Understanding cash flow is the key to business success
Cash Flow
The cash flow of a company at any given time is the difference between the cash available at the beginning of an accounting period and at the end. Cash flow includes loan revenues, investment income, and asset sales, and is used to pay operating expenses, direct expenses, principal debt service, and to purchase assets such as equipment. When running a small business, cash is king. You may be profitable on paper, but lack cash.
How to Conduct a Cash Flow Analysis
Cash is the fuel that keeps your company running. A cash flow analysis is a way to validate your company’s financial situation. To conduct a cash flow analysis, you will first need to prepare cash flow statements for operating, investing, and financing activities.
Generally, you want to see positive cash flow. However, there are situations where negative cash flow can be a good thing. For example, if your company is making investments and growing, there may be negative cash flow for investments.
You should also calculate free cash flow (FCF) which represents the amount remaining after paying operating expenses and investment expenses.
You will also want to review the operating cash flow margin to see how much cash is available from operating activities as a percentage of total sales revenue.
The Difference Between the Cash Budget and the Cash Flow Statement
Tracking cash flow is essential for the survival of your small business. However, accountants sometimes refer to the cash budget and the cash flow statement in more detail.
Cash Budget
The cash budget is used to estimate the inflows and outflows of cash for your company over a specific period of time. It can be used for both long-term and short-term goals. The cash budget is designed to forecast future cash balances and identify potential cash shortages and surpluses. You can then use these forecasts to create plans to manage those situations.
Cash Flow Statement
The cash flow statement is used to show how money moved in and out of the company. This statement has three sections:
- Operating activities: Earning money, paying expenses, and financing working capital
- Investing activities: Gains and losses from buying and selling assets and investments
- Financing activities: Any cash flow activities that change the size and composition of equity financing and borrowings
The First Step in Analyzing the Cash Flow Statement
The business owner should look at the company’s balance sheets for the last two years and compare the differences between them to develop the cash flow statement. Using information from the income statement, such as profit or loss and depreciation, along with information from comparative balance sheets, particularly how current assets and liabilities have changed, you can develop a cash flow statement.
Analyzing the Cash Flow Statement
Analyzing the cash flow statement involves looking at the sources and uses of money from the comparative balance sheets, allowing the company to gain a better insight into its future cash needs.
Calculating Your Company’s Free Cash Flow
Calculating free cash flow is one of the most important outcomes that a small business owner can gain from analyzing the cash flow statement. Simply put, free cash flow is the cash that is available to the company after paying any capital expenses, such as a new plant or equipment.
Free Cash Flow Calculations
Free cash flow is the amount remaining for your company to use for other purposes after paying for capital expenditures, including buildings and equipment, and other expenses necessary to maintain ongoing operations.
The formula for calculating free cash flow is:
Free cash flow = Operating cash flow (CFO) – Capital expenditures
Calculating Cash Flow Ratios for Your Company
Many financial ratios, including operating cash flow, price/cash flow, and cash flow margin, help business owners focus on cash flow.
These ratios can be calculated for your company’s cash flow to give you information about the company’s liquidity and ability to meet obligations and sustainability. Add these calculations to your cash flow analysis to enhance it.
Questions
The Traded
What are the three types of cash flows?
The three types of cash flows come from operating activities, investing activities, and financing activities.
What is a good measure of cash flow?
Free cash flow is a very good measure of cash flow for a company. It is the measure of cash that is available to the company after paying capital expenditures like inventory or property. Free cash flow shows you how much cash your business has for expansion and growth.
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References:
Oracle NetSuite. “Cash Flow Analysis: Basics, Benefits and How to Do It.”
Datarails. “Cash Budget.”
Corporate Finance Institute. “Statement of Cash Flows.”
Seeking Alpha. “Free Cash Flow.”
Corporate Finance Institute. “Free Cash Flow (FCF).”
NetSuite. “Cash Flow Analysis: Basics, Benefits and How to Do It.”
Source: https://www.thebalancemoney.com/cash-flow-analysis-393050
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