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As a business owner, how you manage your finances can have a huge impact—negative or positive—on your business’ success. Conducting a cash flow analysis and monitoring your income statement is the best way to gauge your business health and tell whether you’re barely making ends meet or flourishing.
Put simply, cash flow is the movement of money in and out of your business. That number can give insights into how long your business can last during a rough patch or when it’s time to invest and grow if you’re generating excess cash.
Roughly 20% of businesses fail in the first year, and about 65% fail by the tenth year, according to data from the U.S. Bureau of Labor Statistics, and many of those fail due to cash flow struggles. Performing a regular cash flow analysis can help you make the right decisions about operational activities and investments.
The importance of cash flow
Without assessing cash flow, it’s difficult to predict net income and how much you have available for payroll, suppliers, and growth. Understanding and monitoring cash flow is also helpful for knowing where to make adjustments if there’s a financial problem.
The best way to keep a close eye on the cash generated from your business is to perform a cash flow analysis. A cash flow analysis gives insight into your cash inflow and outflow and contributes to a holistic view of your business’s financial well-being. While it’s essential for all businesses, it’s particularly important for those with a newly started business. When you’re getting up and running, you are bound to encounter unexpected costs, ranging from higher labor costs than expected to the startup costs of new equipment and inventories.
To perform a cash flow analysis, start by examining the parts of your business that affect cash flow. This includes accounts receivable, inventory, accounts payable, and credit terms. The best way to analyze and compare these parts is through a cash flow statement.
1. Prepare a cash flow statement
A cash flow statement is a financial statement that summarizes the cash entering and leaving a company. Most accounting software allows you to create a cash flow statement with a few clicks. Cash flow for a company is typically divided into three sections:
- Cash flow from operating activities (CFO): This type of cash flow includes the revenue-generating activities of a business. This shows how much a company has generated from its core business operations. If your business is healthy, you should generate more cash from operations than you spend. Newer businesses may see a negative result here as they’re building their capabilities and customer base.
- Cash flow from investing activities (CFI): This is an item on a cash flow statement that reports a company’s cash position changes resulting from investment gains or losses, but not necessarily investments in the stock market. Changes to property, plant, and equipment values, for example, are accounted for here.
- Cash flow from financing activities (CFF): This section in your cash flow statement accounts for external activities that allow your business to raise capital. Other financing activities include issuing stock to shareholders, buying back stock, new business loans, payments on business loans, or distributing dividends.
Calculating cash flow
If you prefer to create a cash flow statement using your financial records, you can follow these steps to prepare one with your favorite spreadsheet app, like Google Sheets or Microsoft Excel. Download a free cash flow template to get started.
- Enter your company’s total cash balance at the beginning of a selected time period into the cash flow statement.
- Fill in your cash inflows and outflows in the main cash flow reporting categories: operating, investing, and financing.
- Combine the cash inflows and outflows, then add or subtract from your beginning total cash balance. Net cash flow is the increase or decrease in cash or cash equivalents.
2. Analyze your cash flow statement
As you create monthly or quarterly cash flow statements, you’ll likely discover interesting trends and patterns. A one-time change in cash can be insightful, but long-term trends often determine business success.
While it’s essential to focus on maintaining positive cash flows in the long run, digging into each section can provide insights into improving your business and profitability.
- Calculating free cash flow (FCF): Free cash flow refers to the available funds after paying capital and operational expenses. To calculate free cash flow, follow this free cash flow formula:
- Free Cash Flow = Cash from Operations – Capital Expenditures
- Review your operating cash flow ratio: This ratio can help you understand whether your cash flow covers your current liabilities. In other words, this can help you gauge your company’s liquidity and ability to pay the bills in a specific period. Since earnings can be manipulated, using cash flow instead of income to calculate the ratio is more helpful. To calculate the ratio, divide your cash flow from operations by your current liabilities.
- Operating Cash Flow Ratio = Cash Flow From Operations / Current Liabilities
- Analyze your free cash flow to sales ratio: This ratio, expressed as a percentage, helps you compare your free cash flow to your sales, which can help you understand your ability to turn available cash into new sales. If your business is healthy, you should see your company’s sales grow relative to your operating cash flow and compared to industry peers. To calculate the ratio, divide your operating cash flow by your revenue.
- Free Cash Flow to Sales Ratio = Free Cash Flow / Sales
- Identifying cash flow trends: Using the above ratios and others that make sense based on your type of business, you can track your business’s health and measure how you manage cash. Once you have a year of financial data, you can analyze your year-over-year cash flow by month and chart monthly cash flow to find seasonal and long-term trends. Keep a keen eye out for potential problems before they spiral out of control and successes you can repeat to build a business positioned to thrive for years to come.
Cash flow statement glossary
Cash flow analysis inherently comes with some industry jargon. Here’s a breakdown of key terms you should know:
- Cash flow statement: A cash flow statement is one of three main financial statements, along with a balance sheet and income statement. It shows the change in cash during a specific period, broken down into cash flows from operations, investing, and financing.
- Positive cash flow: Positive cash flow represents an increase in cash over a specific period or bringing in more cash than the business expends. However, it’s important to note that positive cash flow doesn’t necessarily correlate to profitability.
- Capital expenditures: Capital expenditures, or CapEx, represent a business’s investments into capital projects. It’s generally a negative cash flow that’s expected to lead to increased profitability in the future.
- Working capital: This measure represents the amount of cash tied up in a business in the short-term. You can calculate it by subtracting current liabilities from current assets on the balance sheet.
Use cash flow analysis to boost your business. It’s smart to perform a cash flow analysis at least once per quarter, but many businesses do so monthly or even more frequently. Depending on your industry and the current state of your business, you can choose a cadence that keeps you aware of your business’s financial status while avoiding busy work.
If you struggle to manage your business finances, consider consulting with a trusted accountant or financial advisor. They should be able to help you do a cash flow analysis or make sense of the results.
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