How To Do a Cash Flow Analysis

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“Cash is king” is a saying that can be especially relevant to small businesses. In fact, a recent study cited on business mentorship site SCORE found that 82% of small businesses fail because of a lack of adequate cash or cash flow mismanagement.

This is why it’s essential for sole proprietors and small businesses to conduct a cash flow analysis. This is an examination of when and why you have cash inflows to your business and cash outflows from your business, as well as the amounts involved. 

Key Takeaways

  • Cash flow analysis determines your business’s cash inflows and outflows from operations, investing, and financing.
  • Cash inflows include payments to your accounts receivable, loan proceeds, and sales of goods and services, while outflows include operating expenses and the purchase of assets.
  • To analyze your business’s cash position, you must prepare a statement of cash flows using the direct transactional or indirect accrual method. 
  • By developing a cash flow statement, you can get a better picture of your sources and uses of cash and determine what should be changed.

The Importance of Cash Flow Analysis

A company's cash flow at any point in time is the difference between its cash available at the beginning of a quarter or a year and at the end of that accounting period. Cash inflows include:

  • Payments to your credit accounts or accounts receivable
  • Loan proceeds
  • Receipts from the sales of goods and services
  • Investment income 
  • Sale of assets 

Cash outflows, meanwhile, are the payments you make on your liability accounts like accounts payable and loans payable. Outflows go out to pay for operating expenses, direct expenses, debt service, and the purchase of assets like equipment. 

Cash flow and net income or profit, though, are not the same thing. 

Cash flow refers to the actual money that flows in and out of your business from your operations, investing activities, and financing activities. Profit, on the other hand, is an accounting term that refers to what is left after all your expenses are taken out of your sales revenue.

This could mean that according to your income statement, your business can be profitable but still cash-poor. If that’s your position, you could be in danger of losing your business. 

For example, if you have credit customers, you will have accounts receivable that represent the money they owe you. If some of your credit customers do not pay their bills on time, but you have to pay your suppliers anyway, you may be profitable, but you won’t have cash on hand. This could lead to the failure of your business.

The value of cash flow analysis lies in the fact that it shows the changes in the cash flow position of a business. 

This is different from the information you get from the balance sheet or income statement, which are both stated in absolute dollar amounts without changing from period to period. The cash flow analysis instead allows the business owner to fix any troubling problems before they get too serious.

The Cash Flow Statement

To better determine your cash situation, you must prepare a statement of cash flows, one of the key financial statements required for a business. The statement of cash flows shows the changes in the various income statement and balance sheet accounts from the previous time period to the current time period. 

You can prepare this statement in one of two different ways:

  • Direct method: You can use the direct method which just looks like your business bank account transactions list. 
  • Indirect method: The indirect method is based on accrual accounting, which reports income in the period it was earned regardless of when it is received. 

To better understand the statement of cash flows, here’s a hypothetical example below for a small specialty shop. The business is the handcrafting of bridles for thoroughbred racehorses. The bridles are made and sold here. This statement of cash flows shows the change in the accounts from the income statement and the balance sheet from the last time period to this time period. Parenthetical numbers indicate losses.

Statement of Cash Flows for "The Bridle Shop" — Period Ending December 31, 20xx
Cash Flows From Operations
Net Income $50,000
+ Depreciation $5,000
Increase in Accounts Receivable ($2,000)
Increase in Inventory ($10,000)
Increase in Accounts Payable $12,000
Decrease in Loans Payable ($5,000)
$50,000
Cash Flows From Investing
Increase in Property, Plant, Equipment ($6,000)
($6,000)
Cash Flows From Financing
Decrease in Long-Term Debt and Equity ($10,000)
($10,000)
Net Cash at End of Year $34,000

Let’s look at the statement of cash flows and what the different sections illustrate.

Cash Flows From Operations

In this section, you look at the accounts on your income statement and balance sheet to determine last year’s and this year’s levels. This section deals with the cash inflows and outflows from your day-to-day operations. 

You should always start by including the sum of your net income (profit) and depreciation from the income statement.

Accounts receivable and inventory both increased from the previous year. When an asset account increases, it becomes a source of funds—and a negative number—because you pay out cash. In this case, you gained more credit accounts and purchased inventory. 

Accounts payable also increased, but this is on the other side of the balance sheet. When it increases, it is a use of funds since you are tying up some of your cash. Meanwhile, loans payable decreased, showing you paid off some of your loans. 

Sources of funds are a decrease in liabilities or an increase in assets. Net income is also a source of funds. Uses of funds are an increase in liabilities or a decrease in assets.

Cash Flows From Investing

Increase in property, plant, and equipment is an asset account. It increased by $6,000 and is a negative number. If an asset account decreases, that denotes the use of funds. In this case, the business purchased property, plant, or equipment and used cash.

The same rationale about sources of cash and uses of cash applies to the investing section of the cash flow statement. Another account you might see here is your investments account from the balance sheet.

Cash Flows From Financing

This section includes changes in both long-term debt and equity accounts. In this case, you paid off $10,000 in debt so this was a use of cash. 

The net change in cash (in this case, $34,000) signifies your cash account at the end of the year.

How To Analyze the Cash Flow Statement

By developing a cash flow statement, you can analyze both your sources of cash and uses of cash to give you a better idea of anything you should change—especially if the numbers are unequal. 

During your analysis, look particularly at your business’s uses of cash. Be sure they are not out of line with your expectations and business’s goals.

For example, are you extending credit to too many people? If so, you have a chance to correct your credit policy. 

The sources of cash are just as important. You want to see where you have received your cash from and how that has occurred. 

The Bottom Line

The statement of cash flows takes information from your balance sheet and income statement. Specifically, it includes any account from these financial statements that has seen a change in the amount from one time period to the next. The difference in the accounts is either a source of cash or a use of cash to the business. The bottom line of the statement of cash flows is the company’s change in cash, positive or negative, for that time period. The ideal result of the statement of cash flows is that the net cash flow should equal the cash account on the company’s balance sheet for the new time period.

Frequently Asked Questions (FAQs)

How is a cash flow analysis used?

A cash flow analysis is a cash management tool that is used to help a business determine where its trouble spots are by specifying its sources and uses of cash. Sources are where cash comes from. Uses are how the business uses its cash.

How does your cash flow analysis differ from your profit and loss?

Cash flow is not profit. Profit is an accounting term referring to what’s left after you deduct expenses from sales revenue. Cash flow refers to the money flowing in and out of your business from operations, investing, and financing.

How do I improve cash flow in my business?

There are several ways to improve your cash flow including increasing sales, increasing prices, decreasing expenses, restructuring debt, and reducing capital expenditures.