Definition: Cash Flow Analysis is the evaluation of a company’s cash inflows and outflows from operations, financing activities, and investing activities. In other words, this is an examination of how the company is generating its money, where it is coming from, and what it means about the value of the overall company.
What Does Cash Flow Analysis Mean?
Cash Flow Analysis is a technique used by investors and businesses to determine the value of overall companies as well as the individual branches of large companies by looking at how much excess cash they produce. They typically use the Statement of Cash Flows, a document that shows the actual cash that came in and out of the business during a certain period from investing activities, financing activities, and operational activities, as well as a few other reports.
Why Is Cash Flow Analysis Important?
Creating a cash flow statement is a great first step, but if you don’t know how to read or analyze it, it’s not incredibly useful. A cash flow analysis gives you a well-rounded picture of your business’s financial health. Just as keeping an eye on your personal checkbook balance tells you whether you can afford certain personal expenses, regularly analyzing your business cash flow will tell you whether you’ll be able to make payroll, pay your suppliers, buy the materials to fulfill orders, or carry out expansion plans.
If your cash flow analysis shows you’re running short of cash to meet expenses, you can plan ways to cut costs, obtain short-term financing, or take steps to accelerate income. If your cash flow analysis shows you have extra cash on hand, consider whether to invest it in new equipment or save for future slow periods.
Keep in mind that having a lot of cash on hand doesn’t necessarily mean your business is profitable—that’s determined by your profit margins. Conversely, even a business with strong profit margins can get into financial trouble if it doesn’t have the cash on hand to pay the bills. And a business that has a lot of debt at one point in time can still be financially strong as long as the owner knows projected cash flow can be relied on to cover the debts.
Step by Step Cash Flow Statements Analysis
Cash Flow Analysis is divided into three parts – Cash flow from Operations, Cash flow from Investments, and Cash flow from financing. We discuss each of these one by one.
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 receivables, accounts payables, and income taxes payable.
If a client pays a receivable, it would be recorded as cash from operations. Changes in current assets or current liabilities (items due in one year or less) are recorded as cash flow from operations.
Cash Flow From Investing
This sectionrecords the cash flow from sales and purchases of long-term investments like fixed assetsthat include property, plant, and equipment. Items included in this section are purchases of vehicles, furniture, buildings, or land.
Typically, investing transactions generate cash outflows, such as capital expenditures for plant, property and equipment, 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 for the maintenance of, and additions to, a company’s physical assets to support the company’s operation and competitiveness. In short, investors can see how a company is investing in itself.
Cash Flows 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 for financing activities. Cash received from taking out a loan, or cash used to pay down long-term debt would be recorded in this section.
For investors who prefer dividend-paying companies, this section is important since it shows cash dividends paid since cash, not net income is used to pay dividends to shareholders.
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 for capital expenditures. If a company’s cash generation is positive, it’s a strong indicator that the company is in a good position to avoid excessive borrowing, expand its business, pay dividends, and weather hard times.
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