What is Cash Flow Analysis, and Why Does Your Business Need It?
Cash flow has proven to be one of the essential metrics in any business. Simply put, cash flow is the amount of cash in any form that enters and leaves a business within a specified period. It includes available cash, cash tied up in securities and investment, cash for expansion, cash spent on business operations, etc. What cash flow doesn’t cover is profits, but unlike profits, cash flow is more important to businesses for the more profound insights it provides.
Cash flow is crucial because it determines a company’s present and future state. This is why businesses stay informed on the state of their cash flow through a process known as cash flow analysis.
What is Cash Flow Analysis?
Cash flow analysis is a financial analysis of a company’s cash flow within a specified period. Cash flow analysis is carried out to study, compare, and understand how solvent a business is based on the cash flow from three categories:
- Cash flow from Investments;
- Cash flow from Business Operations;
- Cash flow from Financing Activities.
These three categories refer to the three types of cash flow that exist. Each is a point through which money enters or leaves a business. To understand the financial health of a business, you need to understand how money flows through these three points. The comparison between them reveals the actual financial situation of a company.
Without flow analysis, a business might consider itself well off by comparing incoming cash from sales with outgoing cash and the resultant profits. While this is a favorable situation, it doesn’t give a wholesome picture of the business’s financial situation. Cash flow analysis determines if the business has a positive or negative cash flow, and these are steadier metrics to study.
To conduct a cash flow analysis, you’ll need to begin with a cash flow statement.
What is a Cash Flow Statement?
A cash flow statement is a document that shows a detailed tracking of the three cash flow categories. Each cash flow statement is divided into three categories – investment, financing, and operations. Every cash that comes into the business or leaves it is recorded alongside its entry or exit point under each category it belongs to. That way, business owners can note where and how money enters or leaves their businesses.
What to Look Out for in a Cash Flow Analysis
If you’re new to cash flow analysis, you might have a hard time figuring out what is important and why. Not to worry, here are the key metrics to consider.
Positive Cash Flow
Positive cash flow is a state where operating income exceeds operating costs. It’s a strong indicator of good financial health and solvency.
Negative Cash Flow
Negative cash flow occurs when the money spent within the specified time is less than the total income. Negative cash flow isn’t always a harbinger of doom. Sometimes it reflects the expansion or investments that the business is undertaking. If you’re a small business, negative cash flow in your early days is to be expected, so don’t be worried. Nevertheless, keep an eye out for this metric because, in certain situations, it does spell doom for the business.
Free Cash Flow
Free cash flow represents the amount of money you have left after subtracting operating and capital expenditures. This money can be saved, invested or used for expansion.
Operating Cash Flow
Operating cash flow refers to incoming cash from operating activities like product sales. High ratios of operating cash flow indicate profitability.
Why is Cash Flow Analysis Important?
At this point, you have an idea that cash flow analysis is important because it helps business owners track their money. While that’s correct, cash flow analysis has deeper benefits than that. Here are five reasons why cash flow analysis is important.
It Shows The True State of A Business’s Finances
One great thing about cash flow analysis is that it doesn’t lie. It is also very difficult to falsify, so any information you get from your cash flow analysis reflects the actual financial state of your business. If you’re a business trying to acquire another business or looking for investors, the cash flow statement is an essential document that shows the financial health of the company.
It is used for Short-term and Long-term Planning
Every business must have enough cash to operate in the short term for operating activities like paying vendors and utility bills. Having a proper estimate of how much you should set aside for these expenses is difficult without a cash flow analysis.
Since the cash flow statement shows all expenses, you can aggregate, with more accuracy, how much your business needs.
Aside from short-term needs, businesses must plan. Expansion, investments and other activities that grow a business don’t happen by chance. They also don’t happen without planning because they require significant financial input. To make such long-term plans, you need to know precisely where, how, and in what amounts of money enters and leaves your business.
With regular cash flow analysis, you’ll discover:
- How much to put aside for these expenses;
- Any adjustments you should make to position your business better;
- A realistic timeline for these needs.
It is used for Working Capital Analysis
Working capital analysis refers to the “cash at hand” that a business uses to handle its operations on a day-to-day basis.
Working capital is an important metric, more so for small businesses that may be unable to carry on operations without it. Cash flow analysis helps businesses understand their working capital, how much they need, and how it is spent.
It Is Used to Measure and Compare Results
Earlier, I mentioned that cash flow analysis helped businesses adjust their activities to improve positive cash flow. The true reflection of these changes is in subsequent cash flow analyses.
If a business owner decides to adopt a more efficient collection solution to improve cash flow, the state of the cash flow in the subsequent analysis would show if there’s been an improvement. Whatever the result is, it helps the business owner take the next step, which could be maintaining the decision or trying a new approach.
Gives Insight Into Accounts Receivables
Accounts receivables refer to the balance of cash owed to a business for products/services delivered. In essence, it’s money that consumers owe a company. It is a key factor affecting incoming cash and, as an extension, positive cash flow.
Cash Flow analysis reveals the problems surrounding the payment of this money. Through cash flow analysis, business owners can decide to automate their accounts receivables team or use credit control software to improve accounts receivable metrics.
Conclusion
Very little can be done in a business without cash flow. And all good business owners know that the key to growth and longevity is understanding cash flow through cash flow analysis. You can make better, profitable decisions by studying the nitty gritty of cash flow in your business.
