In this lesson, we give you a step-by-step demonstration of how to prepare a cash flow statement based on existing information. We’ll also guide you through an analysis of the cash flow statement and everything you can derive from it.
Cash flow analysis – step by step
Every cash flow statement is divided into three parts – cash flow from operations, investments, and financing. Let’s go through each of these one by one.
1. Operating Cash flow
Operating activities refer to the money your business has generated from regular operating activities, such as the sale of products and services during a given time period. In the indirect method, we use the net income as the first line item and work our way backward. For instance, we add back depreciation, tax expenses, amortization, and other non-cash items.
Once you do that, you proceed to make adjustments for changes in the working capital (difference between current assets and current liabilities). That’s how you arrive at the total cash flow used during the period.
Let’s list the steps so you can better visualise how it works:
- Begin with net income (from the bottomline of the income statement).
- Adjust for changes in working capital (difference between assets and liabilities). Items that cause a reduction in cash will be deducted. Others are added. Eg: An increase in inventory is an outflow of cash. An increase in accounts receivable means there are more defaulting customers who haven’t paid yet so the revenues will be deducted. On the other hand, an increase in accounts payable, accrued expenses, etc. is counted as an increase in cash flow.
- Finally we record the total amount of all the above items as net cash from operating activities.
This is the formula we follow here:
Operating Cash Flow = Net Income + Non-Cash Expenses – Increase in Working Capital
Here’s an example of cash flow from operating activities:
2.Cash flow from investing activities
This is the section that reflects the cash flow generated from (as well as used in) investments. This includes the buying of long-term assets (office space, equipment, computers etc), acquisition of another business, and the purchase of marketable securities (stocks and shares of other companies) on behalf of your business.
A summary of the items we include:
- Purchase of long-term assets, also called capital expenditure. (land, property, office space, equipment etc.)
- The money you made from the sale of long-term assets.
- Money you spend in acquiring other businesses.
- Purchase and sale of marketable securities.
All purchases are considered a cash outflow and all sales are considered a cash inflow. Also note that interest payments, dividends, equity-based financing will not be included.
Here’s an example of cash flow from investing activities:
3.Cash Flow from Financing Activities
This is the cash you generate or use in funding the business. Some companies raise the capital they need by issuing debt (borrowing loans ) or equity issuance (selling shares in the company). Cash inflow occurs when you finance your business through debt or issuance of equity. Later, when you make repayment, it is considered a cash outflow.
Sometimes business owners choose to fund their business using equity alone. Others use a combination of debt and equity.
Here’s an example of cash flow from financing activities:
The above three sections are combined to make up the complete cash flow statement:
Analysing the Cash Flow Statement- Why and How?
The cash flow statement is perhaps the most important component of a financial model, as far as investors are concerned. Some of them often skip straight to this statement to get a quick picture of the company, finance-wise. It tells you everything you need to know about how much money the business is making, how much it’s spending and how much funding it needs.
From a cash flow management vantage point, there are a variety of ratios you can use to analyse and determine how well the company is really doing, and what can be improved. This is why we use these indicators.
7 Major Ratios For Analysis
Operating Cash Flow Ratio
It is a simple, basic ratio that tells you how much money you’re making from sales. You’d generally want this to be a higher number. There is no standard threshold however.
Formula: Operating Cash Flow Ratio = Cash Flow From Operations (CFO) / Sales
In the above example, the CFO is 50,500. Let’s take net sales (revenue) as 40,000. This is merely for the sake of illustrating an example.
(The original sales amount will normally be found in the income statement. It is the top line item to which we make certain deductions and arrive at net income. We’ve discussed this in a previous lesson.
Here, the operating cash flow would be 50,500 / 40,000 = 1.26 or 12%.
This is a comparatively lesser figure. It indicates the business has areas where it could improve. For instance, the statement shows an excessive amount of 17,000 in receivables. This could imply that many customers are defaulting which isn’t a good sign.
Asset Efficiency Ratio
This ratio tells you how well the company’s assets are used to generate money for the company. If you’ve been running the online business for quite a few years, then it would definitely help add some weight to your pitch to investors.
Formula: Asset Efficiency Ratio = Cash Flow from Operations / Total Assets
Let’s say the total assets in the balance sheet amount to 70,000.
The ratio becomes 50,500/70,000 =0.721 or 72%. This implies a healthy asset utilization.
Current Liability Coverage Ratio
It is a ratio that is a useful indicator of solvency. It tells you how well your business is handling debt. The proportion of cash flow from operations (deducting paid dividends) against current liabilities helps you ascertain the current liability coverage ratio. Dividends are included in the finance section of the cash flow statement.
Formula: Current Liability Coverage Ratio = ( CFO – Dividends Paid ) / Current Liabilities.
Let’s say the dividends paid are 0 and current liabilities are 3000.
Then the current liability coverage ratio becomes:
50,500 / 3000 = 16. 83.
Long-Term Debt Coverage Ratio
Although the cash flow statement is primarily concerned with the short-term debt and expenses, we can simultaneously use it to determine long-term obligations as well. The higher the ratio, the more cash you need from operations to meet debt in the long-term.
Formula:Long-term Debt Coverage Ratio = ( CFO – Dividends ) / Long-term Debt
Let’s say long term debt is 30,000. Since dividends are 0, then Long-term debt coverage becomes:
50,500/ 30,000 = 16%
Interest Coverage Ratio
It is a simple ratio that gives you an insight into whether there are sufficient funds to make interest payments on time for current debts. The lower the ratio, the more compromised your business becomes. The higher the number, the more stable your financial position is. If the ratio is less than one, then your business is at serious risk.
Formula:Interest Coverage Ratio = ( Cash from Operations + Interest Paid + Taxes Paid ) / Interest Paid
Let’s say interest paid is 500 and taxes are 1500.
So the example becomes :
(50,500 + 500 + 1500) / 500 = 105.
Cash Generating Power Ratio
As the striking name suggests, this ratio shows you how well your business is able to generate money from operations alone.
Cash Generating Power Ratio = Cash from Operations / ( CFO + Cash from Investing Inflows + Cash from Finance Inflows )
Cash from investing inflows here is 30,000
and from financing is 20,000.
So 50,500 /100,500 = 50%.
Half of the business cash inflows are from operations alone.
External Financing Index Ratio
The ratio measures how much your business depends on financing to maintain a healthy stream of cash inflow. We analyse cash from financing compared to cash from operations. Lower figures indicate stability. A high ratio indicates your company is dependent on financing more than it is on operations, which is a bad sign for the business.
Companies with solid fundamentals generally have a negative number for this ratio.
External Financing Index Ratio = Cash From Financing / Cash from Operations
10,000 / 50,500 = 19%. This is a healthy figure for the business which could be lower in the long run.
These are some of the basic ratios you use to analyze your business based on the cash flow statement. There are numerous insights you can gain from it, especially if you compare it with similar online businesses in your industry.