Updated July 15, 2023
Definition of Cash Flow Analysis
Cash flow analysis means analyzing or checking the different streams of cash flows (i.e. from operating, investing & financing activities) for an entity during the accounting period and, understanding the movement of cash from one stream to another & reconciling the net movement with an opening as well as the closing amount of cash balance of the entity.
Explanation of Cash flow analysis
- Cash flow analysis comprises analyzing the entity’s operating, investing & financing activities during the relevant accounting period.
- Analyzing the different activities means correlating whether the specific activity falls under the category.
- We study the pattern of cash movements.
- The net movement of cash flow from different activities is added to the cash amount’s opening balance to arrive at the closing balance of the cash amount. This closing should match the actual closing cash amount.
How to Do Your Cashflow Analysis?
Cash flow analysis can be done for each stream as follows:
1. Analysing Cash Flows from Operating Activities
Operating activities mean the normal operations of the business.
- Cash flows from operating activities can be computed through two means direct method & indirect method.
- The direct method means the actual amount of cash paid to vendors, cash received from customers, payment to employees, etc., are considered to arrive at the final figure.
- Under the indirect method, one needs to have a crystal understanding of the income statement. The indirect method means the following steps:
- Step 1: Start with the net income figure per the income statement.
- Step 2: Add back the non-cash expenses, such as depreciation & amortization.
- Step 3: After this, working capital changes are incorporated.
- Step 4: adjust cash flows relating to investing or financing activities.
- Step 5: The net cash amount related to cash flow from operations of the entity.
2. Analysing the Cash Flows from Investing Activities
- Companies may consider investing in bonds, debentures, etc., to earn a higher interest rate than bank interest. Alternatively, it may consider providing loans to other corporate entities, purchasing new property, plant & equipment, and intangibles, etc.
- Thus, we need to identify the specific cash flows pertaining to these activities. Gain or loss due to such activities is also included here.
- The following steps can be followed:
- Step 1: Include the cash flows pertaining to investing activities, which are clubbed in the income statement.
- Step 2: Deduct profits from the disposal of long-term assets or marketable securities. The reason is that we consider the actual amount realized.
- Step 3: Add back loss due to the disposal of such assets since there is no cash outflow.
3. Analysing the Cash Flows from Financing Activities
- This includes the acquisition of new loans or repayment of existing loans. It also includes the issuance of securities or redeeming back the old securities.
- The following steps can be followed:
- Step 1: Loan taken & stock issuance amount (issue price * a number of shares) to be added here. Repayment of loans & buyback of stocks is to be reduced from here.
- Step 2: Interest payments clubbed in the income statement are to be reduced from here & add back to operating activities. Similarly, the dividend paid & tax on the dividend paid needs to be added back into operating activities & included here. Thus, all such item needs to be adjusted.
- Step 3: The net amount of all the above would be cash flow from financing activities.
Examples of Cash Flow Analysis
Let’s have the below cash flow statement for our analysis purpose: (Figures are in $ millions)
|Particulars||December 31, 2020 ($)||December 31, 2019 ($)|
|Cash Flows from Operating Activities|
|Net Profit Before Tax||(47,700)||1,40,700|
|Loss/(Profit) on Sale of Fixed Assets||4,800||–|
|Operating Profit before working capital changes||(12,900)||1,68,600|
|Trade and other receivables||(19,600)||(32,400)|
|Operating Profit after working capital changes||(45,100)||37,600|
|Direct Taxes Paid||(500)||–|
|Net Cash Flow Used in Operating Activities ( a )||(45,600)||37,600|
|Cash Flow Used in Investing Activities|
|The net amount of Purchase of Fixed Assets||(1,900)||(2,500)|
|Loss from sale of fixed assets||4,800||–|
|Net Cash Flow Used in Investing Activities ( B )||2,900||(2,500)|
|Cash Flow from Financing Activities|
|Issuance of capital||30,000||–|
|Repayment of Short-Term Borrowings||–||(27,300)|
|Short term borrowing received||50,000||1,45,000|
|Net Cash Flow from Financing Activities ( C )||58,900||1,01,600|
|Net Decrease in Cash & Cash Equivalents (A+B+C)||16,200||1,36,700|
|Cash & Cash Equivalents – Opening Balance||1,37,500||800|
|Cash & Cash Equivalents – Closing Balance||1,53,700||1,37,500|
- We observe that the company is in cash loss due to operating activities starting from operating activities. We analyzed the income statement & seen a drastic reduction in revenue figures. When analyzing the balance sheet for the same, we realized there is a demand reduction & the company has sold its major fixed assets as reflected by the net purchase of fixed assets in investing activities. The demand reduction is attributed to the company’s low quality of goods.
- As compared to the previous year, the company was in operating cash inflows.
- Under investing activities, the company has purchased new fixed assets for trying new product lines for the future. This shows the fight-back approach of the company. The net purchase amount reflects that the cost of new assets is higher than the sale amount of old assets. Thus, we can interpret that new high-efficiency assets are purchased by discarding the old low-efficiency machines.
- The company has borrowed $ 50,000 million this year to fund its operations. The company is successful in issuing new stocks in the current year & thus, we can see cash inflows to that extent.
- The increase in interest payment in the current year is due to the new debt acquired last year, $ 145000 million.
Some of the advantages are given below:
- Any analysis of any sort is always helpful. Analyzing the cash flows helps you understand the cash movement due to each stream.
- Cash budgets can easily be prepared using cash flow statements.
- Cash flows give guidance for working capital management.
- The company can set target cash reserves after analyzing the cash flows.
- The company can also manage when to take to a new loan, pay the existing loan & manage its credit profile.
- The analysis helps you understand when to stop paying the vendors so that you do not run out of cash in the near future.
- Cash flows help to keep sufficient funds at the disposal to meet emergency production requirements. Production should not get disrupted due to cash flow weakness.
- Thus, cash flow can sustain the time production of units & timely supply of the finished products.
Every coin has two sides. We also need to acknowledge a few disadvantages of cash flow analysis as follows:
- We cannot predict the growth percentages or trends using the cash flow parameters as we do for income statements.
- A cash flow statement summarizes stream-wise events that happened in the past. However, potential investors are more interested in knowing the company’s future aspects & which can be done using a balance sheet & income statement only. Thus, cash flows lack this feature of giving insights about future streams due to uncertainty.
- Analyzing the cash flow streams is easy only for persons with a little finance background. For other potential investors, the company needs to explain them. Thus, analyzing part is not that easy for everyone on the floor.
- As the name suggests, cash flow is concerned with cash movement & thus, it is based on a cash system of accounting. Thus, one may get confused with the method of accounting followed.
- With the cash basis of accounting, it has to ignore the accrual basis of accounting. This is why they nullify the effect of provisions & give effect to cash payments.
- You cannot analyze the profitability of the company using cash flows. Deducting profits & adding back losses may create doubt in the minds of some people with a lower finance background.
- Also, each organization’s cash flow is not mandatory yearly, unlike the income statement & balance sheet.
One needs to analyze the three statements together, i.e. income statement, balance sheet & cash flow statement. We cannot analyze one statement in isolation; otherwise, the interpretation may go vague. You should not mellow down seeing the negative cash flows from operating activities. To conclude the fact, one should also look over the reserves the company sustains, profits over the years, the asset-backing ratio of profits, etc. Even if there are many disadvantages, any sort of analysis is always helpful if done in an appropriate manner.
This is a guide to Cash Flow Analysis. Here we also discuss the definition and how to do your cashflow analysis. Along with advantages and disadvantages. You may also have a look at the following articles to learn more –