Key Takeaways

  • Cash flow analysis provides insights into a business’s ability to meet short-term obligations (liquidity) and long-term debts (solvency).
  • Positive cash flow signifies the capacity to cover bills and debts, while negative cash flow suggests potential cash shortages and difficulty meeting obligations.
  • Through cash flow analysis, stakeholders can gauge a business’s profitability and efficiency. Positive cash flow from operating activities indicates effective revenue collection and payable management, while negative cash flow suggests inefficiency in the collection of business debts, excessive inventories, and potential financial strain out of cash shortage.
  • By analyzing cash flows from financing activities, stakeholders gain insights into a business’s financing and dividend policies.
  • Please also briefly define- Investing activities.
  • Cash flow statements can be prepared, irrespective of the accounting method you are using for the preparation of books of accounts i.e. Cash or Accrual.
  • Accrual accounting provides a comprehensive view of financial performance but requires adjustments for non-cash items, while cash accounting offers a clearer picture of cash flow but may overlook non-cash transactions.
  • Ultimately, cash flow analysis aids stakeholders in making informed decisions regarding investments, financing, and operational strategies.

Cash Flow Analysis

Cash flow analysis is a method of evaluating the financial performance and health of a business by examining its cash inflows and outflows. Cash flow analysis helps business owners, managers, investors, and creditors to understand how a business generates and uses cash, and how it meets its short-term and long-term obligations. Cash flow analysis also helps to identify potential problems and opportunities for improving the cash flow situation of a business.

Importance of Cash Flow Analysis

Cash flow analysis is important for several reasons. Some of the benefits of cash flow analysis are:

  • It shows the liquidity and solvency of a business. Liquidity refers to the ability of a business to meet its current liabilities with its current assets, while solvency refers to the ability of a business to meet its long-term obligations with its total assets. A positive cash flow indicates that a business has enough cash to pay its bills and debts, while a negative cash flow indicates that a business may face cash shortages and difficulties in meeting its obligations.
  • It reveals the profitability and efficiency of a business. Profitability refers to the ability of a business to generate income from its operations, while efficiency refers to the ability of a business to use its resources effectively and minimize its costs. A positive cash flow from operating activities indicates that a business is generating more cash than it is spending on its operations, while a negative cash flow from operating activities indicates that a business is spending more cash than it is generating from its operations.
  • It indicates the growth and investment potential of a business. Growth refers to the ability of a business to expand its operations and increase its market share, while investment refers to the ability of a business to acquire new assets and improve its existing assets. A positive cash flow from investing activities indicates that a business is investing in its future growth, while a negative cash flow from investing activities indicates that a business is selling or disposing of its assets.
  • It reflects the financing and dividend policy of a business. Financing refers to the ability of a business to raise funds from external sources, such as debt or equity, while dividend refers to the ability of a business to distribute its earnings to its shareholders. A positive cash flow from financing activities indicates that a business is raising more cash than it is paying out to its creditors and shareholders, while a negative cash flow from financing activities indicates that a business is paying out more cash than it is raising from its creditors and shareholders.

How to Calculate Cash Flow Analysis

Cash flow analysis is based on the cash flow statement, which is one of the main financial statements of a business. The cash flow statement shows the sources and uses of cash for a given period, usually a year or a quarter. The cash flow statement is divided into three sections: operating activities, investing activities, and financing activities. Each section shows the net cash inflow or outflow for that category of activities.

The cash flow statement can be prepared using two methods: the direct method and the indirect method. The direct method shows the actual cash receipts and payments for each category of activities, while the indirect method starts with the net income and adjusts it for non-cash items and changes in working capital. The indirect method is more commonly used because it is easier to prepare and reconcile with the income statement and the balance sheet.

The formula for calculating the net cash flow for each section is:

  • Net cash flow from operating activities = Cash receipts from customers – Cash payments to suppliers, employees, and others + Interest received – Interest paid + Dividends received – Income taxes paid + Other operating cash inflows – Other operating cash outflows
  • Net cash flow from investing activities = Cash receipts from the sale of property, plant, and equipment – Cash payments for the purchase of property, plant, and equipment + Cash receipts from the sale of investments – Cash payments for the purchase of investments + Cash receipts from the sale of intangible assets – Cash payments for the purchase of intangible assets + Other investing cash inflows – Other investing cash outflows (i.e. income/charges on investments)
  • Net cash flow from financing activities = Cash receipts from issuance of debt – Cash payments for repayment of debt + Cash receipts from issuance of equity – Cash payments for repurchase of equity – Cash payments for dividends + Other financing cash inflows – Other financing cash outflows

The formula for calculating the net change in cash for the period is:

Net change in cash = Net cash flow from operating activities + Net cash flow from investing activities + Net cash flow from financing activities

The formula for calculating the ending cash balance for the period is:

Ending cash balance = Beginning cash balance + Net change in cash

Types of Cash Flows

There are three main types of cash flows that are used in cash flow analysis: free cash flow, operating cash flow, and discounted cash flow. Each type of cash flow has a different purpose and meaning.

Free Cash Flow

Free cash flow (FCF) is the amount of cash that a business generates from its operations after deducting the capital expenditures (CAPEX) that are necessary to maintain or expand its asset base. FCF represents the cash that is available to business owners, managers, investors, and creditors for discretionary purposes, such as paying dividends, repurchasing shares, reducing debt, or making new investments. FCF is an indicator of the financial strength and flexibility of a business.

The formula for calculating FCF is:

FCF = Net cash flow from operating activities – CAPEX

Operating Cash Flow

Operating cash flow (OCF) is the amount of cash that a business generates from its core operations, excluding the effects of investing and financing activities. OCF represents the cash that is generated by the normal business activities of a business, such as selling goods or services, paying suppliers or employees, or collecting receivables. OCF is an indicator of the profitability and efficiency of a business.

The formula for calculating OCF is:

OCF = Net cash flow from operating activities

Discounted Cash Flow

Discounted cash flow (DCF) is the present value of the future cash flows that a business expects to receive from a project, investment, or asset. DCF represents the value that a business or an investor is willing to pay for a project, investment, or asset, based on the expected cash flows and the required rate of return. DCF is a method of valuation that is used to estimate the intrinsic value of a business, project, investment, or asset.

The formula for calculating DCF is:

DCF = CF1 / (1 + r) + CF2 / (1 + r)^2 + … + CFn / (1 + r)^n

where CF is the cash flow, r is the discount rate, and n is the number of periods.

Understanding Positive and Negative Cash Flow

Positive and negative cash flow are terms that describe the net cash inflow or outflow for a given period. Positive cash flow means that more cash is coming into the business than going out, while negative cash flow means that more cash is going out of the business than coming in. Positive and negative cash flow can have different implications depending on the section and type of cash flow.

Positive and Negative Cash Flow from Operating Activities

Positive cash flow from operating activities means that the business is effectively able to generate more cash from its core operations and its spending over it. This indicates that the business is profitable and efficient and that it has enough cash to meet its current obligations and invest in its growth. Positive cash flow from operating activities is desirable and sustainable for a business.

Negative cash flow from operating activities means that the business is spending more cash on its operations than it is generating from its core operations. This indicates that the business is unprofitable and inefficient and that it may face cash shortages and difficulties in meeting its current obligations and investing in its growth. Negative cash flow from operating activities is undesirable and unsustainable for a business.

Positive and Negative Cash Flow from Investing Activities

Positive cash flow from investing activities means that the business is receiving more cash from selling or disposing of its assets than it is spending on acquiring or improving its assets. This indicates that the business is liquidating or downsizing its asset base and that it may have excess cash to distribute to its owners, managers, investors, or creditors. Positive cash flow from investing activities is uncommon and temporary for a business.

Negative cash flow from investing activities means that the business is spending more cash on acquiring or improving its assets than it is receiving from selling or disposing of its assets. This indicates that the business is investing in its future growth and that it may need to raise funds from external sources to finance its investments. Negative cash flow from investing activities is common and expected for a growing business.

Positive and Negative Cash Flow from Financing Activities

Positive Cash Flow from Financing means that the entity is raising more cash from its financing activities than it is paying for them. It indicates that the entity is issuing new debt or equity at a favorable rate, or that it is repurchasing its existing debt or equity at a lower price. It also implies that the entity has a high leverage and a high dividend payout ratio.

Negative Cash Flow from Financing means that the entity is paying more cash for its financing activities than it is raising from them. It indicates that the entity is repaying its existing debt or equity at a higher rate, or that it is issuing new debt or equity at a lower price. It also implies that the entity has a low leverage and a low dividend payout ratio.

Accounting Methods for Cash Flow

There are two main accounting methods that are used to record the transactions and events that affect the cash flow of a business: accrual accounting and cash accounting. Each accounting method has a different impact on the cash flow statement and the cash flow analysis.

Accrual Accounting

Accrual accounting is the accounting method that records the transactions and events when they occur, regardless of when the cash is exchanged. Accrual accounting follows the matching principle, which states that the revenues and expenses should be matched and reported in the same period. Accrual accounting provides a more accurate and comprehensive picture of the financial performance and position of a business, as it reflects the economic reality of the transactions and events.

However, accrual accounting does not show the actual cash inflows and outflows of a business, as it includes non-cash items, such as depreciation, amortization, accounts receivable, accounts payable, and accrued expenses. Therefore, accrual accounting requires adjustments to convert the net income to the net cash flow from operating activities. The adjustments include adding back the non-cash expenses, such as depreciation and amortization, and subtracting or adding the changes in the current assets and liabilities, such as accounts receivable, accounts payable, and accrued expenses.

Cash Accounting

Cash accounting is the accounting method that records the transactions and events only when the cash is exchanged. Cash accounting follows the cash basis principle, which states that the revenues and expenses should be reported only when the cash is received or paid. Cash accounting provides a simpler and clearer picture of the cash flow situation of a business, as it reflects the actual cash inflows and outflows of a business.

However, cash accounting does not show the complete and accurate financial performance and position of a business, as it ignores the transactions and events that have not yet resulted in a cash exchange. Therefore, cash accounting may not capture the true profitability and efficiency of a business, as it may overstate or understate the revenues and expenses in each period.

Cash Flow Statement and Its Sections

After the Balance Sheet and Income Statement, Cash flow statements are considered to be the most significant part of financial statements. The cash flow statement shows the sources and uses of cash for a given period, usually a year or a quarter. The cash flow statement is divided into three sections: operating activities, investing activities, and financing activities. Each section shows the net cash inflow or outflow for that category of activities.

Operating Activities

Operating activities are the activities that relate to the core operations of a business, such as selling goods or services, paying suppliers or employees, or collecting receivables. Operating activities are the main source of cash inflow for a business, as they reflect the cash generated from its normal business activities. Operating activities are also the main use of cash outflow for a business, as they reflect the cash spent on its operations.

The net cash flow from operating activities is calculated by either the direct method or the indirect method. The direct method shows the actual cash receipts and payments for each category of operating activities, such as cash receipts from customers, cash payments to suppliers, cash payments to employees, etc. The indirect method starts with the net income and adjusts it for non-cash items and changes in working capital, such as depreciation, amortization, accounts receivable, accounts payable, etc.

Investing Activities

Investing activities are the activities that relate to the acquisition or disposal of long-term assets, such as property, plant, and equipment, intangible assets, or investments. Investing activities are a source of cash inflow for a business when it sells or disposes of its long-term assets, as it receives cash from the buyers. Investing activities are a use of cash outflow for a business when it purchases or acquires new long-term assets, as it pays cash to the sellers.

The net cash flow from investing activities is calculated by subtracting the cash payments for the purchase of long-term assets from the cash receipts from the sale of long-term assets. The cash payments and receipts for each category of investing activities, such as cash payments for the purchase of property, plant, and equipment, cash receipts for the sale of property, plant, and equipment, etc., are shown separately in the cash flow statement.

Financing Activities

Financing activities are activities that relate to the raising or repaying of funds from external sources, such as debt or equity. Financing activities are a source of cash inflow for a business when it raises funds from external sources, such as issuing debt or equity, as it receives cash from creditors or investors. Financing activities are a use of cash outflow for a business when it repays funds to external sources, such as repaying debt or paying dividends, as it pays cash to creditors or shareholders.

The net cash flow from financing activities is calculated by subtracting the cash payments for repayment of debt, repurchase of equity, or dividends from the cash receipts from issuance of debt or equity. The cash payments and receipts for each category of financing activities, such as cash payments for repayment of debt, cash receipts from issuance of debt, etc., are shown separately in the cash flow statement.

Example of Cash Flow Analysis

To illustrate the cash flow analysis, let us consider a hypothetical example of a business that operates in the retail industry. The business sells clothing and accessories to customers and purchases inventory from suppliers. The business also owns a store and a warehouse and has a bank loan and a line of credit. The business follows the accrual accounting method and prepares its cash flow statement using the indirect method. The following table shows the income statement, the balance sheet, and the cash flow statement of the business for the year 2023.

Income Statement
Revenue $1,000,000
Cost of Goods Sold ($600,000)
Gross Profit $400,000
Operating Expenses ($300,000)
Operating Income $100,000
Interest Expense ($10,000)
Income Before Tax $90,000
Income Tax Expense ($18,000)
Net Income $72,000

 

Balance Sheet
Assets
Cash $50,000 $80,000
Accounts Receivable $100,000 $120,000
Inventory $200,000 $180,000
Prepaid Expenses $10,000 $15,000
Total Current Assets $360,000 $395,000
Property, Plant, and Equipment $300,000 $350,000
Accumulated Depreciation ($100,000) ($120,000)
Net Property, Plant, and Equipment $200,000 $230,000
Total Assets $560,000 $625,000
Liabilities and Equity
Accounts Payable $80,000 $100,000
Accrued Expenses $20,000 $25,000
Income Tax Payable $10,000 $12,000
Total Current Liabilities $110,000 $137,000
Long-Term Debt $200,000 $180,000
Total Liabilities $310,000 $317,000
Common Stock $100,000 $100,000
Retained Earnings $150,000 $208,000
Total Equity $250,000 $308,000
Total Liabilities and Equity $560,000 $625,000

 

Cash Flow Statement
Operating Activities
Net Income $72,000
Adjustments for Non-Cash Items
Depreciation $20,000
Changes in Working Capital
Accounts Receivable ($20,000)
Inventory $20,000
Prepaid Expenses ($5,000)
Accounts Payable $20,000
Accrued Expenses $5,000
Income Tax Payable $2,000
Net Cash Flow from Operating Activities $114,000
Investing Activities
Purchase of Property, Plant, and Equipment ($70,000)
Net Cash Flow from Investing Activities ($70,000)
Financing Activities
Repayment of Long-Term Debt ($20,000)
Net Cash Flow from Financing Activities ($20,000)
Net Change in Cash $24,000
Beginning Cash Balance $50,000
Ending Cash Balance $74,000

The cash flow analysis of the business can be done by examining the net cash flow from each section and type of cash flow and comparing them with the net income and the ending cash balance. The cash flow analysis of the business can be summarized as follows:

  • The business has a positive net cash flow from operating activities of $114,000, which is higher than its net income of $72,000. This means that the business is profitable and efficient and that it generates more cash than it spends on its operations. The difference between the net cash flow from operating activities and the net income is due to the non-cash items, such as depreciation, amortization, accounts receivable, accounts payable, and accrued expenses. These items affect the net income, but not the cash flow, as they do not involve cash exchange. The changes in working capital also affect the cash flow, as they reflect the timing difference between the recognition and collection of revenues and the recognition and payment of expenses. The business has a positive change in working capital of $22,000, which means that it has increased its current assets more than its current liabilities and that it has delayed its cash payments or accelerated its cash receipts.
  • The business has a negative net cash flow from investing activities of $70,000, which is lower than its net cash flow from operating activities of $114,000. This means that the business is investing in its future growth and that it has enough cash to finance its investments. The business has spent $70,000 on purchasing new property, plant, and equipment, which indicates that it is expanding or improving its asset base. The business has not sold or disposed of any of its long-term assets, which indicates that it is not liquidating or downsizing its asset base.
  • The business has a negative net cash flow from financing activities of $20,000, which is lower than its net cash flow from investing activities of $70,000. This means that the business is reducing its leverage or increasing its ownership and that it has enough cash to repay its debt or pay dividends. The business has repaid $20,000 of its long-term debt, which indicates that it is decreasing its debt burden or improving its creditworthiness. The business has not issued or repurchased any of its equity or paid any dividends, which indicates that it is maintaining its capital structure or retaining its earnings.
  • The business has a positive net change in cash of $24,000, which is higher than its net income of $72,000. This means that the business has increased its cash balance more than its earnings and that it has a positive cash flow situation. The difference between the net change in cash and the net income is due to the net cash flow from operating activities, investing activities, and financing activities, which are explained above. The business has increased its cash balance from $50,000 to $74,000, which indicates that it has a strong liquidity and solvency position.

Points and Tips for Analyzing Cash Flow

The following are some of the points and tips for analyzing cash flow:

  • Compare the net cash flow from operating activities with the net income to assess the profitability and efficiency of a business. A positive and consistent net cash flow from operating activities that is higher than the net income indicates a high-quality and sustainable income. A negative or volatile net cash flow from operating activities that is lower than the net income indicates a low-quality and unsustainable income.
  • Compare the net cash flow from investing activities with the net cash flow from operating activities to assess the growth and investment potential of a business. A negative and consistent net cash flow from investing activities that is lower than the net cash flow from operating activities indicates a growing and investing business. A positive or volatile net cash flow from investing activities that is higher than the net cash flow from operating activities indicates a shrinking or divesting business.
  • Compare the net cash flow from financing activities with the net cash flow from investing activities to assess the financing and dividend policy of a business. A positive and consistent net cash flow from financing activities that are higher than the net cash flow from investing activities indicates a leveraged or diluted business. A negative or volatile net cash flow from financing activities that are lower than the net cash flow from investing activities indicates a deleveraged or concentrated business.
  • Compare the net change in cash with the net income to assess the cash flow situation of a business. A positive and consistent net change in cash that is higher than the net income indicates a positive and strong cash flow situation. A negative or volatile net change in cash that is lower than the net income indicates a negative or weak cash flow situation.
  • Compare the ending cash balance with the total liabilities and equity to assess the liquidity and solvency position of a business. A high and increasing ending cash balance that is higher than the total liabilities and equity indicates a liquid and solvent business. A low or decreasing ending cash balance that is lower than the total liabilities and equity indicates an illiquid and insolvent business.

Limitations of Cash Flow Analysis

Cash flow analysis is a useful and powerful tool for evaluating the financial performance and health of a business, but it also has some limitations that should be considered. Some of the limitations of cash flow analysis are:

  • Cash flow analysis does not show the accrual basis of accounting, which is more accurate and comprehensive than the cash basis of accounting. Cash flow analysis may not capture the true profitability and efficiency of a business, as it may overstate or understate the revenues and expenses in each period. Cash flow analysis may also not reflect the economic value of the non-cash items, such as depreciation, amortization, accounts receivable, accounts payable, and accrued expenses, which affect the net income, but not the cash flow.
  • Cash flow analysis does not show the future cash flows of a business, which are more relevant and important than the past cash flows. Cash flow analysis may not capture the growth and investment potential of a business, as it may not consider the expected cash flows from the existing or new projects, investments, or assets. Cash flow analysis may also not reflect the risk and uncertainty of the future cash flows, which affect the value and return of a business.
  • Cash flow analysis does not show the opportunity cost of cash, which is the return that could be earned by investing the cash in an alternative use. Cash flow analysis may not capture the optimal use of cash for a business, as it may not consider the trade-off between holding cash and investing cash. Cash flow analysis may also not reflect the cost of capital, which is the minimum required rate of return for a business to invest its cash.

Preparing a Cash Flow Statement

Preparing a cash flow statement is a process of collecting, organizing, and presenting the cash inflows and outflows of a business for a given period, usually a year or a quarter. Preparing a cash flow statement involves the following steps:

  • Identify the sources and uses of cash for each category of activities: operating, investing, and financing. The sources and uses of cash can be obtained from the income statement, the balance sheet, and the other financial records of a business.
  • Calculate the net cash flow for each category of activities: operating, investing, and financing. The net cash flow for each category of activities can be calculated by either the direct method or the indirect method, as explained above.
  • Calculate the net change in cash for the period. The net change in cash for the period can be calculated by adding the net cash flow from operating activities, the net cash flow from investing activities, and the net cash flow from financing activities.
  • Calculate the ending cash balance for the period. The ending cash balance for the period can be calculated by adding the beginning cash balance and the net change in cash for the period.
  • Present the cash flow statement in a clear and concise format. The cash flow statement should show the net cash flow from operating activities, the net cash flow from investing activities, the net cash flow from financing activities, the net change in cash for the period, and the ending cash balance for the period.

Five Steps to Cash Flow Analysis

Cash flow analysis is a method of evaluating the financial performance and health of a business by examining its cash inflows and outflows. Cash flow analysis can be done by following these five steps:

  • Step 1: Prepare the cash flow statement. The cash flow statement shows the sources and uses of cash for a given period, usually a year or a quarter. The cash flow statement is divided into three sections: operating activities, investing activities, and financing activities. Each section shows the net cash inflow or outflow for that category of activities. The cash flow statement can be prepared using two methods: the direct method and the indirect method.
  • Step 2: Analyze the net cash flow from operating activities. The net cash flow from operating activities shows the cash generated or used by the core operations of a business, such as selling goods or services, paying suppliers or employees, or collecting receivables. The net cash flow from operating activities indicates the profitability and efficiency of a business, and its ability to meet its current obligations and invest in its growth.
  • Step 3: Analyze the net cash flow from investing activities. The net cash flow from investing activities shows the cash received or spent by the acquisition or disposal of long-term assets, such as property, plant, and equipment, intangible assets, or investments. The net cash flow from investing activities indicates the growth and investment potential of a business, and its ability to expand or improve its asset base.
  • Step 4: Analyze the net cash flow from financing activities. The net cash flow from financing activities shows the cash raised or repaid by external sources of funds, such as debt or equity. The net cash flow from financing activities indicates the financing and dividend policy of a business, and its ability to raise or repay funds from its creditors or shareholders.
  • Step 5: Analyze the net change in cash and the ending cash balance. The net change in cash shows the increase or decrease in the cash balance for the period, while the ending cash balance shows the amount of cash available at the end of the period. The net change in cash and the ending cash balance indicate the cash flow situation of a business and its liquidity and solvency position.

FAQs on Cash Flow Analysis

The following are some of the frequently asked questions (FAQs) on cash flow analysis:

1. What is cash flow analysis?

Cash flow analysis is a method of evaluating the financial performance and health of a business by examining its cash inflows and outflows. Cash flow analysis is based on the cash flow statement, which is one of the main financial statements of a business. The cash flow statement shows the sources and uses of cash for a given period, usually a year or a quarter. The cash flow statement is divided into three sections: operating activities, investing activities, and financing activities. Each section shows the net cash inflow or outflow for that category of activities.

2. Why is cash flow analysis important?

Cash flow analysis is important for several reasons. Some of the benefits of cash flow analysis are:

  • It shows the liquidity and solvency of a business. Liquidity refers to the ability of a business to meet its current liabilities with its current assets, while solvency refers to the ability of a business to meet its long-term obligations with its total assets. A positive cash flow indicates that a business has enough cash to pay its bills and debts, while a negative cash flow indicates that a business may face cash shortages and difficulties in meeting its obligations.
  • It reveals the profitability and efficiency of a business. Profitability refers to the ability of a business to generate income from its operations, while efficiency refers to the ability of a business to use its resources effectively and minimize its costs. A positive cash flow from operating activities indicates that a business is generating more cash than it is spending on its operations, while a negative cash flow from operating activities indicates that a business is spending more cash than it is generating from its operations.
  • It indicates the growth and investment potential of a business. Growth refers to the ability of a business to expand its operations and increase its market share, while investment refers to the ability of a business to acquire new assets and improve its existing assets. A positive cash flow from investing activities indicates that a business is investing in its future growth, while a negative cash flow from investing activities indicates that a business is selling or disposing of its assets.
  • It reflects the financing and dividend policy of a business. Financing refers to the ability of a business to raise funds from external sources, such as debt or equity, while dividend refers to the ability of a business to distribute its earnings to its shareholders. A positive cash flow from financing activities indicates that a business is raising more cash than it is paying out to its creditors and shareholders, while a negative cash flow from financing activities indicates that a business is paying out more cash than it is raising from its creditors and shareholders.

3. How to calculate cash flow analysis?
Cash flow analysis is calculated by using the cash flow statement, which can be prepared using two methods: the direct method and the indirect method. The direct method shows the actual cash receipts and payments for each category of activities, while the indirect method starts with the net income and adjusts it for non-cash items and changes in working capital. The formula for calculating the net cash flow for each section is:

  • Net cash flow from operating activities = Cash receipts from customers – Cash payments to suppliers, employees, and others + Interest received – Interest paid + Dividends received – Income taxes paid + Other operating cash inflows – Other operating cash outflows
  • Net cash flow from investing activities = Cash receipts from the sale of property, plant, and equipment – Cash payments for the purchase of property, plant, and equipment + Cash receipts from the sale of investments – Cash payments for the purchase of investments + Cash receipts from the sale of intangible assets – Cash payments for the purchase of intangible assets + Other investing cash inflows – Other investing cash outflows
  • Net cash flow from financing activities = Cash receipts from issuance of debt – Cash payments for repayment of debt + Cash receipts from issuance of equity – Cash payments for repurchase of equity – Cash payments for dividends + Other financing cash inflows – Other financing cash outflows
  • The formula for calculating the net change in cash for the period is:
    • Net change in cash = Net cash flow from operating activities + Net cash flow from investing activities + Net cash flow from financing activities
  • The formula for calculating the ending cash balance for the period is:
    • Ending cash balance = Beginning cash balance + Net change in cash

4. What are the types of cash flows?

There are three main types of cash flows that are used in cash flow analysis: free cash flow, operating cash flow, and discounted cash flow. Each type of cash flow has a different purpose and meaning.

  • Free cash flow (FCF) is the amount of cash that a business generates from its operations after deducting the capital expenditures (CAPEX) that are necessary to maintain or expand its asset base. FCF represents the cash that is available to business owners, managers, investors, and creditors for discretionary purposes, such as paying dividends, repurchasing shares, reducing debt, or making new investments. FCF is an indicator of the financial strength and flexibility of a business.
  • Operating cash flow (OCF) is the amount of cash that a business generates from its core operations, excluding the effects of investing and financing activities. OCF represents the cash that is generated by the normal business activities of a business, such as selling goods or services, paying suppliers or employees, or collecting receivables. OCF is an indicator of the profitability and efficiency of business operations.
  • Discounted cash flow (DCF) is the present value of the future cash flows that a business expects to receive from a project, investment, or asset. DCF represents the value that a business or an investor is willing to pay for a project, investment, or asset, based on the expected cash flows and the required rate of return. DCF is a method of valuation that is used to estimate the intrinsic value of a business, project, investment, or asset.

5. What are the advantages and limitations of cash flow analysis?

Cash flow analysis has several advantages and limitations that should be considered. Some of the advantages of cash flow analysis are:

  • It shows the actual cash inflows and outflows of a business, which are more relevant and important than the accrual basis of accounting.
  • It reveals the liquidity and solvency of a business, which are essential for maintaining a financially sustainable business.
  • It indicates the profitability and efficiency of a business, which are key for enhancing the performance and competitiveness of a business.
  • It reflects the growth and investment potential of a business, which are vital for pursuing profitable opportunities and creating value for a business.
  • It provides useful information for decision-making, budgeting, and planning for future cash needs.

Some of the limitations of cash flow analysis are:

  • It does not show the future cash flows of a business, which are more uncertain and riskier than the past cash flows.
  • It does not show the opportunity cost of cash, which is the return that could be earned by investing the cash in an alternative use.
  • It does not consider the time value of money (except DCF method)
  • It ignores the concept of accrual which is one of the fundamental accounting assumptions.
  • One cannot judge the profitability of a firm, as non-cash charges are ignored while calculating cash flows from operating activities.
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