Cash Flow Analysis - The Most Practical Metric for Your Business
The world of finance is replete with metrics. Every calendar year someone is trying to find a new way to measure financial success. While most of them help achieve certain objectives, they are often applicable to big companies with more complex business structures and operations.
One thing that remains true across the board, though, is the old saying, “Cash is King.” No matter what your business model is, cash remains to be a universal unit of measure for the overall health of a business. How much cash you have on hand, how much someone is willing to buy your business are just some ways to measure the success of your business.
It is important to quantify the value of your business, not only for your internal consumption but also to communicate to the rest of the business world that your business is profitable. This helps you get better loan credit, attract investors or even entice buyers when you decide to sell your business. That’s why it’s important to use commonly understood metrics, and what better metric than the Cash Flow Analysis.
Why Cash Flow Analysis?
In a nutshell, Cash Flow Analysis reflects what cash comes in and goes out of the business. It measures how much cash is made and spent within a certain period of time. The Cash Flow Analysis makes the best measure of a company’s performance because it is measurable and comparable; it is difficult to fake, and it’s universal.
Firstly, cash is the most measurable unit. It is tangible and can be measured in standard units acceptable to most individuals and businesses you will transact with.
Secondly, there are many ways to inflate profit; to increase the value of some assets; or to temporarily dress up your business to look more successful than it actually is. It is more difficult to achieve the same effect with cash as the basis.
Lastly, it is a unit of measure that is universally accepted. You don’t need to convince anyone what the value of $1,000,000 is. This nature is different from other assets like intellectual property, goodwill or depreciable assets. A piece of second-hand heavy equipment won’t have the same value it has to a construction company compared to a computer to a writer.
Inside the Cash Flow Statement
The statement has 3 main categories, cash flow from operating activities, investing activities, and financing activities.
Cash flow from the Operating Activities is focused on the main activities of the business. These include selling or buying inventory, merchandise or services. Investing activities involve the cash flow of capital assets of the business. Lastly, the financing activities include the activities from debt financing, which reflect the funding activities.
Analyzing each source is also part of the Cash Flow Analysis. If your cash heavily comes from your financing activities, it means you are reliant on the loans to fund your company. If you get most of your cash from your operating activities, it means your business is self-reliant.
The importance of the statement
Every financial statement is important in a business and each has its own purpose. The Cash Flow Statement shows the movement of cash during a period of time. Without it, a more complete picture of business performance can’t be achieved. For example, in getting a loan, the Income Statement will show the interest expense you incurred; the Balance Sheet will show how much the loan was, but only the Cash Flow will show you how much cash was used in servicing the loan.
When you make a sale, the Income Statement will show you how much the sales are, while it is the Cash Flow Statement that will give you an honest analysis if a product or service is providing enough cash to cover cost and expenses.
Don’t get misled by profitability, it is not the only metric. To create a 360 analysis of your business, you have to look at other statements to tell the complete story.
Applying the Cash Flow Statement
The Cash Flow Statement can be used for short-term planning and controlling or managing cash. It helps managers in projecting the flow of cash in the future by using the past data of the cash flows. This way, managers can be prepared to meet short-term debts and cover operating expenses.
Another application is by providing details on where money is spent. Some obligations are not reflected in the Profit and Loss Statement. You can find a more detailed list of cash spending. If you are paying the principal amount of the loan, this transaction does not reflect in the Profit and Loss Statement but there is a significant cash outflow. Even if your company had some profit if you paid off a debt at the same time, the P/L bottom line might not be reflective of the true financial situation.
The data from the Cash Statement also helps managers make long-term planning for cash. It helps managers identify and prioritize crucial activities for the business’ growth. For example, managers can plan when to invest in heavy equipment or hire new employees or branch out.
The statement also provides data to ascertain the Optimal Level of Cash Balance. It is necessary to determine this number because, through it, the company can identify any idle funds, shortages or excessive spending. Knowing the actual cash position, the decision-makers of the company can make their calls accordingly. For example, excess idle funds can be used to invest in new ventures or new equipment.
The statement also helps decode the working capital movement. The business can preserve cash by negotiating for longer credit terms from their suppliers. They can increase the inflow of cash by reducing the time of collection and delay buying inventory.
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The Cash Flow Statement is not the most popular financial statement, but it is the secret weapon to financial success. If you have any questions regarding your cash flow, don’t hesitate to contact us. We provide services that make sense for your specific business.