and how much it has. That way, it can take corrective action, if needed. When you track your finances, including where cash comes from and where it goes, you can place yourself in a better position to plan business activities and company operations that lead to profits and growth.

Cash flow analysis examines the cash that flows into and out of a company—where it comes from, what it goes to, and the amounts for each. The net cash flow figure for any period is calculated as current assets minus current liabilities.

Ongoing positive cash flow points to a company that is operating on a strong footing. Continued negative cash flow may indicate a company is in financial trouble.

A company's cash flows can be determined by the figures that appear on its statement of cash flows.

Cash Flow Statement

Before it can analyze cash flow, a company must prepare a cash flow statement that shows allcashinflows that it receives from its ongoing operations and external investment sources, as well as all cash outflows that pay forbusiness activitiesand investments during a given quarter.

The three distinct sections of the cash flow statement cover cash flows from operating activities (CFO), cash flows from investing (CFI), and cash flows from financing (CFF) activities.

Cash Flow From Operations

This section reports the amount of cash from the income statement that was originally reported on an accrual basis.A few of the items included in this section are accounts receivable, accounts payable,and income taxes payable.

If a client pays a receivable, it would be recorded as cashfrom operations.Changes in current assets or current liabilities (items duein one year or less) are recorded as cash flow from operations.

Cash Flow From Investing

This section records the cash flow fromcapital expenditures and sales of long-term investments like fixed assets related toplant, property, and equipment. Specific items might include vehicles, furniture, buildings, or land.

Other expenditures that generate cash outflows could include business acquisitions and the purchase of investment securities. Cash inflows come from the sale of assets, businesses, and securities.

Investors typically monitor capital expenditures used forthe maintenance of, and additions to, a company's physical assets to support the company'soperation and competitiveness. In short, investors want to see whether and how a company is investing in itself.

Cash Flow From Financing

Debt and equity transactions are reported in this section. Any cash flows that include payment of dividends, the repurchase or sale of stocks, and bonds would be considered cash flow from financing activities. Cash received from taking out a loan or cash used to pay down long-term debt would also berecorded here.

For investors who prefer dividend-paying companies, this section is important because, as mentioned, it showscash dividends paid. Cash, notnet income, is used to pay dividends to shareholders.

Cash Flow Analysis

A company's cash flow is the figure that appears at the bottom of the cash flow statement. It might be labeled as "ending cash balance" or "net change in cash account." Cash flow is also considered to be the net cash amounts from each of the three sections (operations, investing, financing).

One can conduct a basic cash flow analysis by examining the cash flow statement, determining whether there is net negative or positive cash flow, pinpointing how the outflows compare to inflows, and draw conclusions from that.

However, there is no universally-accepted definition of cash flow. For instance, many financial professionals consider a company's net operating cash flow to be the sum of its net income, depreciation, and amortization (non-cash charges in the income statement). While often coming close to net operating cash flow, this interpretation can be inaccurate, and investors should stick with using the net operating cash flow figure from the cash flow statement.

While cash flow analysis can include several ratios, the following indicators provide a starting point for an investor to measure the investment quality of a company's cash flow.

Operating Cash Flow/Net Sales

This ratio, which is expressed as a percentage of a company's net operating cash flow to its net sales, or revenue (from the income statement), tells us how many dollars of cash are generated for every dollar of sales.

There is no exact percentage to look for, butthe higher the percentage, the better. It should also be noted that industry and company ratios will vary widely. Investors should track this indicator's performance historically to detect significant variances from the company's average cash flow/sales relationship along with how the company's ratio compares to its peers.

It is also essential to monitorhow cash flow increases as sales increase sinceit'simportant that they move at a similar rate over time.

Free Cash Flow

Free cash flow (FCF) is often defined as the net operating cash flow minus capital expenditures. Free cash flowis an important measurement since itshows how efficient a company isat generating cash. Investors use free cash flow to measure whether a company might have enough cash,after fundingoperations and capital expenditures, to pay investors throughdividendsandshare buybacks.

To calculate FCF from thecash flow statement, find the itemcash flow from operations—also referred to as "operating cash" or "net cash from operating activities"—and subtract capital expendituresrequired for current operations from it.

You can go one step further by expanding what'sincluded in the free cash flow number. For example, in addition to capital expenditures, you could include dividends for the amount to be subtracted from net operating cash flow to arrive at a more comprehensive free cash flow figure. This figure could then be compared to sales, asshown earlier.

As a practical matter, if a company has a history of dividend payments, it cannot easily suspend or eliminate them without causing shareholders some real pain. Even dividend payout reductions, while less injurious, are problematic for many shareholders. For some industries,investorsconsiderdividend paymentsto benecessary cash outlays similar tocapital expenditures.

It's important to monitor free cashflow over multiple periods and compare the figures to companies within the same industry. If free cash flow is positive, it should indicatethe company can meet its obligations, including funding its operating activities and paying dividends.

Comprehensive Free Cash Flow Coverage

You can calculate a comprehensive free cash flow ratio by dividing the free cash flow by net operating cash flow to get a percentage ratio. Again,the higher the percentage, the better.

Example of Cash Flow Analysis

Let's say Acme Company produces a cash flow statement showing the cash flows below. It would use that to conduct a basic cash flow analysis.

Cash flow from operations

Net income $400,000

Payroll $65,000

Depreciation $10,000

Office rent $25,000

Accounts receivables $15,000

Net cash from operations $315,000

Cash flow from investing

Equipment sales $100,000

Property purchase $75,000

Net cash from investing $25,000

Cash flow from financing

Loan payment $20,000

Net cash from financing ($20,000)

Net change in cash account $320,000

Acme's cash flow statement indicates that net cash flowfor the financial periodwas $320,000. Most of its positive cash flow came from its operations.

That means that Acme is generating a large percentage of revenue from its operations. Continuing to look at the statement, an investor would also see that Acme bought property and paid down a loan. That can indicate that it's using its cash to for growth purposes and to reduce its debt position. Investors should be pleased with that.

What Cash Flow Analysis Can Tell You

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 always the goal. When it continues over a number of consecutive periods, it demonstrates that a company is capable of healthy operations and can grow successfully.

However, keep an eye out for positive investing cash flow and negative operating cash flow. This could mean trouble ahead if, for instance, cash flowing from the sale of investments is being used to pay operating expenses.

Negative Cash Flow

Negative cash flow may indicate something other than financial trouble. For instance, investing cash flow might be negative because a company is spending money on assets that improve operations and the products it sells.

Free Cash Flow

Having free cash flow is a great advantage. It's the cash flowavailable 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, and more.

Operating Cash Flow Margin

The operating cash flow margin ratio compares cash from operating activities to sales revenue in a particular period. A positive margin shows that a company is able to convert sales to cash and can indicate profitability and earnings quality.

Limitations of Cash Flow Analysis

• The cash flow statement presents past data. It might not be a big help on its own to analysts and investors who want to properly size up a company as an investment. For example, cash flow data that shows investments made point to an outflow (that could contribute to a negative cash flow). But those investments may result in future positive cash flow, profits, and major growth.
• It doesn't depict a company's net income because it doesn't include non-cash items. The income statement must be examined to determine these.
• It doesn't present a full picture of a company's liquidity, just the cash available at the end of one period.

How Cash Flow Is Accounted for

There are two forms of accounting that determine how cash moves within a company's financial statements. They are accrual accounting and cash accounting.

Accrual Accounting

Accrualaccounting is used by most public companies.It reportsrevenue as income when it's earned rather than when the company receives payment.Expenses are reported whenincurred, even though no cashpayments have been made.

For example, if a company records a sale, the revenue is recognized on the income statement,but the company may not receive cash until a later date. From an accounting standpoint, the company would beearning a profit and payincome taxeson it. However, no cashwould have been exchanged.

The transaction would likelyinvolve an outflow of cash initially, since it costs money for the company to buy inventory and manufacturethe product to be sold.

It's common for businesses to extend terms of 30,60, or even 90 daysfor a customerto pay the invoice. The sale would be anaccounts receivable with no impact on cashuntil collected.

Cash Accounting

Cashaccounting is an accounting method in which payment receipts are recorded in the period they are received, and expenses are recorded in the period in which they are paid. In other words, revenues and expenses are recorded when cash is received and paid, respectively.

Acompany's profit is shown as net incomeon the income statement. Net income is thebottom line for the company. However, because of accrual accounting, net income doesn't necessarily mean that all receivables were collected from customers.

From an accounting standpoint, the company might be profitable, but if receivables become past due or uncollected,the company could run into financial problems.Even profitable companies can fail to adequately manage their cash flow, which is why a cash flowstatement is a critical tool for analysts and investors.

The Bottom Line

If a company's cash flow is continually positive, it'sa strong indication that the company is in a good position to avoid excessive borrowing, expand its business, pay dividends, and weather hard times.

Free cash flow is an important evaluative indicator for investors. It captures all the positive qualities of internally produced cash from a company's operations and monitors the use of cash forcapital expenditures.