As business owners or finance professionals, many people struggle to understand the complexities of a cash flow statement analysis. Therefore, they aren’t able to use them to make informed decisions. According to a U.S. Bank study, cash flow mismanagement causes 82% of businesses to fail. Therefore, it is necessary for entrepreneurs to prioritize the efficient cash flow statement analysis of their financial resources and continuously evaluate it to avoid such an outcome. In addition, cash flow statement analysis can also provide insights into how efficiently a business is operating. Further, it indicates where improvements can be made to optimize profitability.
This blog discusses the role of cash flow statements in detail – why it is important for businesses, how to calculate them, and how it is different from the income statement and balance sheet.
What is a Cash Flow Statement?
Simply put, a cash flow statement is a description of the inflow and outflow of cash in a business over a specific time period. In other words, a cash flow statement summarizes a company’s cash receipts as well as payments throughout a specific accounting period. It also offers an overview of how the company’s operating, investing, and financing actions impacted its cash position.
Typically, the statement is divided into three sections:
- Firstly, operational activities that include sales as well as purchases
- Secondly, investment activities that include property, plant, and equipment
- And lastly, financing activities that include paying dividends, borrowing or repaying loans
Why is Cash Flow Statement Analysis Important?
Cash flow statement analysis is a useful tool for investors and financial analysts because it helps assess a company’s liquidity, financial health, as well as ability to satisfy financial obligations. For example, the reasons why it plays a crucial role are:
- Allows investors and analysts to gain a better knowledge of a company’s financial health and ability to create cash flows
- Assists in determining the company’s cash flow pattern as well as forecasting future cash flow requirements
- Helps to find out the liquidity, solvency, and overall financial strength of a corporation
- Supports creditors in making informed judgments about whether to invest in or lend money to a company
- Contributes to the identification of potential hazards and opportunities in a company’s operations and strategies
- Allows financial analysts to compare the financial performance of companies in the same industry or sector
- Facilitates communication as well as transparency about a company’s financial status and cash flow management with its stakeholders
How is Cash Flow Calculated?
Cash flow statements track the inflow and outflow of cash from a business, providing valuable insights into its financial health and liquidity. The following are the two main methods for calculating the statements.
1. The Direct Method
The direct method computes cash inflows and outflows from the company’s activities directly. In this approach, it is necessary to analyze and categorize the company’s cash transactions as well as payments into operating activities such as cash from sales, cash paid to suppliers, and cash paid to staff. However, it takes longer to construct, making it a more time-consuming process than the indirect method. Despite this, professionals prefer the direct method because it provides more accurate and detailed information about a company’s cash flows.
For example, the benefits include the provision of a more accurate picture of the company’s cash flow, easier to identify cash flow issues, and hence, better forecasting.
2. The Indirect Method
The indirect approach computes cash flows by starting with net income and adjusting for non-cash items like depreciation, amortization, and changes in working capital. This cash flow from business operations is calculated by analyzing the company’s income statement and balance sheet and adjusting for non-cash items.
The benefits, for example, are: easy to use and understand, allows better comparability between different companies and industries, as well as prominent availability of data and potential figures.
Both approaches produce the same final cash balance. However, the quantity of detail supplied and the complexity of preparation differ.
Difference Between Cash Flow Statement, Income Statement, And Balance Sheet
Cash flow statements, income statements, as well as balance sheets are three important financial statements that provide different information about a company’s financial performance. Therefore, understanding the following differences between these statements is crucial for making informed financial decisions.
|Cash Flow Statement||Income Statement||Balance Sheet|
|Describes the inflow and outflow of cash (in a specific time period)||Shows the company’s net income or loss (for a specific time period)||Highlights the company’s financial position (at that point in time)|
|Reports the changes in cash and cash equivalents over the period||Reporting includes the revenues, gains, expenses, and losses of a company in a described time frame||Summarizes the assets and liabilities of a company along with the equity at a specific point in time|
|Informative data related to the operating, investing, and financing activities of a company||Provides information about a company’s profitability||Gives prominent figures related to resources and obligations of a company|
|Evaluates a company’s liquidity and cash-generating capacity||Computes a company’s ability to generate profits||Estimates a company’s solvency and financial stability|
Key Ratios Used in Cash Flow Statement Analysis
Analyzing key ratios using a company’s cash flow statement can provide insights into its liquidity, operational efficiency, and financial health. So, here are some of the most important ratios to consider.
Cash Flow Coverage Ratio
This metric assesses a company’s capacity to cover debt payments with operating cash flow. So, to calculate this, the operating cash flow is divided by the total debt. In other words, with a higher ratio, there will be better debt coverage.
Operating Cash Flow Ratio
It assesses a firm’s capacity to earn cash from its primary operations. Therefore, to calculate it, the operating cash flow is divided by net sales. In simple words, a greater ratio shows that operations generate more cash flow.
Free Cash Flow Ratio
The ratio calculates the amount of cash flow available to a business after deducting capital expenditures. It is computed by dividing net sales by capital expenditures minus operating cash flow. A greater ratio suggests improved cash flow generation after capital expenditures.
Price-To-Cash Flow Ratio
It compares a company’s stock price to operating cash flow (per share). It is computed by dividing the market value of the company by its operating cash flow per share. As a result, a lower ratio means that investors are getting a better deal.
Current Liability Coverage Ratio
The current liability coverage ratio is a financial statistic that assesses a company’s capacity to pay down short-term liabilities using current assets. In other words, it is often referred to as the current ratio or working capital ratio and includes cash, accounts receivable, and inventory.
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Effective cash flow statement analysis is critical to the growth and sustainability of a business. For instance, it allows businesses to focus on their core competencies and operational activities without being bogged down by financial constraints.
Moreover, uplifting financial knowledge can be beneficial for personal and professional growth, particularly in finance-related industries and activities. Therefore, understanding finance is advantageous for career advancement and promotes better decision-making.
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By Vasudha Awasthi
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