Cash flow is a measure of money entering and going out of an entity over a specified period. Cash flow is often used to evaluate the efficiency and profitability of an organisation. This resource outlines the relationship between income and expenses, how cash flow can be used to analyse profit performance, the importance of cash flows in business valuation, and other aspects related to cash flows that businesses may need to evaluate.

Cash flow analysis is used to evaluate the profitability and efficiency of an organisation. Cash flow analysis is performed on the income statement, operating expenses and working capital to measure the amount of cash an organisation earns and spends. The working capital section shows how much money a firm needs to keep on hand compared to the amount it can loan or invest. The cash flow statement shows the net change in cash flow between the current year’s income and expenses. This is useful for identifying a firm’s capital resources and the shareholders’ return on investment.

There are three methods of cash flow analysis that are used to evaluate the profitability of an organisation: Cash Flow Before Taxes (CFBT), Cash Flow After Taxes (CFFT), and Free Cash Flow (FCF). These methods are derived from the income statement and balance sheet. The cash flow statement has two sections: operating activities and financing activities. Operating activities include sales, investments, expenses, depreciation, taxes, and changes in working capital.

Why is Cash Flow Important?

Cash flow can be used to analyse profitability and efficiency and is particularly useful for evaluating capital expenditures. Cash flow can also be used to evaluate project-level cash requirements because it identifies the net cash needed for investments in capital equipment.

Organisations have three sources of cash: Operating activities, investing activities, and financing activities. The operating activities may result in increases or decreases in net cash; the investing activities may result in either an increase or a decrease in net cash; while the financing activities would always decrease net cash.

Businesses may use cash flow to evaluate their profit performance or the efficiency and profitability of operations. Cash flow is also useful for evaluating an organisation’s ability to pay its debt.

Cash flows are similar to income statements but provide vital information about an organisation’s financial situation, such as the cash resources available for investing in capital assets, capital budgeting strategies and budgeting options, etc. A business may review its operating activities and then analyse its investing and financing activities.

Cash Flow Analysis Includes the Following

The main source of cash flow is sales. If a company’s cash flows are more than net income, it may mean that it is using its excess cash to invest in capital expenditures. If there are no additional capital expenditures, then free cash flow can be used to evaluate the profitability of an organisation. Free cash flow excludes capital expenditures and non-cash items such as depreciation and amortisation expenses.

The statement of cash flows is typically prepared after the balance sheet and income statement. However, the cash flow statement can be prepared monthly, quarterly or annual.

Cash Flow Statement: Operating Activities

Cash flow from operating activities primarily depends on the amount of revenue generated from sales fewer expenses incurred in operations (i.e. cost of goods sold, operating expenses such as rent, supplies, utilities and wages). The cash flow statement shows that the amount of revenue received from sales, and fewer expenses incurred in operating the business, will result in a positive cash flow. A negative cash flow means that expenses exceed revenue.

Cash Flow Statement: Investing Activities

Cash flow from investing activities is also not dependent upon the amount of cash needed to purchase or construct capital assets. Because of this, we do not show any amounts relating to purchases or construction costs under investing activities.

Cash Flow Statement: Financing Activities

Cash flow from financing activities depends on the amount of net cash used for financing purchases of capital assets. This section does not show any amounts relating to purchases or construction costs, although we do show under investing activities any amounts relating to purchases or construction costs.

It is important to note that the finance activities section of the cash flow statement is for financing cash needs. However, this may not show the actual source of these funds. For example, if a business raises money in external financing such as debt or equity, then the funds would be shown in this section; however, if internally generated funds are used to finance the capital expenditure, they would be recorded as investing activities.

Cash flow analysis is also important because it can be used to evaluate the efficiency of an organisation and its ability to generate cash. It can also be used to project future cash needs by determining whether or not revenue will cover operating expenses.

Final Verdict

If an organisation has no free cash flow or negative free cash flow, it may mean the company is not generating enough revenue to cover its operating expenses. This can result in the company being forced to borrow money to meet its financial obligations (short-term debt) and reduce its capital expenditures. Cash flow is also useful for planning purposes because it shows the amount of cash available for investing in capital assets.