What is cash flow analysis and why does it matter?

Revolut Contributor

 · 08/05/2020  · 08/05/2020

The premise of cash flow analysis is to examine how cash moves into and out of a business over a given period. At the simplest level, this horizon scanning enables the business to notice a cash flow crisis, such as running short of funds to pay its bills. On a more positive note, this style of analysis provided insights about how or when the business should invest its cash reserves for success.

What is cash flow analysis?

There are several lenses through which to explore the financial health of a business. The most common is profitability, which assesses the extent that the revenue of a business exceeds its costs. Just as crucial, though, is liquidity. This lens will reveal if the business has enough working capital to keep going without sourcing external funds or perhaps seeking extended credit terms from suppliers.

Cash flow analysis is a loose term which describes a smorgasbord of metrics that each shine a light on the liquidity of the business and –  in some cases – its profitability too. One thing that every metric of this type does have in common is that it measures the movement of cash. The clue is in the title.

What is cash flow statement analysis

The most fundamental tool of cash-flow analysis is the cash flow statement. While these statements are not obligatory for a smaller business preparing them is a smart idea, as they provide invaluable perspective about its liquidity.

The starting point for cash flow analysis is to see whether the net effect of the total cash movements over a reporting period is positive or negative. A typical inference of a positive cash flow is that the business will boost its cash assets and add value for shareholders. We explore positive cash flow here.

The cash flow statement is broken down into three categories:

  • Operating cash flow (i.e. activities related to operations e.g. sales revenue or supplier costs)
  • Investing cash flow (i.e. activities related to investment e.g. purchase or sale of machinery)
  • Financing cash flow (i.e. activities related to providers of capital e.g. long-term loans)

Even a swift glance at these categories shows if the business has, say, a positive cash flow due to its core operating activities or because it has drawn-down funds from a new debt finance facility.

How to prepare a cash flow analysis

The first step is to create a cash flow statement, which is a summary of the historic cash movements of the business. The other vital tool for cash flow analysis is a forecast, to predict the near-future of its cash position. The forecast can be a model of the complete cash flow statement or a straightforward exercise based on modest data. We explore the concept of cash flow forecasting here.

Once you have the statement of cash flows and, ideally, a forecast of the cash position, the analysis is ready to begin. The main task is to notice the overall cash flow pattern.

Aside from identifying deficits or surplus of cash, the two crucial factors are the timescale and scope. For instance, once the business owners quantify both the magnitude of a cash shortfall and whether it is due to last weeks or months, they can make the appropriate decisions. Here are some scenarios:


Short-term actions

Long-term actions

Cash deficit

  • Arrange overdraft facility
  • Reduce prices to clear inventory 
  • Chase invoices or seek trade credit
  • Raise finance (e.g. loan)
  • Issue new share capital
  • Alter credit terms of business

Cash surplus

  • Invest in additional stock
  • Pay suppliers early to get a discount
  • Offer more credit to reliable clients
  • Expand or diversify business
  • Invest in new equipment 
  • Hire extra staff

What are the principal cash flow metrics?

Alongside the basics of cash flow analysis, as outlined above, this toolbox contains several other metrics which enable the business to dig deep into the mysterious movements of its cash balances. These cash flow metrics range in sophistication from straightforward yet potent ideas like free cash flow, right through to more complicated ones, such as discounted cash flow analysis.

As with profit equations, it’s easy to convert the underlying metrics into cash flow ratios to compare the business to others which might be a completely different size.

Why does cash flow analysis matter?

Running out of cash is the primary reason why a business fails. So there is profound truth in the old saying that: turnover is vanity, profit is sanity, but cash flow is reality. Ignore this at your peril.

The point about cash flow analysis is that it enables a business to preempt these problems, or at least discover why its bucket is leaking long before the entire well runs dry. Cash metrics also empower the business to make sensible choices about how – or when – to use its resources to maximum effect.

Many investors cherish a business that has proven it can generate cash, without the crutch of external finance. If so, this preference makes cash flow analysis a powerful way to persuade them of its value.

The challenge of a relentless focus on cash flow rather than the creation of profit is that this style of analysis can only take you so far. While liquidity is the lifeblood of the business, it’s the generation of profit that typically provides the pulse to keep the enterprise alive.

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