Cash Flow Analysis: Everything You Need To Know

Welcome to our Pulse guide for SMEs looking to master their cash flow analysis. We want to help business owners understand exactly why cash flow is so essential for running a successful enterprise, and hopefully empower as many budding entrepreneurs as we can along the way. A thorough cash flow analysis is really no different to performing a health check up on your business, helping to keep you in the know about your inflows and outflows, ensuring long-term financial versatility.

Below we’ll break down the basics of cash flow analysis, with the aim of delivering all the right tools for business owners, regardless of their experience, to start analysing cash flow effectively, and develop the financial resilience necessary to thrive. We’ve got lot’s of terms, numbers, and items to look at, as well as questions to ask and answer, so let’s get started.

Understanding Cash Flow Analysis

While there are many components to gaining a true understanding of your cash flow, at its most basic, cash flow analysis can be defined as the detailed tracking of money flowing in and out of a business over a set time period. To start with, we’re looking to get a number of primary questions answered with as much clarity as possible, creating a groundwork for us to expand our cash flow analysis on:

• Do we have enough cash to meet our obligations during this time period?
• Can we sustain our operations throughout this period?
• Can we generate further growth through investments in new opportunities?
• Are there any clear cash flow trends or anomalies that should be investigated?
• How efficiently are we managing our receivables and payables?
• What steps can be taken to improve our cash flow management?

By answering these questions, we can start to get a handle on numerous important things, and will realise the significance of what cash flow analysis can achieve for them. Enterprise health should be at the top of priorities, and through the correct analysis we can quickly learn if there is enough cash to pay the bills or make investments. A thorough analysis will also help with strategic decision making regarding budget as we get a full picture of the business’s finances. With a complete cash flow analysis, business owners will also have an up-to-date set of numbers on hand to show to potential investors or lenders, and can demonstrate their competency while building trust in their brand.

Different Types of Cash Flow

While the net cash flow of any given period, which is calculated by subtracting your business’s current liabilities from its assets, is going to be relevant for any kind of analysis, there are three different types of cash flow that we’ll need to be familiar with when making our analysis, as each will provide an additional insight into the different aspects of your business’s financial health:

Operating Cash Flow

This is any cash generated or used by a business’s core activities, and will include all revenue from sales, as well as any payments for expenses such as rent or salaries. When we have a positive operating cash flow it indicates good business health, where there is enough revenue to cover operating expenses.

Investing Cash Flow

Cash used for and generated from buying and selling assets will be found in this category, and can include anything from investments in equipment, property, securities, and any other niche investments that are relevant to your brand. Investing cash flow outlines how much your business is investing in future growth, so if your investments into long-term assets are high, short term cash flow may be negative, but this isn’t necessarily something to worry about.

 Financing Cash Flow

This is cash that has been exchanged between your business and either its owners or creditors. It involves areas like loans and debts, or issuing stock and paying dividends. Figuring your financing numbers is important because it not only illustrates how your business is financed, but explains how it can return value to potential shareholders.

Once we have the grasp of our cash flow types, and have thoroughly examined each relevant metric within, we can start to gain a complete understanding of a business’s financial health, ideally going on to use them and make smarter decisions for its future. With our cash flow types now thoroughly in mind then, let’s start exploring everything you need to know about the steps of cash flow analysis, and how you can make it simple and actionable.

Components of a Cash Flow Statement

A cash flow statement essentially tracks all of your business’s cash inflows and outflows to provide aggregates of your financial data. Again separated into our three main cash flow sections — Operating, Investing, and Financing. Each one will provide its own important insights, and is necessary to gain a complete view of your cash flow, so let’s break down each section to gain a better understanding of what they include and why they matter. Later we’ll put some example numbers to get a picture of how our finances might look on a statement:

Operating Activities

As we have previously noted, operating cash flow is the money coming in and out of your business, and as such, should all be recorded in your cash flow statement so we know how much cash your business is generating.

Example items that will appear on Operating Section:

• Any cash received from customers
• Any cash paid to suppliers
• Staff salaries and wages
• Property rent and utilities

Investing Activities

Just to recap, investing cash flow is related to the purchases and sales of long-term assets, which means a large expenditure for an investment might see a reduction in short-term cash flow, but will ideally lead to growth and profitability in the long run.

Example items that will appear on Investing Section:

• The purchasing of new equipment
• Any sales of properties
• Investments made in business securities (stocks, bonds, mutual funds etc)
• Any proceeds made from the sale of acquired assets

Financing Activities

As the name suggests, this will be cash flow from financing your business, with a positive flow typically indicating a cash source from new loans or investments, while a negative financing flow will normally indicate that your enterprise is paying off debts or redistributing dividends.

Example items that will appear on Financing Section:

• The issuing of stocks or bonds
• Any borrowing that is currently being done from banks or alternative lenders
• Any ongoing loan repayments
• The payment of dividends

With these things in mind, let’s start adding some numbers to each of our cash flow statement sections, as well as our items, and get an extremely basic example together of how our sections breakdown. Bear in mind that in reality, the numbers will not be so simple, however the calculations do not change.

Example Cash Flow Statement.

Year Ending December 31, 2023

Operating Activities

Cash received from customers: £500,000

Cash paid to suppliers and employees: £350,000

Net cash from operating activities: £150,000   Indicates healthy core operations

Investing Activities

Purchase of equipment: £50,000

Proceeds from sale of old equipment: £10,000

Net cash from investing activities: £40,000      Reflects investment in business growth

Financing Activities

Proceeds from issuing stock: £30,000

Repayment of bank loan: £20,000

Dividends paid: £10,000

Net cash from financing activities: £0                Balances funding activities

Net increase in cash: £110,000      Shows overall cash flow position

Cash at beginning of year: £40,000

Cash at end of year: £150,000       Final cash position

Preparing a Cash Flow Statement

Now that we’ve figured out the components of our cash flow statement, we’ll next need to perform a thorough cash flow analysis to start preparing the statement. It can get complex for individuals not versed in financial technicalities, however we’ll try and break it down with a step-by-step approach, and hopefully take away some of the daunt from it.

While the components of the cash flow statement — Operating, Investing, and Financing activities — provide a detailed view of cash movements, preparing an accurate cash flow statement will still also require data from an income statement (this is to adjust net income for non-cash items) and a balance sheet (this is to account for changes in working capital and other balances). Let’s make a note of these two items before we go into the preparation of the cash flow statement:

• Income Statement: This is also known as a profit and loss statement (P&L). It is the report that outlines the income, expenses and financial outcomes of an enterprise during a set timeframe, effectively generating a database to demonstrate how profitable it is.
• Balance Sheet: This is a financial statement that provides important snapshots at a particular point in time, and entails an enterprise’s assets and liabilities, as well as any shareholder equity. Again it provides data on the business’s financial position, and adds towards the bigger picture we seek to help with our cash flow analysis.

Preparing a Cash Flow Statement

Below we’ll go through the necessary steps for preparing your cash flow statement along with simple numerical examples to illustrate our points. This is important as it is a large factor in cash flow analysis:

Step 1: Gathering your Financial Data

• To start with, we’ll need the income statement and balance sheet (discussed above) for the specific period you’re analysing, as these documents will provide us with the data we need for our cash flow statement.

Step 2: Calculating your Cash Flow from Operating Activities

• Next we’ll take the net income from our income statement, and adjust for non-cash expenses. This could include things like depreciation or amortisation. We then want to adjust the numbers for changes in working capital (inventory, accounts payable / receivable etc).

Numerical Examples:

Net Income: £100,000

Add: Depreciation: £20,000

Increase in Accounts Receivable: £10,000

Decrease in Inventory: £5,000

Increase in Accounts Payable: £15,000

Net Cash from Operating Activities: £130,000

Step 3: Determine your Cash Flow from Investment Activities

• Now we want to record all the transactions the business has made related to purchasing and selling long-term assets (property, machinery and equipment, vehicles etc)

Numerical Examples:

Purchase of Equipment: £50,000

Proceeds from Sale of Equipment: £10,000

Net Cash from Investing Activities: £40,000

Step 4: Calculating Cash Flow from Financing Activities

• Next, we’ll take any cash inflows from issuing stocks or taking loans, as well as any outflows for things like loan repayments and dividends.

Numerical Examples:

Proceeds from Issuing Stock: £30,000

Repayment of Loans: £20,000

Dividends Paid: £10,000

Net Cash from Financing Activities: £0

Step 5: Let’s Summarise and Review our Numbers

• Now we can combine our net cash from our prior steps (operating, investing, financing etc) and find the net change in cash. We’ll add this to the beginning cash balance and finally get our ending balance.

Numerical Examples:

Net Increase in Cash: £90,000

Cash at Beginning of Period: £60,000

Cash at End of Period: £150,000

Tools and Templates for Creating Your Own Statement

In reality, there are many convenient tools available for business owners to input their numbers into, and we wouldn’t just have nonlinear separate lists like we’ve got in the examples. Between spreadsheets, templates, and accounting software, there are lots of options to create a thorough cash flow statement and simplify the analysis process. Let’s get a run down of the popular options:

• Spreadsheet Software: If you’ve done any office based work you will likely be familiar with tools like Microsoft Excel or Google Sheets, most likely not for financial reasons, but the templates they offer, and how their formulas work to automate calculations remain relevant and useful regardless of your intended use.
• Online Templates: There are many resources available online, in particular from financial websites, that will offer free cash flow statement templates, so if you do not have access to spreadsheets or accounting software, these could be an ideal place to start.
• Accounting Software: There are plenty of innovative accounting programs on the market in the current year, both open source bookkeeping and proprietary software. Two of the most popular programs are Quickbooks and Xero, both of which offer a range of accounting tools, and can generate cash flow statements for you based on the input data.

Hopefully the breakdown of our cash flow statement basics and subsequent steps that are necessary to follow have given a grasp of what numbers we should expect to see, and from what sources. That will settle the groundwork for what we’ll need for our cash flow analysis.

Using the right tools, and now with the right knowledge, you can also create clear and accurate cash flow statements that will help to manage your business’s finances more effectively. Next we can look at how to analyse a cash flow statement, and how the numbers can be interpreted in search of actionable financial insights.

Analysing a Cash Flow Statement

Now we are familiar with the necessary steps involved in preparing a cash flow statement, and have definitions of the activities (operating, investing and financing) we need to explore, let’s start getting to grips with how to accurately analyse our cash flow statement. First, we should note that interpreting each section of a statement really involves understanding the implications of the cash inflows and outflows, and while it may seem like basic logic to some, let’s explain those implications for each of our previously defined activities before we move on:

Operating Activities:

• For our operating activities, a positive cash flow will underline the fact that your business’s core operations have been generating enough cash to sustain operations, and is a sure sign that the enterprise is in great shape. On the other hand, a negative inflow will most likely indicate costly operating issues, but it may also just be that the company is expanding and heavily investing in working capital. This is why analysis is so important, to maintain awareness of whether negative cash flows are necessarily an overall negative for business health.

Investing Activities:

• A positive cash flow in investing activities is typically achieved when your business sells off any kind of assets, and while this isn’t necessarily a bad thing if those assets were purchased with intent to re-sell, if there is a negative cycle of selling more than you are buying this is a red flag. Inversely, negative cash flow from this activity suggests that your business is growing, and if steady, more likely than not means you are cleverly investing in your future and success.

Financing Activities:

• Now we come to financing, where a positive inflow will most likely indicate that your business is raising its capital through debt or equity, and again is why cash flow analysis is so important, as it means you can determine whether this financial method is sustainable in the longer term. A negative flow here can again be seen as a positive, as it means you are paying off your debts in a timely manner, or distributing to dividends, but once again should be monitored. Out of control debt will produce liquidity issues, and it’s a difficult slope to climb back out of.

Identifying Trends, Anomalies and Common Mistakes

Next let’s think about how we can start identifying trends and anomalies across your activities, and to do this we’ll suggest a number of common issues that business owners come to us with, and see what they mean, and how they can be avoided:

Possible Cash Flow Trends

• A consistently positive operating cash flow: Will confirm that your core operations are stable and working as intended.
• Increasing investment outflows: Seeing this will most likely suggest that you are using cash for expansion and growth.
• Stable or declining financing outflows: Will likely imply that your business model is handling debt management effectively, creating a positive financial stability.

 Possible Cash Flow Anomalies

• Unexpected spikes in operating cash flow: While this could be a result of many things, it often runs down to one-off events where large sales occur and payment delays happen.
• Sudden negative cash flow from operating activities: We often hear of problems in businesses collecting receivables, or experiencing increased operational costs that result in negative cash flow occurring here.
• Larger inflows in financing activities: This could be that a company has become heavily reliant on external funding, and as previously mentioned, may not be sustainable.

Common Mistakes to Avoid

• Ignoring non-cash adjustments: It is important to adjust your net income for non-cash expenses such as depreciation, otherwise you will stop getting an accurate figure on your operating cash flow.
• Misrepresentation of investing outflows: We’ve touched on it already, but not all negative cash flows from investing activities are bad (long term investments in assets), and should be taken into account individually to understand each case’s context.
• Overlooking important trends: We suggest that you keep a close focus on financial patterns over time rather than getting caught up on isolated figures, this way trends can be spotted, whether they are positive or negative, and an appropriate strategy can be devised to either resolve the issue or capitalise on an opportunity.
• Not considering seasonality (if applicable): If your business relies on seasonal cash flows (retailers who operate around holidays for example), it will be much more efficient to compare year over year data to get a long term picture of how seasonal fluxes compare.

Cash Flow Ratios and Their Significance for Analysis

Next we’ll move on to look at the cash flow ratios that are important for assessing the different parts of a business’s financial health. Knowing these ratios and applying them to your numbers should also give business owners some awareness of how their operations are running, and whether they need to take any immediate actions. For our examples we’ll use some basic numbers, with the intent of demonstrating how each ratio is applied:

Operating Cash Flow Ratio

• Formula: Operating Cash Flow ÷ Current Liabilities
• Calculation Example: Let’s take an operating cash flow of £130,000, with current liabilities at £100,000 — this gives us a ratio of 1.3.
• Interpretation: For operating cash flow, anything above a 1 is considered healthy, and means your business will be able to cover the costs of its operations. The higher your number is after divisions have been done the better.

Cash Flow to Equity (FCFE) Ratio

• Formula: Cash Flow ÷ Average Shareholders’ Equity
• Calculation Example: Here, let’s consider a free cash flow of £90,000, and an average shareholders equity sitting at £500,000 — this gives us a ratio of 0.18.
• Interpretation: This shows the amount of money that is available to shareholders after covering costs and making investments, with better values suggesting a healthy financial flexibility.

 Cash Return on Assets (CROA)

• Formula: Operating Cash Flow ÷ Average Total Assets
• Calculation Example: For our sample numbers we put operating cash flow at £130,000, and the business’s total assets at £1,000,000 — giving us a ratio of 0.13.
• Interpretation: The intention of this ratio is purely to measure how efficiently the company is capable of generating cash from its assets, and the higher these ratios are, the more likely it is that there is efficient cash flow generation.

Cash Conversion Cycle (CCC)

• Formula: No more divisions now — Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding
• Calculation Example:

Days Inventory Outstanding: 30 days

Days Sales Outstanding: 45 days

Days Payable Outstanding: 20 days

CCC = 30 + 45 – 20 = 55 days

• Interpretation: Because a business’s CCC measures how long it takes for them to convert inventory and receivables into cash (minus the time taken to pay suppliers), it means a shorter cycle is better, and quicker cash conversions are being made.

The reason these ratios are so important, is because they can help business owners gain deep financial insights over their cash flow metrics, from liquidity and operational efficiency to the overall financial health of an establishment. It is also why business owners should frequently track these indicators so they can make well informed decisions about their cash flow, ideally sustaining a strong financial plan in the long term.

Advanced Techniques in Cash Flow Analysis

For our advanced techniques we can start with the predicting or forecasting of our cash flows, whereby your business can aim to estimate its inflows and outflows using historical data and market trends, as well as any planned business activities. There are a number of reasons why forecasting cash flow is important, so let’s cover them:

1. Planning and Budgeting:  Without an accurate forecast, your business’s budget, and the plans you make around it may quickly become skewed. If you want to ensure you have sufficient cash to meet your obligations you should closely monitor the metrics of your cash flow.
2. Managing Liquidity:  Accuracy will also ensure your business can reliably predict periods of cash surpluses and shortages. This is important for making informed decisions regarding taking on debt, as well as investment opportunities or simply saving.
3. Strategic Decision Making:  Thorough forecasts are also more likely to offer insights into the potential financial outcomes of your business’s strategic choices, such as expanding into new markets or introducing new products.
4. Investor Confidence:  A detailed cash flow projection will go a long way towards convincing investors that your company is being proactive in financial management and is equipped to tackle potential obstacles.

How to Forecast Cash Flows

With the why out the way, let’s take a closer look at some steps you can take to start forecasting your cash flow:

1. Gather your Historical Financial Data:  You can start off with collecting all your data from past cash flow statements, as this will be necessary for identifying your business’s financial patterns and trends.
2. Identify the Key Drivers:  While exploring your past statements, begin determining any of the primary factors that are influencing your cash flow. It could be anything from sales growth to cost structures, and there will more than likely be more than one.
3. Develop Assumptions:  Now you have your historical data and have done your market research, you should start creating some thorough assumptions about future performances, and should include your expected sales growths and changes in expenses, as well as any investment plans.
4. Create Potential Scenarios:  From here you can start developing any number of best, worst, and most likely case scenarios for each of your assumptions, with the aim of envisioning potential financial outcomes.
5. Start Building your Forecast:  When building your forecast we advise that you use some of the spreadsheet software or tools we discussed earlier, as these will help to create detailed cash flow projections for each of your scenarios. Within your forecast remember to include monthly or quarterly timeframes for your operating, investing, and financing activities.
6. Reviews and Adjustments:  Finally, to ensure your forecasts remain accurate and relevant, decide on a time period, be it every month / three / six months, and compare your forecasts against how your business is performing, then adjust any necessary numbers to suit.

Scenario Analysis and Stress Testing

Evaluating hypothetical scenarios is a great way to gain financial insights into how they might affect your business’s cash flows. This method also helps in identifying any risks or opportunities, allowing your business to better prepare for different future situations. Taking it a step further, stress testing also assesses how well your business might fare during adverse conditions ensuring your ability to withstand major financial challenges should they come up. Let’s take a look now at how we go about both scenario analysis and stress testing, as well as go through some brief example scenarios to illustrate our ideas:

Scenario Analysis

1. Identify the Scenarios:  When you have developed your scenarios that you believe will impact your business’s cash flow, be they changes in sales volumes, potential supplier cost increases, or dips in economic conditions, the list could go on, you want to determine the key variables and act.
2. Analyse any Impact:  For each identified scenario, you can then adjust your established cash flow forecast to reflect any changes made. Then go on to analyse how each of these scenarios will affect your cash inflows and outflows, as well as liquidity and your overall financial health.
3. Plan your Responses:  While equally as important to the rest of your scenario analysis, your responses should revolve around developing a plan that will either mitigate negative impacts or capitalise on positive ones, depending on those identified scenarios.

Some Example Scenarios:

• The Best Case: Sales increased by 20% and costs decreased by 10%
• Worst Case: Sales down 15% but costs increased 5%
• Most likely: Sales increased by 5% and costs remained the same.

Stress Testing

1. Define Stress Scenarios:  Start off by identifying your most extreme but also most plausible scenarios. Again this could be an economic downturn, a loss of key customers, or suppliers running short of materials, it will be dependent on your industry and sector.
2. Assess Financial Impact:  Adjusting your cash flow projections will help to identify and reflect these new conditions, and will help you to better analyse the impact they have taken on your cash reserves and liquidity ratios.
3. Evaluate Business Resilience:  By figuring out any liquidity shortfalls that may result from your scenarios, you can determine how long your people could sustain its operations without the need of any additional outside funding.
4. Develop a Contingency Plan: Thorough contingency plans set in place across all of your scenarios is a great way to preemptively prepare yourself for possible future problems, and while none of us who are in business want to consider the idea of failure, being prepared for any potential outcome will only increase your resilience.

Example Stress Tests:

• Scenario: Sales drop by 30% due to an expected economic recession.
• Impact: Cash flow slows down significantly and a possibility of liquidity is identified within 6 months.
• Response Plan: Secure a revolving credit line and reduce non essential expenditures to ease on cash flow losses, follow up by negotiating an extended payment term with suppliers.

By integrating forecasting, scenario analysis and stress testing into your cash flow evaluation we see that you can effectively enhance your business’s readiness for potential future hurdles. These advanced methodologies will ideally offer combined insights into your business’s financial risks and potential opportunities. In all, these methods will enable you to make informed strategic choices and uphold the financial stability of your enterprise.

Using Pulse for the Practical Application of Cash Flow Analysis

Tools for accountants, business owners, and financial advisors are available in abundance in the current year, fortunately for all of us, and our tool, Pulse, is able to integrate seamlessly with the best Open Accounting and Open Banking software out there.

Through our intuitive AI driven dashboard, SMEs and their advisors can see up-to-date financial information about their cash inflows and outflows, each of which are presented via easy to understand infographics and data breakdowns, allowing business owners to gain a more accurate understanding and timely analysis of their cash flow.

Through our fintech you will also gain comprehensive insights into your key financial metrics, including Turnover Trends, Gross Margin, Debtor&Creditor Ratios, as well as Income Statements. By aggregating your financial data, Pulse can also go a step further when it comes to businesses who are seeking loan applications, as our tool will deliver the precise data that lenders require, presented and formatted to the preferences they request. Let’s go through now, and see what our innovative Fintech tool has to offer, and why it is becoming so popular among SMES:

Cash Flow Forecasting

Pulse, at the user’s permission, pulls all requested financial data from accounting and open banking sources, and uses your current and historical data to help predict future financial positions. SMEs can recognise potential cash shortages or surpluses ahead of time, enabling them to make informed business decisions, as well as manage risks and opportunities.

Automated Reporting

Our tool generates monthly automated reports for businesses that will be sent directly to your inbox, as well as any advisors if requested. Our platform will generate detailed cash flow reports that emphasise all of your important financial metrics and trends, helping to keep you up-to-date while you are on the go.

Performance Insights

We can deliver actionable insights to help improve your small business financial intelligence through our advanced analytics features, and by analysing your transaction patterns and financial data, we can help your business in pinpointing areas where it can improve its cash flow. Our insights also help SMEs understand their spending patterns, letting you identify and eliminate unnecessary spending.

Scenario Planning

With Pulse, you can use our dashboard and the easy to grasp infographics to help perform effective scenario analysis, using the broken down financial data to model different situations accurately and easily. This is of course particularly useful for contingency planning and strategic decision making, helping evaluate any potential impacts that different scenarios might present.

User Friendly Interface

We built Pulse with the key intention of making it easy to understand and accessible for business owners who don’t have an extensive background knowledge in finances. Through our weekly reports, broken down infographics in the form of bar graphs and line charts, we will present your complex financial data to you in a way that is plain and simple. This is also beneficial when it comes to planning strategy with your advisors, as you will be able to understand the figures that they want to discuss. Our dashboard is also easily navigable, and includes management accounts for your and your advisors’ convenience.

Our mission at Pulse is to equip SMEs with a laser vision into their finances, equipping them with the best tool on the market to conduct thorough cash flow analysis of their own, improving both their financial planning and ability to maintain financial stability, so, If you are looking for a way to convert your real time data directly into financial intelligence, why not sign up to Pulse, and get in contact with us to see how our services can start enriching your business.