Just like you square up your checkbook balance against your bank statements, a company will use cash flow analysis to compare its cash flow statement with its income statement. This is done to explain why cash flow is different from profit, which is called reconciliation.
The cash flow analysis is crucial for businesses, particularly small ones, because many struggle to generate enough cash, even if they're profitable. You want to find ways to improve cash flow and build a more sustainable brand.
Ahead, you’ll learn how to analyze cash flow with an example to visualize it.
What is a cash flow analysis?
Cash flow analysis refers to a company’s regular review of the money it receives from all sources and the money it pays out for all uses. A company may examine the flow of cash through the business monthly, as many do with their checkbooks, but most perform an analysis quarterly and annually.
The importance of cash flow analysis
The primary purpose of cash flow analysis is to give business owners a comprehensive understanding of the business, so they can plan ahead to meet any challenges or move on opportunities.
For instance, if the analysis shows cash flow is positive or growing, the company can consider how to use the excess cash profitably. On the other hand, if cash flow is declining, a company has time to take measures such as increasing sales, cutting expenses, or arranging short-term debt financing to cover a temporary cash crunch.
Examination of the timing of cash flows also allows a company to make adjustments. For example, if the company pays its bills (accounts payable) within 30 days but customers are taking 90 days to pay (accounts receivable), it might decide to stretch out bill payments and tighten up on customer collections. This is critical to managing the company’s working capital, which is its current assets minus current liabilities. Working capital, a part of operating cash flow, determines the company’s ability to pay expenses in the current operating cycle, whether a quarter or a year.
How to analyze cash flow
- Prepare your cash flow statement
- Determine your cash flow ratio
- Investigate positive or negative cash flow
- Analyze cash flow from operations
- Compare cash flow from investing
- Consider cash flow from financing
- Identify trends and patterns
- Spot potential risks
- Find opportunities to improve cash flow
1. Prepare your cash flow statement
Your cash flow statement is a financial statement that provides a detailed summary of cash flowing into and out of your business over a specific time period. You can prepare this manually in a spreadsheet simply by listing each time money comes in and money goes out of your business. If you use small business accounting software, many platforms will create a cash flow statement for you.
You can use your cash flow statement to see if you have more money coming in or going out of your business for that period. Over time, you’ll also be able to see trends—maybe some months have lots of cash inflow every year, while others have high cash outflow every year. Noting these trends will help you better prepare your business finances so you always have enough liquid capital to keep the doors open.
2. Determine your cash flow ratio
The cash flow ratio is a financial metric that shows whether your business has enough cash from operations to cover its existing debts and liabilities. You can calculate your cash flow ratio with the following formula:
Cash flow ratio = operating cash flow / current liabilities
A high cash flow ratio generally indicates your business has enough operating cash flow to cover current liabilities—this is a sign of financial stability. A low ratio, on the other hand, could demonstrate potential struggle to meet your business’s short-term obligations with its operating cash flow.
3. Investigate positive or negative cash flow
Positive cash flow is generally regarded as a good thing. It reflects that more money is coming into your business than leaving your business. However, it could also mean you have too much coming in—for example, maybe you missed utilities payments.
Negative cash flow, on the other hand, is mostly to be avoided. It means your business is spending more money than it’s making, which signals unsustainability. You can look at ways to cut back on expenses or drive more sales. It’s always a good idea to understand why your cash flow is particularly positive or negative.
4. Analyze cash flow from operations
Most of the analysis of a company’s cash flows is focused on cash from operations. Cash flow from operations is money received and money paid from the company’s normal business operations.
It’s the most important of the three cash flows because it shows if a company is self-sustaining by generating enough money to pay all expenses and pursue other opportunities, without the need for outside funding. The business is operating every day, whereas investing and financing activity happens intermittently or as needed.
The main object of any business is to produce consistent, strong positive cash flow. Cash from operations excludes capital expenditures, or the money spent to update and maintain the operating efficiency of the company’s assets. Free cash flow is what’s left after capital expenditures. Business owners and investors use free cash flow to measure a company’s financial strength, including its ability to expand, make acquisitions, or pay dividends, among other things.
The analysis of operating cash flow can be done in either of two ways: the direct method or the indirect method. The direct method, like checkbook balancing, only considers cash transactions. The indirect method is a roundabout way of determining operating cash flow, but it’s more informative because it shows the relationship among a company’s income statement, balance sheet, and cash flow statement. It also shows the effect of accrual accounting for any income or expenses that haven’t yet been received or paid.
Direct method
The direct method formula, like totaling up a checkbook balance, is simply:
Cash flow from operations = cash revenue - cash expenses
Indirect method
When using the indirect method for calculating cash from operations, start with net income and then add back any noncash items such as depreciation and amortization expense. Then, in the balance sheet, you calculate the company’s change in working capital—its current assets minus current liabilities. The basic formula is:
Cash flow from operations = net income + depreciation and amortization - change in net working capital (current assets - current liabilities)
The change in working capital is important to cash flow because an increase in working capital means a decrease in operating cash, as more cash is spent on assets such as inventory or tied up in accounts receivable.
5. Compare cash flow from investing
Cash flow from investing is money spent to buy assets, commonly known as capital expenditures, and money received from selling assets. These assets include property, plant, and equipment (PPE), which are called fixed tangible assets, as well as trademarks, brand names, patents, and other intellectual property, typically referred to as intangible assets.
Cash from investing includes money received from buying securities held for investment, and from selling such securities. The goal of investing cash flows is to buy the most productive assets, which offer the best potential return on investment, and to sell less productive assets.
6. Consider cash flow from financing
Cash flow from financing is money received from outside sources, and money paid to such sources. Money received would include the proceeds from loans, bond issues, or stock sales; money paid would include loan or bond principal repayments, and stock dividends or stock buybacks. Interest paid on loans and bonds is treated as a cash flow from operations.
Cash flow from financing is important if a company uses borrowed money, or leverage, in an effort to boost profits. A company must weigh the cost of borrowing against the expected return. Also, if a company receives cash from a stock sale, it must reward shareholders by generating higher profits or paying dividends.
7. Identify trends and patterns
When you proactively analyze cash flow, you can spot trends and patterns over time. For example, certain months may consistently show higher cash inflow due to seasonality, while others may have higher outflows.
Recognizing these patterns helps you forecast cash flow and plan accordingly. You can make informed decisions about managing working capital and ensuring you have sufficient liquidity during periods of lower cash flow.
8. Spot potential risks
Regular cash flow analysis helps identify potential risks that could threaten the financial stability of a business. For instance, declining operating cash flow could indicate issues with revenue generation or increasing operational costs. Similarly, consistent negative cash flow can signal underlying problems that need immediate attention—like inefficient cost management or poor credit control.
When you detect issues early on, you can mitigate the negative effects. Take proactive measures when needed—adjust credit terms, renegotiate supplier contracts, or secure additional financing.
9. Find opportunities to improve cash flow
Just like cash flow analysis can help you spot issues, it can also help you identify opportunities. You can use it to think of ways to accelerate receivables, delay payables, reduce costs, or optimize inventory levels. You can also consider cash flow analysis when expanding product lines, entering new markets, or doubling down on your marketing efforts. Regular analysis keeps you agile and responsive to changing financial conditions.
Cash flow analysis example
Below is a cash flow analysis example, using the Shopify free cash flow calculator as a tool.
The business has both a retail store and an online store. It’s cash inflow for the past 30 days looks like this:
- In-store sales revenue: $7,500
- Online sales revenue: $12,500
- Other revenue: $1,000
- Total cash inflow: $21,000
The monthly cash outflows break down as follows:
- Rent: $1,000
- Payroll: $800
- Inventory costs: $1,500
- Utilities: $500
- Equipment and supplies: $200
- Marketing spend: $500
- Taxes: $2,000
- Insurance: $400
- Interest: $50
- Fees: $250
- Other: $500
- Total cash outflow: $7,700
For that month, the business’s cash flow is:
Cash flow = $21,000 - $7,700 = $13,300
This represents a healthy cash flow.
What does your cash flow tell you?
Rather than simply looking at whether you have positive or negative cash flow, consider why. Businesses that not only track cash flow over time but also analyze it for business insights set themselves up for financial stability and sustainable success. Start benchmarking your cash flow today to see how your business can improve over time.
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- Cash Flow Formula Definition: How To Calculate Free Cash Flow
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- What Is Fulfillment? Definition and Guide
- What Is a Fiscal Year? Definition and Guide
- What Is a Product Life Cycle? Definition and Guide
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Cash flow analysis FAQ
Why is doing a cash flow analysis important?
Doing a cash flow analysis is important because it helps businesses determine if they have enough working capital to keep funding operations. Understanding cash flow helps you analyze your business’s financial health.
Which technique is used for cash flow analysis?
The direct method and the indirect method are two common techniques used for cash flow analysis. The direct method is simply cash flow from operations = cash revenue - cash expenses. The indirect method accounts for liabilities, assets, depreciation, amortization, and change in net working capital.
What is a good ratio for cash flow analysis?
Generally, 1 or higher is a good ratio for cash flow analysis. This means the cash generated through operations is equal to or greater than liabilities.
How to do a quick cash flow analysis?
You can do a quick cash flow analysis by using the Shopify free cash flow calculator. Just gather your numbers and plug them into the cash flow formula to figure out your calculation.
How do you interpret cash flow statements?
Look at operating, investing, and financing activities. Also consider whether the cash flow is positive or negative. Also look for trends or outliers over time.
