Cash flow analysis is an essential tool for effectively managing your business. It helps you recognize opportunities to improve profitability, and also helps anticipate periods of low cash inflows, so that you can either use your existing funds strategically, or obtain a Line of Credit ( LOC) to help smooth over the troughs before they happen.
The other option is to ignore your cash flow, and hope it will " all just work out", something that many business owners do, which can lead to significant liquidity problems, and is the primary cause of business failure.
Here’s what you should know about performing cash flow analysis to optimize your business decision-making and avoid working capital issues. A business’s cash flow refers to its capital receipts and disbursements during a given period. In addition to the cash earned and spent in day-to-day operations, it includes funds gained and lost through investing and other financing activities.
Cash flows are distinct from revenues and expenses, especially for businesses using the accrual accounting basis. For example, you could close a deal on net 30 terms and generate sales, but not receive any cash for weeks.
Cash flow analysis requires that you organize the inflows and outflows from your business activities into a statement of cash flows—one of the three primary financial statements—along with the income statement and balance sheet.
Next, it involves adjusting for any items such as seasonal cash flow trends, opportunities to reduce expenses, or signs you need additional financing.
You may want to create a variance analysis, or budget, to estimate cash spending and expenses for an upcoming period, then comparing it to your actual results. This highlight areas where costs are significantly different than you expected, giving you the chance to ensure that you have the cash available to meet those expenses.
Here are a list of items to help you create a Cash Flow Analysis:
Operating activities: These include the cash inflows you generate by selling your products or services and the cash outflows you incur as operating expenses.
Investing activities: Include the purchase of investments like fixed assets and securities. Meanwhile, investing inflows refer to any returns they generate and the proceeds you get from selling them.
Financing activities: Are the cash flows associated with debt and equity financing. The proceeds you receive are inflows, while repayment activities are financing outflows.
Calculate your cash runway: Your cash runway is the length of time you can support your current cash flow, It’s highly relevant to new startups losing money and trying to gain traction and equals your cash reserves divided by monthly net cash flows, assuming they’re negative.
Check cash flow ratios: Ratios can help you assess solvency, liquidity, and profitability. For example, the cash flow coverage ratio tells you if your operating cash flows are enough to afford your debt payments. If it’s greater than one, your default risk is low. It equals net operating cash flows divided by total liabilities.