Why Should Every Entrepreneur Know How To Do Cash Flow Analysis?

July 11, 2024

An image of a desktop with some Canadian money below a calculator

Cash flow tells you how much money comes in, goes out, and from where it comes and goes. Cash flow analysis doesn’t tell you if your business is profitable or your debt is high. It tells you where your cash came from and where it went. Therefore, a highly profitable company could report a negative cash flow, and a loss-making company could show a positive cash flow.

Knowing how much of your business activities convert into cash is vital for a business’s survival. A company can fund multi-year losses from its cash balance and survive, but a company with long-term negative cash flow could go toward bankruptcy.

In this article, we will understand how to do cash flow analysis and how to use it to make informed decisions.

How To Do Cash Flow Analysis?

Every business owner should start doing cash flow analysis from Day one of the business. The process is simple: Record the transactions when the cash is exchanged in hands. Before we begin cash flow analysis, you should have a separate bank account for your business wherein you perform all business-related transactions. Accumulating all business transactions in one place will make it easier to record them.

Step 1: Prepare Cash Journal

You need to prepare a cash flow statement to analyze it. Even if a professional accountant prepares your cash flow statement, you should know how it is ready.

To prepare a cash flow statement, start with your business bank account’s closing balance and add all amounts you expect to receive this month, such as invoice payments, dividends/interest on investments, or a loan you applied for. Then, deduct all amounts you expect to pay this month, such as rent, salaries, utilities, and taxes. The balance left is your available cash in hand.

Note: Do not add or subtract any future income or expenses where cash has not changed hands. However, advanced payments and bookings should be added to the cash flow even if expenses are yet to be incurred. For instance, James booked a flight for July in May. The airline will add the booking amount to its cash flow statement in May when it receives the amount, while expenses on that ticket will be incurred in July.

Step 2: Categorize To Prepare Cash Flow Statement

Once you have all your cash flow in one place, categorize the cash transactions under the following three buckets to prepare a cash flow statement.

Operating cash flow

It includes all revenue cash payments and cash spent on operating expenses.

Investing cash flow

It includes transactions related to the purchase or sale of business assets such as property, plant and equipment, or financial instruments like stocks of another company.

Financing cash flow

This includes financing transactions related to debt repayments, share buybacks, dividends, and new capital raised from debt and equity.

Step 3: Identify Cash Flow Trends

It is better to prepare monthly cash flows and identify trends. There might be periods of low inflows and high outflows and vice versa. These trends can help you forecast future cash flows and make decisions accordingly. You could hold higher cash reserves for periods of low inflows, identify the minimum cash flow your business can comfortably get and accordingly determine dividends.

What Cash Flow Analysis Can Tell You?

As you get the hang of cash flow analysis, you will realize they can tell you many things about a business. A higher cash inflow may not always be good, and a higher cash outflow may not always be bad. The good and bad depends on the source from which cash is coming.

  • Newer businesses may have negative operating cash flow but a positive financing cash flow. In the early stages, business owners spend on assets and working capital. It takes some time for a business to turn cash flow positive. Private equity investors and business owners are ready to pump in money with hopes of long-term returns when the company turns cash flow positive.
  • A business may have positive investing cash flow and negative operating cash flow. It could signal that the business is in a crisis and is selling its assets to pay for expenses. Such a situation is not sustainable.
  • A business may have negative investing cash flow and positive operating cash flow. It could hint that the company is reinvesting the cash in the business to buy property or equipment for future growth.

Why Cash Flow Analysis Is Important?

When you know how much cash you need to fulfill your obligations for the month, how much is coming, and how much you have, you can better prepare for the future by:

  • Having sufficient cash reserves for emergencies and higher one-off payment obligations.
  • Making timely debt payments and avoiding declined charges, interest penalties, fees, and a weaker company credit report.
  • Maintaining liquidity for working capital to prevent production interruptions due to lack of cash flow.

Contact KSSP Partners LLP in Markham to Help You with Cash Flow Analysis

Talk to a professional accountant to help you prepare accurate cash flow statements and identify risks and opportunities. To learn more about how KSSP Partners LLP can provide you with the best accounting and bookkeeping expertise, contact us online, or by telephone at 289-554-5997.