Cash Flow Analysis: The Basics

Cash flow analysis is an important aspect of a company's financial management because it reveals the cash it has available to pay bills and invest in its business. The analysis goes beyond accounting profits, which can be influenced by non-cash items, such as depreciation expenses or goodwill write-offs. Instead, cash flow analysis focuses on a company's available cash to cover operating expenses, pay down debt, and reinvest in growth.

Investors can analyze cash flow by viewing a company's cash flow statement, which provides a detailed breakdown of how cash moves into and out of the business during a specific period.

Companies, investors, and analysts examine cash flow for various reasons, including to gain insight into a company's financial stability and health and to inform decisions about possibly investing in a company. Ultimately, investors are more attracted to businesses that can generate consistent, positive cash flow, as these businesses are better equipped to expand operations or weather any potential downturns in the market.

Why Cash Flow Analysis Is Important

As the popular saying goes, "cash is king." Having enough cash to pay the bills, purchase assets, and keep the business running profitably is crucial for a company's long-term success.

Also, while a company may appear profitable based on net profits, cash flow provides a more accurate picture of its liquidity—whether it has enough cash to cover expenses, restock inventory, or invest in growth.

A company must also understand how well it generates cash. By tracking cash inflows and outflows, businesses can better plan operations and activities that drive profits and growth.

Cash flow analysis examines the cash that flows into and out of a company—where it comes from, what it goes to, and what's left over. Consistent positive cash flow signals financial stability, while ongoing negative cash flow could indicate financial trouble. A company's cash flow can be found in its statement of cash flows.

Cash Flow Statement

Before it can analyze cash flow, a company must prepare a cash flow statement that shows all cash inflows that it receives from its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given quarter. 

The three distinct sections of the cash flow statement cover cash flows from operating activities (CFO), cash flows from investing (CFI), and cash flows from financing (CFF) activities.

Cash Flow From Operations

This section reports the amount of cash from the income statement originally reported on an accrual basis. Some items included in this section are accounts receivable, accounts payable, and income taxes payable. 

If a client pays a receivable, it would be recorded as cash from operations. Changes in current assets or current liabilities (items due in one year or less) are recorded as cash flow from operations.

Cash Flow From Investing

This section records the cash flow from capital expenditures and sales of long-term investments like fixed assets related to plant, property, and equipment (PPE). Specific items might include vehicles, furniture, buildings, or land. 

Other expenditures that generate cash outflows could include business acquisitions and purchasing investment securities. Cash inflows come from the sale of assets, businesses, and securities.

Investors typically monitor capital expenditures used to maintain and add to a company's physical assets to support its operation and competitiveness. In short, investors want to see whether and how a company is investing in itself. 

Cash Flow From Financing

Debt and equity transactions are reported in this section. Any cash flows that include the payment of dividends or the repurchase or sale of stocks and bonds would be considered cash flow from financing activities. Cash received from a loan or cash used to pay down long-term debt would also be recorded here.

This section is important for investors who prefer dividend-paying companies because, as mentioned, it shows cash dividends paid. Cash, not net income, is used to pay dividends to shareholders.

Cash Flow Analysis

A company's cash flow is the figure that appears at the bottom of the cash flow statement. It might be labeled as "ending cash balance" or "net change in cash account." Cash flow is also considered the net cash amounts from each of the three sections (operations, investing, financing).

One can conduct a basic cash flow analysis by examining the cash flow statement, determining whether there's net negative or positive cash flow, pinpointing how the outflows compare to inflows, and drawing conclusions from that.

However, there's no universally-accepted definition of cash flow. For instance, many financial professionals consider a company's net operating cash flow to be the sum of its net income, depreciation, and amortization (non-cash charges in the income statement). While often coming close to net operating cash flow, this interpretation can be inaccurate, and investors should stick with using the net operating cash flow figure from the cash flow statement.

Though cash flow analysis can involve several ratios, certain key indicators are essential for evaluating the quality of a company’s cash flow.

Operating Cash Flow/Net Sales

This ratio is expressed as a percentage of a company's net operating cash flow to its net sales, or revenue (from the income statement). It indicates how many dollars of cash are generated for every dollar of sales.

There's no exact percentage to look for, but the higher the percentage, the better. Industry and company ratios will also vary widely. Investors should track this indicator's performance historically to detect significant variances from the company's average cash flow/sales relationship and how the company's ratio compares to its peers.

It's also crucial to monitor cash flow as sales grow to ensure that cash inflows keep pace with the increase in sales. A business that sees its sales growing at a faster pace than cash flow could face liquidity issues.

Free Cash Flow 

Free cash flow (FCF) is often defined as net operating cash flow minus capital expenditures. It is an important measurement since it shows how efficiently a company generates cash. Investors rely on FCF to determine if a company has enough cash to reward shareholders through dividends and share buybacks, after covering operational and capital expenses.

To calculate FCF from the cash flow statement, take cash flow from operations—also referred to as "operating cash" or "net cash from operating activities"—and subtract capital expenditures. You can further refine this figure by subtracting additional cash outflows, such as dividends, to arrive at a more comprehensive free cash flow calculation.

A company with a history of dividend payments can't easily suspend or eliminate them without causing shareholders some real pain. Even dividend payout reductions, while less injurious, are problematic for many shareholders. For some industries, investors consider dividend payments as necessary cash outlays similar to capital expenditures.

Monitoring free cash flow over time and comparing it to industry peers is important. A positive FCF suggests the company can meet its obligations, including operational costs and dividend payments. In industries where dividends are seen as essential, consistent FCF is crucial to maintaining shareholder confidence.

Comprehensive Free Cash Flow Coverage

You can calculate a comprehensive free cash flow ratio by dividing the free cash flow by net operating cash flow to get a percentage ratio. The higher the percentage, the more efficiently the company generates free cash relative to its operations, which is typically a positive indication of financial strength.

Example of Cash Flow Analysis

Let's say Acme Company produces a cash flow statement showing the cash flows below. It would use that to conduct a basic cash flow analysis.

Cash flow from operations

Net income $400,000

Payroll $65,000

Depreciation $10,000

Office rent $25,000

Accounts receivables $15,000

Net cash from operations $315,000

Cash flow from investing

Equipment sales $100,000

Property purchase $75,000

Net cash from investing $25,000

Cash flow from financing

Loan payment $20,000

Net cash from financing ($20,000)

Net change in cash account $320,000

Acme's cash flow statement indicates that net cash flow for the financial period was $320,000. Most of its positive cash flow came from its operations.

That means that Acme generates a large percentage of revenue from its operations. The statement also shows that Acme is investing in property and paying down debt, which could indicate the company is positioning itself for growth and improving its financial health. This would likely be viewed favorably by investors.

What Cash Flow Analysis Can Tell You

Cash flow analysis can lend insight into the financial vibrancy or financial instability of a company and its prospect as a good investment. Bear in mind these points when analyzing cash flow:

Positive Cash Flow

Positive cash flow is usually a goal for most businesses, and sustained positive cash flow over multiple quarters indicates that a company is running its operations efficiently and has the potential for successful growth.

However, watch for positive investing cash flow and negative operating cash flow. This could signal trouble, as it may suggest the company is selling off assets or investments to cover operating expenses, which is unsustainable in the long term.

Negative Cash Flow

Negative cash flow may indicate something other than financial trouble. For instance, investing cash flow might be negative because a company spends money on assets that improve operations and the products it sells. Similarly, for a startup, negative cash flow might indicate that it has raised funds from investors and is now making significant investments to drive future growth and profitability.

Free Cash Flow

Having positive free cash flow is a great advantage. It's the cash available after paying operating expenses and purchasing needed capital assets. A company can use its free cash flow to pay off debt, pay dividends and interest to investors, or re-invest in the business for growth.

Operating Cash Flow Margin

The operating cash flow margin ratio compares cash from operating activities to sales revenue in a particular period. A positive margin shows that a company is able to convert sales to cash and can indicate profitability and earnings quality.

Limitations of Cash Flow Analysis

• The cash flow statement presents past data. It might not be very helpful to analysts and investors who want to evaluate an investment properly. For example, outflows shown in the cash flow statement from investments might lead to negative cash flow in the short term, but those investments could drive future growth, profits, and positive cash flow. 
• It doesn't depict a company's net income because it doesn't include non-cash items. The income statement must be examined to determine these.
• Finally, cash flow analysis provides a snapshot of available cash at the end of a period but doesn’t offer a comprehensive view of the company's overall liquidity.

How Cash Flow Is Accounted for

There are two forms of accounting that determine how cash moves within a company's financial statements. They are accrual accounting and cash accounting.

Accrual Accounting

Most public companies use accrual accounting. It reports revenue as income when it's earned rather than when the company receives payment. Expenses are reported when incurred, even though no cash payments have been made.

For example, if a company records a sale, the revenue is recognized on the income statement, but the company may not receive cash until later. From an accounting standpoint, the company would be earning a profit and paying income taxes on it, but no cash would have been exchanged.

The transaction would likely involve an outflow of cash initially since the company must spend money to buy inventory and manufacture the product to be sold.

It's common for businesses to extend terms of 30, 60, or even 90 days for a customer to pay the invoice. The sale would be an accounts receivable with no impact on cash until collected.

Cash Accounting

Cash accounting is an accounting method in which payment receipts are recorded in the period they are received, and expenses are recorded in the period in which they are paid. In other words, revenues and expenses are recorded when cash is received and paid, respectively.

A company's profit is shown as net income on the income statement. Net income is the bottom line for the company. However, because of accrual accounting, net income doesn't necessarily mean that all receivables were collected from customers. 

From an accounting standpoint, the company might be profitable, but if receivables become past due or uncollected, the company could run into financial problems. Even profitable companies can fail to adequately manage their cash flow, which is why a cash flow statement is a critical tool for analysts and investors.

The Bottom Line

If a company's cash flow is continually positive, it's a strong indication that the company is in a good position to meet its obligations without relying on excessive borrowing, support business expansion, pay dividends, and weather economic challenges. 

Most investors closely analyze free cash flow, as it reflects a company’s ability to generate cash internally and shows how wisely that cash is reinvested or used for shareholder returns. This makes free cash flow an essential indicator of a company's long-term health and growth potential.