How to Do Cash Flow Analysis

Cash flow analysis is essential for effective business management. It helps you recognize opportunities to improve profitability, anticipate periods of low cash inflows, and use your funds strategically when they’re limited.

Conversely, ignoring your cash flows can lead to significant liquidity problems, one of the leading contributors to business failure.

Here’s what you should know about performing cash flow analysis to optimize your business decision-making and avoid working capital issues.

What is Cash Flow Analysis?

A business’s cash flow refers to its capital receipts and disbursements during a given period. In addition to the cash earned and spent in day-to-day operations, it includes funds gained and lost through investing and financing activities.

As a result, cash flows are distinct from revenues and expenses, especially for businesses using the accrual accounting basis. For example, you could close a deal on net 30 terms and generate sales, but not receive any cash for weeks.

Cash flow analysis requires that you organize the inflows and outflows from your business activities into a statement of cash flows—one of the three primary financial statements—along with the income statement and balance sheet.

Next, it involves applying analytical techniques to the assembled data to extract beneficial insight, such as seasonal cash flow trends, opportunities to reduce expenses, or signs you need additional financing.

For example, variance analysis is a technique that involves creating an estimated cash spending budget for an upcoming period, then comparing it to your actual results.

That helps highlight aspects of your operation where costs were significantly different than you expected, giving you the chance to address the issues or refine your cash flow forecasting.

How to Do Cash Flow Analysis

Cash flow analysis is complex and encompasses several distinct processes. Here’s a step-by-step guide to give you a general framework for how it works.

1. Identify All Inflows and Outflows

The first step to analyzing your cash flows is to track them. If you already have an income statement and balance sheet, you can use them to back into your inflows and outflows. Otherwise, you can pull the information from your bank statements.

The cash flow statement generally separates these activities into the following groups:

• Operating activities: These include the cash inflows you generate by selling your products or services and the cash outflows you incur as operating expenses.
• Investing activities: Investing cash outflows include the purchase of investments like fixed assets and securities. Meanwhile, investing inflows refer to any returns they generate and the proceeds you get from selling them.
• Financing activities: These refer to the cash flows associated with your debt and equity financing. The proceeds you receive are inflows, while repayment activities are financing outflows.

Every business has a unique combination of cash activities, so you may not have some that fall into every category. After all, some small businesses go without external financing or choose not to invest their excess capital.

2. Create a Statement of Cash Flows

Once you’ve identified all your cash activities for the period you want to analyze, you’ll need to organize them into a statement of cash flows. You can create the financial statement using the direct or indirect method.

The direct method of calculating cash flows is straightforward, but it’s often labor-intensive. It involves adding up all your cash inflows and subtracting all your cash outflows from them, using raw transactional data from bank statements.

The indirect method of calculating cash flows can be more complex, but it’s usually more efficient if you have a finalized income statement and balance sheet.

Generally, it involves backing into your cash flows by removing accruals and non-cash activities from the other financial statements. For example, you’d need to reverse any accounts receivable, accrued revenues, and depreciation.

3. Investigate Your Statement of Cash Flows

Whether you use the direct or indirect method, you should end up with the same statement of cash flows. With it, you can finally begin your cash flow analysis. Here are some sample techniques to give you an idea of how it works:

• Calculate your cash runway: Your cash runway is the length of time you can support your current cash flow, usually expressed in months. It’s highly relevant to new startups losing money and trying to gain traction and equals your cash reserves divided by monthly net cash flows, assuming they’re negative.
• Check cash flow ratios: Ratios can help you assess solvency, liquidity, and profitability. For example, the cash flow coverage ratio tells you if your operating cash flows are enough to afford your debt payments. If it’s greater than one, your default risk is low. It equals net operating cash flows divided by total liabilities. 

There are countless ways to extrapolate information using your statement of cash flows. Which techniques are relevant to you depends on your goals, business model, and current stage of growth.

If nothing else, you can use it to determine whether your company is generating sufficiently high net cash flows over a given period. Without it, that’s not always obvious to businesses using the accrual method of accounting. 

4. Use Insights to Inform Business Decisions

Cash flow analysis is only beneficial if you use the insight you gain to make better business decisions. As a result, you should monitor your statement of cash flows and review it before making significant decisions.

For example, businesses often benefit from ongoing financial forecasting. It involves creating projected financial statements, including the statement of cash flows, using historical data.

Updating these projections at the end of each calendar year helps you develop benchmarks and predict potential cash flow shortfalls. If you foresee that you’ll need additional working capital, you can start looking for financing.

Of course, you should examine your statement of cash flows further before accepting a credit offer to confirm you have enough cash flow to make your monthly payments.

Cash Flow Analysis Example

Let’s walk through an example to help you understand how cash flow analysis looks in practice. For the sake of simplicity, we’ll use the direct method to construct a manageable statement of cash flows.

Say you’re a small business owner in the construction industry and primarily take on landscaping projects. In January of your third business year, you have the following cash transactions:

• January 3: $500 rent expense for landscaping equipment
• January 7: $5,000 cash receipt as payment for an invoice
• January 10: $200 payment toward an outstanding business loan
• January 16: $1,250 payment to subcontractor
• January 27: $50 gas expense to refill the company truck
• January 30: $3,250 cash receipt as payment for a second invoice
• January 31: $120 dividend payout from invested securities

Fortunately, you’ve been performing cash flow statement analysis for several years. As a result, you recognize that your net operating cash flows are 20% higher than in January of the previous year.

In addition, you notice that your cash reserves have grown steadily along with your operating cash flows. This month, you’ll have $10,000 left after setting cash aside for taxes and personal expenses.

You like to keep enough cash to support four months of cash outflows without income. Since your total cash outflows in January are $2,000, you realize you don’t need more than $8,000 in cash reserves.

Based on your cash flow analysis, you use your excess funds to invest in a $2,000 commercial-grade lawn mower. It saves you $200 monthly in equipment rent, improving your operating cash flow.

Leverage Software for Cash Flow Analysis

Cash flow analysis is an essential part of financial planning for small businesses. However, building your cash flow statements in clunky spreadsheets is time-consuming, labor-intensive, and prone to human error.

Fortunately, you can manage your cash like a pro with Lendio’s cash flow forecasting software. It can track your activities in real-time, automatically generate cash flow statements, and provide personalized cash flow insights. Sign up for a free trial today!