Cash Flow Analysis 101: What it is and how to do it

very small business needs a system for tracking the money coming in and out the door. Even businesses with in-demand products and services can falter if they don't anticipate and balance their sales against their payroll and other mission-critical expenses. A cash flow analysis allows businesses to understand their financial health and adjust accordingly. Put this practice in place to ensure that your business remains a powerful presence in the marketplace long-term.

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What is a cash flow analysis?

A cash flow analysis analyzes a company's financial vital signs in specific detail — typically operating, investing and financing. A cash flow analysis aims to gain insight into the amount of cash coming into a business and the amount of cash going out. From there, an owner can learn how to anticipate cash flow and expenses, spot inflow and outflow trends, and navigate key decisions for the business.

Difference between cash flow analysis and profit/loss statements

A cash flow analysis is designed to illustrate the myriad ways that a company uses its available cash. That might look like investing in equipment, real estate or other key assets. It can also look like paying down loans or paying investors back.

In contrast, a profit and loss statement is intended to show how much revenue the company generates and how that compares with its expenditures. Profit (or loss, if the number is negative) is calculated by subtracting operating expenses from revenue.

Why cash flow analysis is important for small businesses

As a small business owner, it's all too easy to feel confident that you know how your business runs. You’re likely too used to multi-tasking and juggling every detail on your own. Despite that, documentation matters. When you conduct a cash flow analysis, you commit to understanding the operational costs, investments, and financing terms that affect your business. Those details, in turn, help you figure out what the next right decision is for your company, whether that's a new product launch or time to re-calibrate.

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How to do a cash flow analysis

You can get your cash flow statement analysis up and running in just a handful of steps. Here's a look at what to do.

Steps to prepare a cash flow statement

You'll want to start documenting your business's financial ins and outs. Who are the vendors you do business with, and how often do they require payment? Who are your clients, and how often are they billed for your services? What products do you sell, and how often are taxes paid on those sales? Every ounce of financial movement will matter as you do a full cash flow analysis.

Determine the reporting period

Determine how often you need to do a cash flow analysis based on how your business receives payment—for example, via client invoices—and how often money needs to go out the door, as it will for the payroll cycle and vendor payments. The reporting period is typically a month, a quarter, or a fiscal year, but it can be any other length of time you need to get a snapshot of your business.

Gather financial data

Record the current balance of your business bank account(s), as well as the amount of cash coming in and the amount of cash leaving your small business in a given reporting period. Incoming cash can take several forms, from recurring subscriptions and sales of products and services, to loans or personal funds you transferred to your business. Outgoing cash includes staff paychecks, office space rent, and equipment. Make sure you account for every dollar in and every dollar out.

Organize data into categories

Your incoming and outgoing cash should be split into categories for later analysis. These categories are operating, investing, and financing activities. Calculate net cash flow in all three categories to view the complete picture of your business.

Calculate the net cash flow

To calculate your net cash (i.e., the cash you have on hand after your bills are paid):

• Enter your starting bank account balance
• Record total incoming cash
• Record total outgoing cash
• Subtract outgoing cash from incoming cash to come up with your cash position
• Look at cash position repeatedly, over time, to understand your company's cash flow

Analyze your cash flow statement

As you analyze your company's cash flow position over time, you'll begin to understand the cash flow trends for your business.

The numbers you're most often looking for on a cash flow statement are your net cash or ending cash balance — which should stem from the net amounts in each of the three sections of the statement (operations, investments, and financing). You can also define cash flow in other ways, as there's not necessarily one model that works for every business.

One of the indicators worth looking at is the ratio of operating cash flow to net sales. This number reveals how many cash dollars come in per every dollar in sales. Ideally, this percentage should be as high as possible, and you want the two numbers involved to expand or contract at a similar pace.

You can also look at free cash flow, the cash that’s available after you’ve paid your operating expenses like rent and payroll, and after you’ve accounted for the expense of other assets, such as real estate and equipment.  

To learn how much discretionary income a business has, you can look at a comprehensive cash flow ratio measurement — or the company’s free cash flow divided by its net operating cash flow. This ratio reveals how much cash is truly available for use while still keeping the operation up and running.

All of these numbers will show investors how well your company is doing compared to competitors and how well it’s performing against its goals in the marketplace. They will help guide your decisions and determine how and when you can take your business to the next level.

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Tips for accurate cash flow reporting

Even when you have a handle on the reporting needs for a cash flow analysis, the details matter. Here are some suggestions for achieving accuracy and stronger analysis in your reporting.

Track all money movements

Make sure you budget for the financial inflow and outflow in your business. If certain bills hit your business quarterly, such as taxes or vendor payments, but you track cash flow monthly, you'll only record those payments in your cash flow statement in the month you pay them. However, this means cash flow can change significantly from month to month. Make sure that you also remember to include any annual renewal fees, from your business license to the software programs and services your company uses.

Use cash flow forecasting

Cash flow forecasting involves anticipating future cash flow to understand challenges and opportunities. You might anticipate receiving funding from investors at an upcoming date or have contracts near closing. On the other hand, you'll need to pay some expenses out regularly, such as utilities, rent, and debt payments. Forecasting allows you to predict what your business will need financially, which in turn should ensure that you don't run out of money and have the cash position needed to handle debts and prepare for growth.

Keep an eye on seasonality

Many businesses are vulnerable at certain times of the year. For example, the real estate market is widely known to be more competitive over the summer as families move before the start of the following school year. Retail businesses are always in the news for how they navigate the holiday season, and some businesses are particularly vulnerable to the impact of national and world events and economic conditions. Any cyclical factor capable of disrupting your business should have a presence in your cash flow analysis and should be factored into any calculations about how your business tends to fare in an average reporting period.

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Cash flow statement analysis

How do you analyze a cash flow statement so that it can provide you with invaluable insights? Here's a look.

The sections of a cash flow statement

Recall the three sections of a cash flow statement:

• Operating activities — the transactions associated with doing business (i.e., selling goods or services)
• Investing activities — the acquisition of or reduction in assets
• Financing activities — needs of the business that involve the presence of stockholders, lenders, or creditors

Each of these sections may show positive or negative cash flow. Having negative cash flow in one area or another is not necessarily bad, as your business may pursue different strategies over time. For example, if you're preparing to launch a new product, you may need to invest in equipment or supplies, which could create a negative cash flow until your new offering hits the marketplace.

How to interpret data on a cash flow statement

If the amount of cash going into a company is more than that of cash leaving, the company is said to have a positive cash flow. If the amount of cash leaving a company exceeds the amount pouring in, the company has a negative cash flow.

Each new cash flow statement a company generates is unique to the period it covers, so a new reading should be done per reporting cycle.

Examples of positive and negative cash flow scenarios

If you're starting a business and in pre-launch mode, you may be investing in products, services, or resources to help you bring your vision to market. During this period, you're likely to have a lot of expenses mounting while not having a single customer. You're in a period of negative cash flow.

Now fast forward a year. You've launched your start-up, and it's finding its way to customers. Your clientele is growing, and you've got a steady stream of sales that allows you to pay your bills and still have money left over. You're in a period of positive cash flow.

The fluctuation from positive to negative cash flow and back again is common for small businesses. You should expect changes, particularly as you re-invest in your business or endure periods of economic uncertainty. You may also find that some of your products are unsuccessful, creating negative cash flow until you can pivot and improve your product line.

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Takeaways

Cash flow can vary widely from one industry to another and from one small business to another. Depending on the broader economic climate, it can also change due to seasonality and ebb and flow. Nonetheless, doing the work to understand your cash flow trends enables you to gauge your small business's current and projected performance. Committing to this process will help you operate your business even in times of uncertainty, and cash flow reporting will also help you attract the right investors.

Novo is ready to help you accomplish this task by providing a best-in-class business checking account and invoicing tools that will help you track cash flow.

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