Definition: what is a cash flow analysis? 

Cash flow analysis examines a company's cash flow over a specific period, such as monthly, quarterly, or annually. It involves cash revenues (income) and expenses. It is also called liquidity analysis.

To conduct a cash flow analysis, you need to understand what cash flow is: cash flow is the net amount of cash that flows into and out of a company during a specific period. It shows how much money a company generates and whether there is a surplus or deficit at the end of a period.

Cash flow analysis: understanding cash flow

Cash flow can be divided into these four categories:

• Total cash flow: Sum of all cash flows from operating, investing, and financing activities.
• Operating cash flow (OCF): Cash flows from core business operations, like revenue minus operating expenses.
• Investing cash flow (ICF): Cash flows from investment activities, such as purchasing or selling assets.
• Financing cash flow (FCF): Cash flows from financing activities, such as borrowing or repaying loans and paying dividends.

The cash flow analysis shows how liquid a company is over the analyzed period and how it meets its financial obligations.

Unlike the P&L statement, which is based on revenues and expenses to determine profit, the cash flow analysis only considers actual cash movements.

To achieve the most accurate cash flow analysis, you should look at the total cash flow and the specific areas mentioned above.

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The importance of cash flow analysis

Cash flow analysis is crucial. Companies get insights on how much money they spent and how much money is coming in. Plus, they can improve their cash flow planning. You can use this information to achieve various goals or evaluate different areas, including:

• Liquidity assessment: It shows if a company can meet its short-term obligations (operating costs or repayments). Cash flow analysis can help improve short-term liquidity.
• Financial stability: It provides insights into resilience against financial crises and aids in developing a financial strategy.
• Investment decisions: It supports informed investment decisions.
• Profitability analysis supplement: It considers actual cash flows.
• Financial planning: It enhances the creation of financial plans and budgets.
• Risk analysis: Investors use it to make investment and credit decisions.

How to conduct a cash flow analysis

Since cashflow comprises four areas, the cash flow analysis can also be divided into these four areas:

• Cash flow analysis for total cash flow
• Cash flow analysis for operating cash flow
• Cash flow analysis for investing cash flow
• Cash flow analysis for financing cash flow

You can use two methods to conduct a cash flow analysis: direct and indirect. The direct method calculates the net cash flow, giving an overview of all inflows and outflows.

To go a step further, use the indirect method for cash flow analysis. It provides a deeper insight into the three cash flow areas besides total cash flow.

But let's start from the beginning. Here are the five steps usually taken in cash flow analysis:

1. Data collection: Gather all relevant financial data regarding inflows (revenues) and outflows (operating costs).
2. Method selection: Choose between the direct or indirect method.
3. Cash flow calculation: Calculate the total cash flow, operating cash flow, and investing and financing cash flow.
4. Result analysis: Interpret the results and relate the individual areas to each other.
5. Reporting: Create a report and provide recommendations.

Calculating cash flow

As mentioned, you can use two methods to analyze and calculate cash flow: direct and indirect method. For both methods, cash and non-cash revenues and expenses are relevant.

Cash flow analysis: direct method to calculate cash flow and example

In the direct method, you subtract all cash revenues from cash expenses within a specific period. Cash revenues and expenses related to actual cash flows, including:

Cash Revenues

• Revenue
• Loans and borrowings
• Tax refunds
• Interest income
• Dividends 

Cash Expenses

• Salaries and wages
• Supplier invoices
• Rent
• Purchases of goods
• Utility costs

The formula for the direct method is: Net Cash Flow = Cash Revenues – Cash Expenses

Let's look at an example: Over 12 months, your company generates €2 million in revenue and has expenses for salaries (€800,000), rent (€300,000), and supplier invoices (€200,000).

With the direct method, net cash flow is: 

€2,000,000 Revenue 

– €800,000 Salaries 

– €300,000 Rent 

– €200,000 Supplier invoices 

= €700,000

The €700,000 calculated using the direct method represents the net cash flow. This example shows the company has generated an annual surplus. This method offers a clear overview of cash flows and is easy to understand. However, it is time-consuming because it requires detailed accounting records to determine all revenues and expenses.

Cash flow analysis: indirect method and example

Due to its efficiency, the indirect method is more common for calculating cash flow. It can be derived directly from the income statement and uses non-cash revenues and expenses to determine the cash flow from operating activities.

Non-cash revenues and expenses are items in the income statement that affect the result but do not involve direct cash inflows or outflows, such as:

Non-Cash Revenues

• Reversal of provisions
• Reduction in retained earnings
• Withdrawal from reserves

Non-Cash Expenses

• Depreciation
• Creation of provisions
• Increase in retained earnings

The formula is: Indirect Method Cash Flow = Net Income – Non-Cash Revenues + Non-Cash Expenses

Assume we have the following information for a company and calculate the cash flow using the indirect method, based on the previously calculated net cash flow:

• Net Income: €700,000
• Depreciation on fixed assets: €100,000
• Depreciation on current assets: €50,000
• Increase in accounts receivable: €70,000
• Decrease in accounts payable: €40,000
• Increase in inventory: €40,000

Adjustments for non-cash expenses:

€700,000 Net Income

– €100,000 Depreciation on fixed assets

– €50,000 Depreciation on current assets

= €850,000

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Adjustments for non-cash revenues (changes in working capital): 

– €70,000 Increase in accounts receivable 

– €40,000 Decrease in accounts payable 

– €40,000 Increase in inventory 

= -€150,000

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With the indirect method, the cash flow is: 

€850,000 – €150,000 = €700,000

The €700,000 calculated using the indirect method represents the operating cash flow or gross cash flow.

The 3 areas of cash flow analysis

Now that we've determined the direct cash flow and seen an example of how to use the indirect method for calculating operating cash flow, let's look at the other areas.

With the indirect method, you can also calculate the investing cash flow and financing cash flow. It is advisable to consider all three areas for a comprehensive cash flow analysis, providing an accurate picture of the total cash flow.

Cash flow analysis with operating cash flow

Operating cash flow measures the liquidity generated from a company's core business activities. It shows whether the core business generates enough cash to cover operating costs without external financing.

What does operating cash flow indicate?

• Business efficiency: a positive operating cash flow indicates that the company operates effectively and can meet its liabilities.
• Sustainability: a consistently positive operating cash flow suggests that the business model is sustainable.
• Core business problems: a negative operating cash flow may indicate that the company is struggling to finance its operations, possibly requiring cost-cutting measures or increased sales.

Cash flow analysis with investing cash flow

Investing cash flow shows the cash flows generated by investments in long-term assets, including purchase and sale of assets such as real estate, machinery, or investments.

The formula for investing cash flow is: Income from the Sale of Assets – Expenses for the Purchase of Assets

What does investing cash flow indicate?

• Growth strategies: a negative investing cash flow suggests that the company invests in future growth by acquiring new assets.
• Divestment: a positive investing cash flow may indicate that the company is selling assets, possibly to generate liquidity or because the assets are no longer needed.
• Capital intensity: a high investing cash flow (positive or negative) indicates that the company is capital-intensive, meaning it regularly makes significant investments in long-term assets.

Cash flow analysis with financing cash flow

Financing cash flow shows the cash flows from financing activities, including loans, dividends, and other financial transactions with shareholders and creditors.

The formula for financing cash flow is: Income from Borrowings – Repayments of Loans and Dividends Paid

What does financing cash flow indicate?

• Capital structure: a positive financing cash flow indicates that the company is raising additional funds, through borrowing or issuing equity.
• Debt repayment: a negative financing cash flow suggests that the company repays debt or distributes dividends to its shareholders.
• Financing strategy: regular patterns in financing cash flow can provide insights into the company's long-term financing strategy.

Interpretation of cash flow analysis

The three areas of cash flow are closely interconnected and influence each other.

Cooperation for liquidity assurance

Firstly, consider cooperation for liquidity assurance: With a positive operating cash flow, a company can invest in its future (investment cash flow) while simultaneously paying off debt or distributing dividends (financing cash flow).

Balancing through financing

The areas can also support each other in refinancing: If the operating cash flow is insufficient to make investments or repay debts, the company must rely on financing cash flow by taking out loans or raising equity.

Balancing investment needs through operational efficiency

A high investment cash flow can lead to a negative total cash flow in the short term. However, if the return on investment is positive, it can improve operational efficiency and operating cash flow in the long term.

Growth financing

Companies looking to expand via growth financing might intentionally have a negative financing cash flow to secure funds for investments, which can increase future operating cash flow.

Total cash flow compared to operating, investment, and financing cash flow

Assume we have the following information for a company:

• Cash flow from operating activities: €51,000
• Cash flow from financing activities: €15,000
• Cash flow from investing activities: -€20,000

We can calculate the total cash flow as follows:

€51,000 – €15,000 – €20,000 = €46,000 total cash flow

Conclusion: cash flow analysis

Cash flow analysis is a crucial tool for understanding a company's financial health.

Operating cash flow demonstrates the efficiency and sustainability of the core business, investment cash flow provides insights into growth strategies and capital intensity, and financing cash flow reveals financing strategies and capital structure.

All three combined, these cash flow areas offer a comprehensive view of a company's financial position and long-term prospects.