Cash flow analysis: Why it's important and how it works
What is cash flow analysis?
Cash flow analysis is the process of identifying and monitoring the cash flow in and out of your company to determine the net amount of cash left. You can see your cash flow figure at the bottom of your cash flow statement, labelled “net change in cash account.” Analysing your cash flow reveals if your cash flow is positive or negative, allowing you to make changes to improve your financial situation.
Cash flow statements
You’ll need a cash flow statement for the analysis process. This document covers a specific accounting period and lists incoming and outgoing amounts and their descriptions.
Types of cash flow
Cash from operating activities
Cash flow from operations represents how much cash a company produces or consumes from operating activities over time. Operating activities include sales and revenue generation, paying for operational expenses and changes in working capital.
Cash from investing activities
Cash from investing activities describes how much money a business generates or spends on investment-related activities during a specific accounting period. Investing activities include purchasing, holding and selling physical assets and marketable securities. This figure shows your ability to manage investments and generate cash for your business.
Cash from financing activities
Financing cash flow represents how much cash a company receives from or pays for its financing activities over time. Financing activities include obtaining loans and equity investments as well as repaying debts. The figure gives analysts and investors valuable insight into your company's financial position.
Why is cash flow analysis important?
Cash flow analysis is critical for understanding your finances. Knowing where, when and how money comes into and goes out of your business is essential. This information helps you make informed decisions for budgeting and investing. It's also helpful for identifying market opportunities, planning for future growth and anticipating cash flow fluctuations.
A clear grasp of your cash flow can help you identify areas to save money and allocate additional resources. For example, if you notice rising expenditures, you can prioritise operations management to improve efficiency and reduce costs.
Cash flow analysis ratios (with examples)
There’s no standard way to analyse cash flow, but you can start by calculating a few common cash flow ratios:
Current liability coverage ratio
The current liability coverage ratio, also called the cash current debt coverage ratio, gauges a company's ability to meet its short-term obligations or current debts due within the fiscal year. A higher value indicates better liquidity. Ratios below 1.0 signal challenges in repaying short-term debt.
Use this formula to calculate your current liability coverage ratio:
Current liability coverage ratio = (Operating cash flow – Cash dividends) / Average current liabilities
Cash flow analysis example: If a business has $100,000 in net cash from operating activities, pays a dividend of $5,000 and has average current liabilities of $12,000, its current liability coverage ratio is 7.9. This means the company has enough liquidity to cover its debts nearly eight times over.
Operating cash flow ratio
The operating cash flow ratio is a liquidity ratio that shows how well a business can repay its debt. It's the same as the current liability coverage ratio, only it doesn't include dividends. A number greater than 1.0 is considered good, but the higher, the better.
Use this formula to calculate your operating cash flow ratio:
Operating cash flow ratio = Operating cash flow / Current liabilities
Cash flow analysis example: If a business has an operating cash flow of $120,000 and a current liability of $90,000, the operating cash flow ratio is 1.33. This indicates that the company can generate $1.33 in cash flow for every $1 of current liabilities.
Cash flow coverage ratio
The cash flow coverage ratio resembles the current liability coverage ratio, but it measures solvency. It evaluates the company's ability to cover all debt, not just short-term. Higher ratios indicate a greater ability to repay debt, while values under 1.0 indicate potential long-term solvency problems.
Use this formula to calculate your cash flow coverage ratio:
Cash flow coverage ratio = Operating cash flow / Total liabilities
Cash flow analysis example: If a company generates $50,000 in net cash flow from operating activities and has $75,000 in total liabilities, its cash flow coverage ratio is 0.67. The company can only cover 67% of its liabilities with cash flow from operations, putting it at risk of default.
Cash flow margin
Cash flow margin measures your net cash flow from operating activities as a percentage of revenue during your chosen accounting period. This profitability ratio reflects how well your company converts sales into cash.
Use this formula to calculate your operating cash flow margin:
Operating cash flow margin = (Net income + Non-cash expenses + Change in working capital) / Sales
Cash flow analysis example: A company with a net income of $100,000, a non-cash expense of $10,000 and a change in working capital of $10,000 that sold $1 million worth of goods would have an operating cash flow margin of 12%.
Free cash flow
Free cash flow is another profitability measure that assesses a company’s financial health. This calculation shows a company's cash after covering operating and capital expenses. This figure represents free cash with no internal or external obligations that the business can invest or distribute without risk.
Use this formula to calculate your free cash flow:
Free cash flow = Operating cash flow – Capital expenditures
Cash flow analysis example: A company with $10 million in net cash from operating activities and $8 million in capital expenditures has $2 million in free cash flow to invest in assets or distribute to shareholders.
How to analyse a cash flow statement in 3 steps
1. Gather your data
Start by identifying your income for your cash flow statement. Add all cash flows into your account during your chosen accounting period, including sales revenue and investment or asset proceeds.
You'll also need to identify your outflows during the same period. Gather and add your operating expenses, such as rent, salaries, utility and supplier bills. Also, note any debt repayments or capital expenditures.
2. Prepare a cash flow statement
Complete the statement using your financial records and the figures from step one. Review the information to ensure accuracy and completeness.
3. Analyse statement using cash flow ratios
Use the ratios above to work out your current liability coverage, operating cash flow and cash flow coverage ratios. These figures will help you determine your liquidity and solvency. You can also calculate your cash flow margin and free cash flow to assess how much cash you have available for growth.
Cash flow analysis example
Here’s an example of a cash flow statement from a hypothetical small business.
Cash flow from operations
Net income: $450,000
Payroll: -$60,000
Depreciation: -$5,000
Office rent: -$15,000
Accounts payable: -$17,000
Net cash from operations: $353,000
Cash flow from investing
Equipment sales: +$10,000
Property purchase: -$20,000
Net cash from investing: -$10,000
Cash flow from financing
Loan payment: -$1,000
Assumed loan proceeds: +$20,000
Net cash from financing: $19,000
Based on this cash flow statement, the firm’s operating cash flow for this accounting period was $353,000. It made most of its income through operating activities, showing potential investors the business is in good financial health.
The owner of the firm wants to know if the company can repay their short-term debt without using dividends and if they’re well-positioned to pay off all long-term liabilities over time. Additionally, they'd need to know how much free cash they have available for investment.
The company has $98,000 in current liabilities, $215,000 in total liabilities and $22,000 in capital expenditures. Knowing this, the firm can use the following ratios and calculations:
Operating cash flow ratio
Operating cash flow / Current liabilities = $353,000 / $98,000 = 3.6
This figure indicates the firm can generate $3.60 of cash flow for every $1 of current liabilities, so it has plenty of cash to cover its current liabilities.
Cash flow coverage ratio
Operating cash flow / Total liabilities = $353,000 / $215,000 = 1.6
The business can cover 160% of its liabilities with cash flow from operations, so it's not at risk of defaulting.
Free cash flow
Operating cash flow – Capital expenditures = $353,000 – $22,000 = $331,000
The company has $331,000 in cash that’s free from obligations and available for investment.
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