Cash flow is the cycle of money moving in and out of your business. It’s the engine that powers your business, determining your solvency and growth.
There may be several reasons for too much or too little cash flow, and the first step toward optimizing your cash flow is to analyze it.
This article tells you more about cash flow analysis and its relevance to your business. We cover the following points:
- What is cash flow analysis, and why is it important?
- How to analyze your business’s cash flow
- Most common reasons for cash flow problems
- Which software can you use for cash flow analysis?
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What Is Cash Flow Analysis?
Cash flow is the study of a business’s cash inflows and outflows. More specifically, it’s a way to investigate how your business earns and burns money over time.
However, it isn’t the same as profit. Profit is the money left after subtracting expenses from your revenue. Whereas cash flow refers to the money coming in and going out of your business over a set period.
A cash flow analysis gives you information about:
- Who your biggest customers are
- What are your biggest expenses?
- How much cash do you have liquid to meet expenses?
The main goal is to maintain sufficient liquid cash to meet your financial obligations while investing enough in your growth prospects.
Why Is Cash Flow Analysis Important?
Cash flow analysis is especially important for startups or small businesses that are seeking to expand quickly.
Excess cash flow may indicate missed opportunities or an unnecessarily high cost of capital. On the other hand, too little cash flow prevents you from making payments on time, hampering your operations.
The growth phase brings with it massive cash outflows through increasing customer acquisition cost (CAC), rising cost of labor, and more inventory.
However, there’s typically a lag when it comes to the cash inflows for most small businesses. Here are some of the most common reasons for this:
- Underestimating costs
- Trying to grow too quickly
- Slow collection of accounts receivables
It’s crucial to ensure you aren’t spending beyond your means while also being mindful of your future cash inflows.
Monitoring cash flow is also vital for businesses whose revenues are seasonal. These businesses tend to receive cash inflows only for a few months in a year while yet incurring expenditure for the other months as well.
Performing a cash flow analysis can help you isolate problematic customers and identify inefficiencies in your operations.
How To Do a Cash Flow Analysis?
- Identify your sources of income
- Identify your business expenses
- Make your cash flow statement
- Analyze your cash flow statement
Now that we’ve gone through the basics of what a cash flow analysis is and why it’s important, let’s understand how a cash flow is carried out.
Broadly speaking, it involves examining the aspects of your operations that impact cash flow, such as credit terms, inventory, accounts receivable (A/R), and accounts payable (A/P). Separating these different components makes it easier to isolate issues and find solutions.
A detailed cash flow analysis involves the following steps, starting with collecting the necessary financial information about your business.
Identify Your Sources of Income
First, you need to familiarize yourself with how money flows into your business. One of the key elements of a cash flow statement is your total income. You need to add up all of the income generated by your business during a time frame. This includes revenue from goods and services and any capital generated from investments or the sale of assets.
Identify Your Business Expenses
Secondly, you need to understand how money flows out of your business. Your business expenses include accounts payable, purchase of inventory, deferred revenue, depreciation of fixed assets, income tax, and other liabilities.
This contributes to the calculation of your net income as well. Your net income is your total income minus your business expenses.
Make Your Cash Flow Statement
Now that you have all the information you need about your business’s cash inflows and outflows, you just need to organize it in the form of a cash flow statement. You can divide the statement into three distinct sections that separate operating income and expenses from company investments and financing arrangements:
- Operating income and expenses: Highlights the money related to your primary business activities. When you subtract your expenses from income, if you get a positive number, that means you have positive cash flow.
- Investing activities: Highlights the money that’s related to your investment in different assets. This includes the sale or purchase of property, equipment, stocks, bonds, and other investments. For most small businesses, this is a negative number because of the many investments you make while trying to grow your business.
- Financing activities: Highlights any borrowed funds, loan repayments, and the buyback or issuance of company stock. The final amount depends on the amount of debt and equity your business has.
Analyze Your Cash Flow Statement
Next, you need to look for patterns. The statement shows you how your money flows in and out over a specific time frame. This allows you to identify how much is tied up in investments or debt and how much you earn after subtracting operating expenses. It also helps you understand whether your cash flow is positive or negative.
The most important thing is that you have positive cash flow from your operating activities. At the same time, you also need to keep investing and making purchases that contribute to your growth. Therefore, it’s a good idea to use the positive cash flow from operations to make investments.
Additionally, keep a watch on when your expenses are due. If you monitor when your business is due to be paid by your customers, you can budget easily for future expenses.
You can also look at your monthly cash flow statements to identify any patterns of deficits. If you see that you have a deficit in the same month or months each year, and this is only growing, it could indicate sales issues.
There may be a deficit during a specific month when you have large payments due ― quarterly taxes or insurance. If this number becomes too large over time, it might be time to adjust your business model.
What Are Your Next Steps as a Small Business Owner?
The first step is to analyze your cash flow and understand whether your business has any cash flow problems.
Problems with cash flow could be the result of substandard bookkeeping, or they may indicate a larger business problem. If it’s a business problem, you need to isolate where the issue is arising from and take corrective measures to fix it.
As an owner of a small business or entrepreneur, you’re likely overburdened with work, so keeping your books up to date can be cumbersome. An excellent way to fix this is to use an accounting software that helps you generate invoices, pay bills, and create cash flow statements.
If you are finding solutions to optimize your cash flow for your business, check out our recommendations for the best cash flow management software of 2023.
