“Cash is king” is a saying that can be especially relevant to small businesses. In fact, a recent study cited on business mentorship site SCORE found that 82% of small businesses fail because of a lack of adequate cash or cash flow mismanagement.
This is why it’s essential for sole proprietors and small businesses to conduct a cash flow analysis. This is an examination of when and why you have cash inflows to your business and cash outflows from your business, as well as the amounts involved.
Key Takeaways
- Cash flow analysis determines your business’s cash inflows and outflows from operations, investing, and financing.
- Cash inflows include payments to your accounts receivable, loan proceeds, and sales of goods and services, while outflows include operating expenses and the purchase of assets.
- To analyze your business’s cash position, you must prepare a statement of cash flows using the direct transactional or indirect accrual method.
- By developing a cash flow statement, you can get a better picture of your sources and uses of cash and determine what should be changed.
The Importance of Cash Flow Analysis
A company's cash flow at any point in time is the difference between its cash available at the beginning of a quarter or a year and at the end of that accounting period. Cash inflows include:
- Payments to your credit accounts or accounts receivable
- Loan proceeds
- Receipts from the sales of goods and services
- Investment income
- Sale of assets
- Funding disbursed by investors
- Proceeds from grants, prizes, or awards
- Proceeds from winning a litigation
Cash outflows, meanwhile, are the payments you make on your liability accounts like accounts payable and loans payable. Outflows go out to pay for operating expenses, direct expenses, debt service, and the purchase of assets like equipment.
Cash flow and net income or profit, though, are not the same thing.
Note
Cash flow refers to the actual money that flows in and out of your business from your operations, investing activities, and financing activities. Profit, on the other hand, is an accounting term that refers to what is left after all your expenses are taken out of your sales revenue.
This could mean that according to your income statement, your business can be profitable but still cash poor. If that’s your position, you could be in danger of losing your business.
For example, if you have credit customers, you will have accounts receivable that represent the money they owe you. If some of your credit customers do not pay their bills on time, but you have to pay your suppliers anyway, you may be profitable, but you won’t have cash on hand. This could lead to the failure of your business.
The value of cash flow analysis lies in the fact that it shows the changes in the cash flow position of a business.
Note
This is different from the information you get from the balance sheet or income statement, which are both stated in absolute dollar amounts without changing from period to period. The cash flow analysis instead allows the business owner to fix any troubling problems before they get too serious.
The Cash Flow Statement
To better determine your cash situation, you must prepare a statement of cash flows, one of the key financial statements required for a business. The statement of cash flows shows the changes in the various income statement and balance sheet accounts from the previous time period to the current time period.
You can prepare this statement in one of two different ways:
- Direct method: You can use the direct method, or cash accounting, which just looks like your business bank account transactions list.
- Indirect method: The indirect method is based on accrual accounting, which reports income in the period it was earned regardless of when it is received.
To better understand the statement of cash flows, here’s a hypothetical example below for a small specialty shop. The business is the handcrafting of bridles for thoroughbred racehorses. The bridles are made and sold here. This statement of cash flows shows the change in the accounts from the income statement and the balance sheet from the last time period to this time period. Parenthetical numbers indicate losses.
| Statement of Cash Flows for "The Bridle Shop" — Period Ending December 31, 20xx | |
|---|---|
| Cash Flows From Operations | |
| Net Income | $50,000 |
| + Depreciation | $5,000 |
| Increase in Accounts Receivable | ($2,000) |
| Increase in Inventory | ($10,000) |
| Increase in Accounts Payable | $12,000 |
| Decrease in Loans Payable | ($5,000) |
| $50,000 | |
| Cash Flows From Investing | |
| Increase in Property, Plant, Equipment | ($6,000) |
| ($6,000) | |
| Cash Flows From Financing | |
| Decrease in Long-Term Debt and Equity | ($10,000) |
| ($10,000) | |
| Net Cash at End of Year | $34,000 |
Let’s look at the statement of cash flows and what the different sections illustrate.
Cash Flows From Operations
In this section, you look at the accounts on your income statement and balance sheet to determine last year’s and this year’s levels. This section deals with the cash inflows and outflows from your day-to-day operations.
Note
You should always start by including the sum of your net income (profit) then add depreciation or amortization from the income statement.
Accounts receivable and inventory both increased from the previous year. When an asset account increases, it becomes a source of funds—and a negative number—because you pay out cash. In this case, you gained more credit accounts and purchased inventory.
Accounts payable also increased, but this is on the other side of the balance sheet. When it increases, it is a use of funds since you are tying up some of your cash. Meanwhile, loans payable decreased, showing you paid off some of your loans.
Sources of funds are a decrease in liabilities or an increase in assets. Net income is also a source of funds. Uses of funds are an increase in liabilities or a decrease in assets.
Cash Flows From Investing
An increase in property, plant, and equipment is an asset account. It increased by $6,000 and is a negative number. If an asset account decreases, that denotes the use of funds. In this case, the business purchased property, plant, or equipment and used cash.
The same rationale about sources of cash and uses of cash applies to the investing section of the cash flow statement. Another account you might see here is your investments account from the balance sheet.
Cash Flows From Financing
This section includes changes in both long-term debt and equity accounts. In this case, you paid off $10,000 in debt, so this was a use of cash.
The net change in cash (in this case, $34,000) signifies your cash account at the end of the year.
How to Analyze the Cash Flow Statement
By developing a cash flow statement, you can analyze both your sources of cash and uses of cash to give you a better idea of anything you should change—especially if the numbers are unequal.
Note
During your analysis, look particularly at your business’s uses of cash. Be sure they are not out of line with your expectations and business’s goals.
For example, are you extending credit to too many people? If so, you have a chance to correct your credit policy.
The sources of cash are just as important. You want to see where you have received your cash from and how that has occurred.
How Is a Cash Flow Analysis Used?
A cash flow analysis is a cash management tool that is used to help a business determine where its trouble spots are by specifying its sources and uses of cash. Sources are where cash comes from. Uses are how the business uses its cash.
How Does Your Cash Flow Analysis Differ From Your Profit and Loss?
Cash flow is not profit. Profit is an accounting term referring to what’s left after you deduct expenses from sales revenue. Cash flow refers to the money flowing in and out of your business from operations, investing, and financing.
How Do I Improve Cash Flow in My Business?
There are several ways to improve your cash flow, including increasing sales, increasing prices, decreasing expenses, restructuring debt, and reducing capital expenditures.
The Bottom Line
The statement of cash flows takes information from your balance sheet and income statement. Specifically, it includes any account from these financial statements that has seen a change in the amount from one time period to the next. The difference in the accounts is either a source of cash or a use of cash for the business. The bottom line of the statement of cash flows is the company’s change in cash, positive or negative, for that time period. The net cash flow should equal the cash account on the company’s balance sheet for the new time period.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
SCORE. "The #1 Reason Small Businesses Fail - and How To Avoid It."
Purdue University. "Sources and Uses of Funds Statement."
Introduction
As an expert in cash flow analysis, I can provide you with valuable insights and knowledge on this topic. I have a deep understanding of the concepts and principles involved in analyzing cash flow for small businesses. Let's dive into the details!
Cash Flow Analysis: Understanding the Basics
Cash flow analysis is a crucial process for small businesses to assess their financial health and identify potential issues. It involves examining the inflows and outflows of cash in a business, including the timing and amounts involved. By conducting a cash flow analysis, you can gain a better understanding of your business's sources and uses of cash and make informed decisions to improve your financial position.
Key Concepts in Cash Flow Analysis
To fully grasp the concept of cash flow analysis, it's important to understand the key terms and components involved. Here are the main concepts used in the article:
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Cash Inflows: These are the sources of cash for your business. They include payments from accounts receivable, loan proceeds, sales of goods and services, investment income, and funding from investors, grants, prizes, or awards [[1]].
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Cash Outflows: These are the uses of cash in your business. They encompass operating expenses, direct expenses, debt service, and the purchase of assets like equipment [[1]].
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Net Income vs. Cash Flow: Net income refers to the profit your business generates after deducting expenses from sales revenue. Cash flow, on the other hand, refers to the actual money flowing in and out of your business from operations, investing activities, and financing activities. It's important to note that a business can be profitable but still face cash flow issues, which can be detrimental to its survival [[1]].
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Statement of Cash Flows: This financial statement provides a comprehensive view of the changes in a business's cash flow position over a specific period. It shows the cash inflows and outflows from operations, investing, and financing activities. The statement of cash flows can be prepared using either the direct method (cash accounting) or the indirect method (accrual accounting) [[1]].
Analyzing the Cash Flow Statement
Analyzing the cash flow statement is crucial to gaining insights into your business's cash position and making informed decisions. Here are some key points to consider:
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Sources of Cash: Analyze where your cash is coming from and how it is generated. This includes examining the cash inflows from operations, investments, and financing activities. Understanding your sources of cash can help you identify areas of strength and potential opportunities [[1]].
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Uses of Cash: Evaluate how your cash is being utilized within your business. This involves assessing the cash outflows for operating expenses, debt payments, asset purchases, and other expenditures. Ensuring that your uses of cash align with your business goals and expectations is crucial for maintaining a healthy cash flow [[1]].
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Identifying Issues: By comparing your sources and uses of cash, you can identify any discrepancies or troubling problems. This analysis allows you to address potential issues before they become serious and take appropriate corrective actions [[1]].
Improving Cash Flow
If you're looking to improve your cash flow, consider implementing the following strategies:
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Increase Sales: Explore ways to boost your revenue by attracting more customers, expanding your market reach, or introducing new products or services.
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Increase Prices: Evaluate your pricing strategy to ensure it aligns with the value you provide. Adjusting your prices appropriately can positively impact your cash flow.
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Decrease Expenses: Review your expenses and identify areas where you can reduce costs without compromising the quality of your products or services. This can help free up cash within your business.
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Restructure Debt: If you have outstanding debts, consider renegotiating the terms or consolidating them to improve your cash flow.
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Reduce Capital Expenditures: Assess your capital expenditure plans and prioritize investments that have a high potential for generating cash flow. Delaying or scaling back on non-essential expenditures can help preserve cash [[1]].
Conclusion
Cash flow analysis is a vital tool for small businesses to understand their financial position and make informed decisions. By examining the inflows and outflows of cash, businesses can identify potential issues, improve their cash flow, and ensure their long-term success. Remember, maintaining a healthy cash flow is essential for the sustainability and growth of your business.
I hope this information provides you with a comprehensive understanding of cash flow analysis. If you have any further questions, feel free to ask!
