A financial statement analysis of the balance sheet and the income statement are important management tools, but on their own can provide a misleading view. It is quite feasible for a business to show a healthy balance sheet and be profitable, but if it runs out of cash it will fail. The balance sheet only shows the position at a particular point in time, and the income statement deals in profit not cash. The purpose of the cash flow statement analysis is to correct this situation.
Cash Flow Analysis Example
Consider the cash flow statement example below for two accounting periods.
| 2021 | 2020 | |
|---|---|---|
| Beginning cash balance | 10,746 | 9,815 |
| Net income | 37,037 | 41,733 |
| Add back depreciation | 10,151 | 19,422 |
| Changes in working capital | 6,478 | 299 |
| Cash flows from operating activities | 53,666 | 50,856 |
| Amount paid for long-term assets | -33,774 | -48,227 |
| Cash flows from investing activities | -33,774 | -48,227 |
| Proceeds from long-term debt | 16,896 | |
| Proceeds from issue of share capital | 1,231 | 2,016 |
| Repayment of long-term debt | -34,506 | -3,714 |
| Cash flow from financing activities | -16,379 | -1,698 |
| Net cash flow | 3,513 | 931 |
| Ending cash balance | 14,259 | 10,746 |
The first thing to consider in any cash flow statement analysis is the five major line items.
- Cash flows from operating activities
- Cash flows from investing activities
- Cash flows from financing activities
- Net cash flow
- Free cash flow
Cash Flow from Operating Activities
The cash flow from operating activities tells you whether the underlying business operation is generating sufficient cash to fund the business or whether additional funding is needed.
The need for working capital has a major impact on the cash flow from operating activities. As a business expands, inventory and accounts receivable increase, working capital increases, and the cash flow from operating activities falls and could become negative.
A business can sustain a short period of negative operating cash flow. However, in the long term without adequate funding from other sources, the business will fail.
In the above example the cash flow from operating activities is healthy and consistent at 53,666 for 2021 and 50,856 for 2020.
Cash Flow Statement Analysis Ratios
Numerous cash flow ratios can be calculated, but those based around cash flow from operating activities are the most significant and used. Two in particular should be considered as part of the cash flow statement analysis.
Cash Flow Margin Ratio
The cash flow margin ratio is the cash flow from operating activities divided by the revenue of the business. It is similar in nature to the operating profit margin but uses operating cash flow instead of operating income.
If the income statement showed revenue of 2021: 170,910 and 2020: 156,508, then in the above example the cash flow margin ratio is calculated as follows:
Cash flow margin ratio = Cash flow from operating activities / Revenue 2021: Cash flow margin ratio = 53,666/170,910 = 31.4% 2020: Cash flow margin ratio = 50,856/156,508 = 32.5%
The ratio shows the businesses ability to turn revenue into cash. The ratio should ideally be improving each accounting period. In this case the ratio has fallen slightly but is consistent at approximately 30% of revenue being converted into cash. The higher the ratio the better.
Cash Flow Coverage Ratio
The cash flow coverage ratio is the ratio of cash flow from operations to its debt.
If the balance sheet showed debt of 2021: 37,168 and 2020: 16,664, then in the above example the cash flow coverage ratio is calculated as follows:
Cash flow coverage ratio = Cash flow from operating activities / Debt 2021: Cash flow coverage ratio = 53,666/37,168 = 1.44 2020: Cash flow coverage ratio = 50,586/16,664 = 3.05
The ratio shows the number of times the debts of the business are covered by its operating cash flow. A ratio higher than one indicates that the business can repay its debts using cash flow from its operations and is considered a sign of a healthy business.
In the above example, the ratio has declined from 3.05 to 1.44. and while still healthy, the trend should be monitored to ensure action is taken if it continues to decline.
Cash Flow from Investing Activities
The cash flow from investing activities shows the amount of cash the business is investing in long term assets (capital expenditure) in order to maintain and expand future growth. Without any investment in new equipment or other assets, the business will ultimately not develop.
In the above example, the business has invested 48,277 in 2020 and a further 33,774 in 2021 indicating a substantial investment in the growth of the business.
Cash Flow from Financing Activities
The cash flow from financing activities shows cash from new loans and equity less cash used for the repayment of debt. Cash flow from financing activities is particularly important as the business expands, as it reveals the financial structure and strategies adopted by the owners and management of the business.
In the above example, in both years the cash flow from financing activities is negative as the business has made substantial repayments of its long term debt offset by the issue of new shares, and the addition of new loans in 2021.
Net Cash Flow
The three cash flows detailed above add together to give the net cash flow in or out of the business over the period. In the example above, the net cash flow is positive and therefore shows net cash flow into the business for 2021 of 3,513 and for 2020 the net cash flow is 931. A healthy business should have a positive cash flow.
Free Cash Flow
One final figure which can be calculated and reviewed as part of the cash flow statement analysis is free cash flow.
Free cash flow is the cash flow from operating activities less cash invested in capital expenditure (long term assets) needed to maintain the current rate of growth. This free cash flow is then available to improve growth by taking advantage of expansion opportunities, to invest in new products, and to reduce debt and pay dividends to equity providers.
Using the figures from the cash flow statement analysis above, the free cash flow is calculated as follows:
Free cash flow = Cash flow from operating activities - Capital expenditure 2021: Free cash flow = 53,666 - 33,774 = 19,892 2020: Free cash flow = 50,856 - 48,227 = 2,269
An alternative way of reviewing free cash flow is to monitor the free cash flow ratio.
Free Cash Flow Ratio
Free cash flow ratio shows what percentage of the cash flow from operating activities is free to enable the business to grow.
Free cash flow ratio = Free cash flow / Cash flow from operating activities 2021: Free cash flow ratio = 19,892/53,666 = 37.1% 2020: Free cash flow ratio = 2,269/50,856 = 5.2%
In the above example, there has been a significant improvement in the free cash flow ratio from 5.2% to 37.1% of cash flow from operations. The improvement results from the reduction in capital expenditure needed to maintain the current growth in 2021.
The cash flow statement is an important financial statement and is often misunderstood and under-utilized. The purpose of cash flow statement analysis is simply to show the flow of money in and out of the business during the accounting period. Regular cash flow statement analysis, together with a review of the balance sheet and income statement, can help business owners spot trends enabling prompt corrective action to be taken.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.