Cash Flow Analysis: What It Is, Why It’s Important, and Methods to Use

by Kieran Daly
June 5, 2024
Cash Flow Analysis: What It Is, Why It’s Important, and Methods to Use

Getting on top of cash flow is important. If you don’t have enough money in the bank, then you will struggle to have enough working capital to pay the bills. In fact, 44% of startup businesses go under because of cash flow problems. That’s why running a regular cash flow analysis is so important, as it allows you to spot potential issues early to ensure your business remains healthy and solvent.

In this article, find out why cash flow is important, the different types of cash flow analyses you can run to assess your financial performance, and how to manage cash flow balances.

What Is Cash Flow?

In the simplest possible terms, cash flow consists of your cash inflows (money coming into your company) and cash outflows (money leaving your business).

Positive cash flow is when your cash balance in the bank is higher than at the start of the accounting period you’re measuring. Negative cash flow is when the amount you’re left with is lower.

What Is Cash Flow Analysis, and Why Is It Important?

Cash flow analysis involves examining your cash flow statements over a specific period of time (like a month) to understand the amount of cash you’ve taken in and paid out.

Some company owners only focus on business profitability — the bottom line — when they run a financial analysis. They’re less concerned about how much actual cash they have in the bank now and in the future. 

This is a problem, although it does actually make sense to a point. 

After all, you need to know if the invoices you’re sending out total more than the money you owe suppliers, the wages you need to pay, and any other financial obligations you have to meet. 

But sending invoices is one thing and collecting payment is another. If you’re not proactive in getting cash into your firm, you could run into trouble very quickly. Even a company that’s very profitable with a healthy balance sheet can go under if it doesn’t collect money fast enough from its customers.

Running a regular cash flow analysis is important because you find out whether you have enough money to meet your current obligations as well as spot potential future cash shortages. 

These analyses also give you the financial data you need to make informed decisions on sustaining and growing your company.

4 Main Cash Flow Analysis Methods

Here are four popular cash flow analysis methods used by entrepreneurs and business owners.

1. Ratio Analysis

Ratio analysis is a way of helping business owners understand their liquidity. Liquidity is the company's ability to meet its short-term financial obligations — in other words, how well the company can pay its way.

There are many ways to measure cash flow ratios including:

  • Current liability coverage ratio: This calculates the amount of cash a business has available to pay off its debt. If the ratio is one or more, a company can pay its debts off. To calculate this, you divide your cash flow from operating activities (CFO) by your current liabilities.

  • Price-to-cash-flow ratio: This approach to cash flow analysis shows how much investors pay for each dollar a company earns. A low ratio means a stock may be undervalued, whereas a high ratio suggests the opposite. To calculate, divide the share price by the cash flow price per share.

  • Operating cash flow ratio: This is how much a business generates in revenues in comparison to its liabilities. To calculate, divide your CFO by your liabilities. Ratios greater than one suggest the business is generating enough cash to cover its liabilities.

  • Cash flow coverage ratio: Sometimes known as the solvency ratio, this measures whether you can pay off outstanding debt from your operating income. The calculation is your net cash flow from operations divided by your liabilities. Ratios higher than one suggest that a company can meet its debt obligations.

  • Cash interest coverage ratio: This cash flow analysis method measures whether the cash a company generates will cover its interest expenses on items like loans and bonds. To calculate, divide your earnings before interest and tax by the interest you’re charged on loan payments and other financial instruments. If the figure is higher than one, this suggests that a business can comfortably meet its interest payments.

  • Cash flow to net income ratio: This ratio measures how well a company's earnings translate into actual cash. The calculation is CFO divided by your net income. A ratio of more than one suggests that a company is turning its sales into cash.

2. Direct vs. Indirect Cash Flow Analysis

Direct and indirect cash flow analysis are two different ways of tracking cash inflows and outflows from your business.

The accrual-accounting-based direct method involves tracking actual cash transactions in your business like:

  • Cash you receive from customers

  • Interest and dividends you've received

  • Interest payments

  • Income taxes

  • Payments to vendors and suppliers

  • Salaries to employees

You get a clear and detailed view of your cash flow here because you see how cash moves in and out of your business.

With the indirect method, you start with the net profit or loss from your income statement and then make adjustments to show your company’s cash flow from business operations. To do this, you:

  • Add back non-cash expenses, like amortization, and depreciation.

  • Subtract gains and add losses from the sale of long-term assets.

  • Adjust for changes in accounts receivable, accounts payable, and your levels of inventory.

The indirect method is easier to prepare than the direct method because it’s already using financial data you have in your accounting package. You don’t have to check whether you have paid an invoice or been paid on an invoice.

Both the direct and non-direct methods should come to the same operating cash amount.

3. Free Cash Flow Analysis

Investors and lenders use free cash flow analysis to make informed decisions on whether to back a business based on its financial health.

A free cash flow analysis measures how much cash you have left in the business after your operating and capital expenditure costs. The higher a company’s cash position after meeting those costs, the more attractive investors and lenders consider it to be.

There are three ways to work out the amount of money remaining using the free cash flow analysis method:

  • Net operating profits: With this metric, you subtract your company’s operating income from the amount of cash it generates.

  • Sales revenue: For this method, you subtract the costs associated with generating revenue from the total cash generated by sales.

  • Operating cash flow: The most commonly used method, you subtract capital expenditures from operating cash flow to work out the remaining levels of cash.

4. Discounted Cash Flow (DCF) Analysis

Discounted cash flow analysis is a way of working out what a business’s current cash flows will be worth in the future in today’s money.

Investors and financial analysts use DCF when they’re determining the value of a business and whether it’s worth investing in or buying.

Discounted cash flow uses a “discount rate.” It takes the company’s current cash flow and then discounts the following year’s cash flow by that rate.

So, if a small business had an operating cash flow of $1 million, which was expected to remain the same, and the discount rate was 10%, the first year discounted cash flow would be $909,091 ($1 million divided by 1.10). The second year would be $826,446 ($1 million divided by 1.10 and divided by 1.10 again) and so on.

The DCF value is the value of all the discounted years added together. So, if someone wanted to buy a $1 million operating cash flow business for $4 million, they’d have to wait five years and five months for the total discounted cash flows to earn back the initial $4 million purchase price.

How to Manage Cash Flow Problems in Your Business

If you’re having cash flow issues because you’re not getting paid fast enough for your products or services, here are some steps you can take to overcome that:

  • Start chasing clients: Eighty-seven percent of businesses are paid late. When you issue an invoice, send reminders before the due date that your client needs to pay you. Consider instituting a late fee to encourage on-time payments. Make chasing payments a business activity you and your colleagues perform every day.

  • Take card payments: Give customers an option to pay by credit or debit card, which results in quicker payment processing. You can also put a link on your invoices in many accounting apps that direct customers to an online card payment portal.

  • Use a factorer: If you sell your invoices to a factorer, you can greatly reduce the period of time it takes to get paid. You get up to 90% of an invoice’s value within 24 hours and the remainder, minus the factoring fee, when your client pays up.

  • Offer B2B BNPL: Buy Now Pay Later (BNPL) services have become very popular in recent years. Small, regular repayments make products and services more affordable for end users, and you get your money (minus a fee) immediately.

Sometimes, cash flow analysis might reveal that you’re having no problem getting cash in but that you’re not making enough sales in the first place to cover your costs. Additionally, if you run a seasonal business, an analysis may uncover that you will struggle with cash temporarily until the next busy season comes around. 

In these cases, consider:

  • Sell your assets: Have a look around all your current assets to see if you can sell any to deliver a quick boost to your cash reserves to cover urgent expenses. You may be able to use equipment financing to borrow money against fixed assets you use in your business.

  • Take out flexible financing: Various flexible financing solutions — like business lines of credit, working capital advances, merchant cash advances, and bridge lending — can be effective solutions for seasonal and short-term cash flow slumps.

  • Reduce operating expenses: Look through all your business subscriptions to see if you need them all. You could also look for less expensive suppliers. As a last resort, you may need to reduce your staff.

  • Do less: Focus on more profitable areas of your business and scale back or close down the less profitable areas to improve budgeting across your business.

  • Inventory clearance: Look for excess inventory within your company to sell off at a discount or in bulk to generate immediate cash and reduce storage costs.

  • Extend long-term debt: You could look to refinance your existing debt with another supplier or extend terms with your existing lender to cut down your monthly repayments. This will free up cash to more easily pay for day-to-day operating activities as well as improve your short-term financial position.

Look for Ways to Improve Cash Flow in Your Business

Managing cash flow is key to the long-term survival and growth of any business. While it’s good to make a profit on paper, failure to collect cash from customers on time can quickly spiral into insolvency. As the saying goes, “turnover is vanity, profit is sanity, cash flow is reality.”

Make sure you run cash flow analyses regularly so you can spot opportunities and challenges ahead.

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