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What is cash flow analysis?

GoCardless
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Last editedJun 20222 min read

It’s common knowledge that cash is the lifeblood of businesses, especially SMEs. This means that healthy cash flow is as vital to businesses as healthy blood flow is to people. With that in mind, here is a guide to what you need to know about cash flow analysis.

The basics of cash flow analysis

There are three types of cash flow analysis:

  • Operating cash flow analysis

  • Investing cash flow analysis

  • Financing cash flow analysis

All companies need to undertake operating cash flow analysis. This analyses the inflow and outflow of cash from standard operating activities. 

Only some companies need to do cash flow analysis from investing activities and financing activities. The term ‘investing activities’ does not necessarily mean investing in the stock market, although it may; it can also mean investing in long-term business assets (capital expenditure). The term ‘financing activities’ refers to cash that comes from owners (including shareholders) and creditors. Again, it is only relevant to some companies.

Preparing a cash flow statement

Before performing a cash flow analysis, you need to have a cash flow statement. If you are using accounting software, it usually generates this for you. If you don’t have the software, it’s straightforward to create one manually. Just keep in mind that it generally takes longer and there is the potential for human error. It’s therefore preferable to use accounting software.

If you do need to create a cash flow statement manually, get online templates which are useful as prompts; you do not need to use them. Simply ensure that all your cash income and outgoings are properly recorded. If you’re not using accounting software, this may require you to gather data from different sources.

If you’re doing more than one form of cash flow analysis, also be clear about which line items belong in which category. The standard way to do this is to have operating cash flow items at the top, followed by investing cash flow items and then financing cash flow items. You can use subheadings to make it clearer where each section begins and ends.

When adding your line items to the operating cash flow section, use the direct or indirect cash flow methods. The direct method simply lists all the cash collections and cash disbursements from operating activities, which ultimately leaves net income. The indirect method uses net income as the starting point, then adds or subtracts non-cash items (both incomings and outgoings).

Analysing your cash flow statement

Once you have your cash flow statement, here are the key points to assess.

Your free cash flow

This is the cash you have left over after paying all your expenses.

Your operating cash flow margin

The formula for operating cash flow margin is:

(Net Income + Depreciation & Amortisation + Change in Working Capital)/Revenue

This is a reliable indicator of how well you are doing at converting your revenue into actual cash profits. It’s therefore a reliable indicator of your company’s overall health.

Trace the flow of both your income and expenses. See if you’re managing them both as effectively as you can. Make sure you assess your income streams as thoroughly as you assess your outgoings. Are you making the most of upselling, cross-selling and selling add-ons?  Are you generating recurring income?

Similarly, when examining your expenses, look at the costs you incur when collecting income. See if they can be reduced. For example, could you use GoCardless to charge people automatically?  Could you link GoCardless with accounting software to benefit from automatic reconciliation?

Underlying meanings

Regardless of whether your cash flow is positive or negative, identify the factors making it trend that way. Then think about what they mean for the health and hence the future of your business.

Implications for the future

Use your real-world data to test possible scenarios and assess their significance.

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