Effective cash flow analysis: top 7 tips for financial growth

What is cash flow analysis?

Cash flow analysis reviews a company's inflow and outflow of cash, assessing its ability to maintain adequate cash for operations and growth.

In an analysis, the team reviews all cash transactions over a specific period, including everything from operational activities to investing and financing decisions.

A well-executed cash flow analysis reveals valuable insights housed within the company’s raw finance data, such as liquidity, solvency, and future cash flow generation. Cash flow analysis lets businesses understand where money is going, get ahead of potential shortfalls, make the most of budget surplus, and more.

The two primary cash flow methods used in cash flow analysis are:

• The direct method: This involves a detailed examination of each instance of cash inflow and outflow within an organization. It scrutinizes every transaction, from customer receipts to supplier payments, providing a comprehensive view of all cash-based activities. This method offers high accuracy but can be time-consuming due to its meticulous nature.

• The indirect method: This starts with net income and adds or subtracts changes in balance sheet accounts to arrive at operational cash flow. It's based on accrual accounting rather than actual cash transactions. While this approach may not offer insights as granular as the direct method, it is simpler and less labor-intensive, making it more commonly used (especially when quick overviews are needed).

Both methods provide valuable insights into a company's financial health but serve different purposes. The choice between using one over the other often depends on the business's specific needs, such as the level of detail required or resources available for conducting the analysis.

Conducting analysis: the basics of cash flow

When it comes to analyzing cash flow, there are three main categories to keep in mind: operational, investing, and financing. Let's take a closer look at each one.

Operational cash flow

Operational cash flow refers to cash from a company's regular business operations, such as sales revenue, payments for supplies and salaries, and other day-to-day transactional activities.

To calculate operational cash flow, you need to take net income and adjust it for non-cash expenses like depreciation, changes in working capital, and changes in deferred tax. If operational cash flow is positive, the company can generate more cash than it needs for everyday operations.

Investing cash flow

Investing cash flow refers to the cash involved in buying or selling long-term assets, such as property, plant, equipment, or investments in other businesses. When a company purchases an asset, it will result in negative investing cash flow. When an asset is sold, or any gains from investments are realized, there would be a positive investing cash flow.

Financing cash flow

Financing cash flow refers to cash flow involving owners or creditors of the company in the form of equity, loans, leases, or stock activities (issuing new stock, repurchasing existing stock, paying dividends to shareholders, repayment of debt principal, etc.).

Positive financing cash flow indicates more money was raised than paid out. If cash flow is negative, the company has distributed more funding.

Monitoring all cash flow sources closely on their statement of cash flows helps finance maintain financial health and make strategic decisions about the company’s future action and direction. 

➡️ Need to create pro forma cash flow statements? Get started with this free template.

Top tips for financial growth: a holistic approach to cash flow analysis

1. Ensure accurate forecasting and budgeting.

Accurate cash forecasting is vital for effective financial planning. It enables companies to anticipate potential shortfalls or surpluses, allowing time to strategize optimal allocation of resources. This foresight can prevent financial strain and facilitate uninterrupted operations. 

Here are five of the best ways to increase the accuracy of forecasting and more accurately track a cash budget in your FP&A practice:

• Incorporate past financial data: Historical data can provide valuable insights into recurring trends, seasonal variations, and unexpected anomalies. These patterns can be instrumental in shaping a realistic forecast model.
• Use analytical tools: The right software solutions can automate data collection and analysis, significantly reducing the margin for human error. AI enhancements also help identify nuanced patterns that may go unnoticed with manual methods.
• Integrate all revenue sources: Every source of income, no matter how insignificant, should be incorporated into the forecast model. This comprehensive approach ensures all potential cash inflows are accounted for.
• Account for variable and fixed costs: Both categories of expenditures impact cash flow. Including them in your forecast provides a complete picture of potential outflows.
• Contextualize with external factors: Market trends, economic climate, legislation changes - these external factors can significantly impact a company's finances. An effective forecasting model takes these into account.

Budgeting is also pivotal to successfully managing and predicting cash flows. It acts as a financial blueprint, outlining projected income and expenses. By detailing anticipated revenues and costs—both fixed and variable—budgeting offers an overall view of potential cash inflows and outflows. 

Budgeting is the cornerstone of efficient resource allocation. It also plays a role in spotting shortfalls or surpluses, making it integral to cash flow statement analysis and financial planning.

2. Manage receivables efficiently.

Optimizing the accounts receivable process significantly enhances cash management. Even the best customers can’t issue prompt payment if the process is difficult or unclear, so be sure to incorporate technology and tracking into the process for minimal friction.

Technology is the most effective way to ease AR management struggles. It creates a centralized source of truth about receivables, makes it easier for buyers to meet obligations, and reduces the manual labor and errors that bog down even high-performing accounting teams. 

3. Ensure effective payables management.

On the other side of the coin, managing your obligations to vendors optimizes cash utilization and preserves revenue for a stronger overall cash position. There are many ways to improve the AP process for better cash flow, such as:

• Streamlining processes: Simplify your accounts payable process to reduce paperwork, automate manual tasks, and expedite payment approval. This minimizes errors and ensures timely payments to avoid fees.
• Using invoice verification: Verify invoices as soon as they arrive to detect discrepancies or issues immediately. Early verification also allows for efficient budgeting and avoids last-minute cash flow problems.
• Establishing clear payment terms: Set clear payment terms with vendors from the beginning. This may include payment deadlines, penalties for late payments, or early payment discounts. It ensures both parties have a mutual understanding of expectations.
• Monitoring payables: Keep a close watch on your payables to avoid overdue payments that could harm your relationships with suppliers or accrue late fees. Establish a reminder system for upcoming payments or discrepancies in payment transactions. 
• Using three-way matching: Before making any payment, ensure that purchase orders, receiving documents, and invoices match. This minimizes the chance of overpayment or duplicate payments and ensures that the supplies ordered and delivered match what was promised during the purchase order process.
• Leveraging technology: Utilize tools like accounting and FP&A software that integrate seamlessly with other financial systems in your company. Technology significantly enhances efficiency and accuracy and provides real-time visibility into your organization's cash flow.
• Partnering with vendors: This is one of the best ways to improve cash management across the AP process. Vendors and buyers alike want to build stronger supply networks for sustainability and friction-free procurement. Fostering these partnerships can lead to more favorable terms in the future, like extended payment periods or discounts.

4. Optimize inventory management.

Inventory optimization is one of the best ways to preserve cash position, as it prevents overruns that tie up cash and understock that may disrupt sales.

Maintaining sufficient stock to meet demand without tying up working capital in idle assets is a delicate balance. This practice prevents cash crunches, minimizes storage costs, and avoids disruption in product availability, thus driving business sustainability.

Here are five popular methods for managing inventory that also preserve cash flow optimization:

• Demand forecasting: This involves predicting future demand based on historical data, market trends, and statistical techniques. Accurate forecasting helps businesses plan production, maintain optimal inventory, and minimize waste. It improves customer satisfaction, informs strategic planning, and aids decision-making for budgeting, sales, and capacity.
• Just-in-time (JIT) inventory management: This works hand-in-hand with demand forecasting to optimize inventory levels by ordering and receiving goods or materials only as needed in the production process rather than maintaining large inventory stockpiles. This approach aims to reduce excess inventory, minimize storage costs, and improve efficiency by ensuring that the right amount of inventory is available when needed. 
• Always Better Control (ABC) analysis: This method divides items into three categories based on their importance. A items are very important due to their high value; B items are moderately important; and C items are the least important. The premise here is that accurately controlling a few important items can yield significant operational and cost advantages. 
• Vendor-managed inventory (VMI): This is a supply chain method where the supplier maintains an agreed inventory at the buyer's location. The goal is to improve turnover, reduce stockouts, and streamline operations. Vendors monitor usage, anticipate demand, and ensure timely delivery, minimizing costs. This fosters a closer relationship, improving efficiency, service levels, and competitiveness.
• Drop-shipping: This is an inventory approach in which the store doesn't keep products in stock. Instead, the store purchases items from a third party and has them shipped directly to the customer. This eliminates the need for the seller to handle the products. The main difference between drop-shipping and standard retail is that the selling merchant doesn't stock or own inventory. Instead, they purchase inventory as needed from a third party to fulfill orders. This method reduces costs, risk, and investment while offering customers a wide range of products.

5. Ensure strategic capital expenditure planning.

Strategic capital expenditures planning involves identifying, evaluating, and prioritizing large-scale purchases or investments contributing to a business's long-term success. It considers costs, benefits, risks, returns, business goals, timing, and financial capabilities to ensure alignment and fiscal discipline for growth and innovation.

While vital for business growth and innovation, capital investments significantly influence cash flow. The immediate outflow of funds for such purchases may decrease available cash reserves. However, these expenditures often lead to increased operational efficiency or revenue streams over time, boosting the company's overall cash flow.

Be sure to:

• Analyze and prioritize investments: Not all capital expenditures are created equal. Companies should rigorously assess each potential investment based on their strategic priorities, projected returns, and risk tolerance. 
• Maintain a healthy cash reserve: While capital spending can boost operational efficiency and create new revenue streams, it can also reduce cash reserves. It's essential to maintain a healthy cash balance to cushion against unexpected downturns or expenses. 
• Leverage financing options: Purchasing assets outright isn't always the best or only option. Leasing or financing arrangements may allow companies to obtain needed assets without depleting their cash reserves entirely.

6. Facilitate continuous monitoring and analysis.

Continuous monitoring and cash flow statement analysis is crucial for financial stability and optimizing working capital. It helps identify trends, predict future needs, and make informed decisions. 

Use these metrics as part of your cash flow analysis to keep a comprehensive view of cash position:

• Net Cash Flow: The difference between a company's cash inflows and outflows during a specific period. It provides insight into the company's liquidity and its ability to cover operational costs.
• Operating Cash Flow (OCF): This metric measures the cash generated from primary business operations, indicating the company's capacity to generate sufficient positive cash flow to maintain and grow operations.
• Free Cash Flow (FCF): Indicates how much cash a company has left after it has paid off all its expenses, including investments in capital assets. It's an important measure of financial flexibility and the company’s ability to generate shareholder value.
• Cash Conversion Cycle (CCC): Measures how long each net input dollar stays in the business before converting it into cash received through sales. It helps in understanding how efficiently a company manages its working capital.
• Current Ratio: Compares current assets to current liabilities, providing information about a company’s ability to pay off short-term obligations with short-term assets.
• Quick Ratio: Also called the acid-test ratio. Quick ratio evaluates whether a firm can pay off its current liabilities without relying on inventory sales. A higher quick ratio implies stronger short-term liquidity.
• Cash Burn Rate: Particularly relevant for startups or growth-stage companies, this metric shows how quickly an organization spends its existing cash reserves over time.
• Days Sales Outstanding (DSO): The average number of days receivables remain outstanding before collection. A lower value suggests customers pay their debts rapidly, improving cash flow.

These metrics together present a comprehensive view of a company’s cash flow situation and help in making informed financial decisions. Using them as part of a continuous monitoring program provides the maximum insight into cash position and financial health.

7. Leverage financial technology.

The right technology makes cash flow analysis and management easier and more insightful. Advanced software tools like Cube offer real-time tracking, predictive analytics, and automated workflows to streamline processes and enable proactive measures in maintaining cash position.

Software also improves forecasting, metrics tracking, budget performance, and reporting capabilities. With advanced algorithms for predictive analysis, businesses can anticipate future cash positions accurately.

Integrating technology into financial processes also offers operational benefits like more cost efficiency in administering finance activities, scalability for continued control and visibility as the company grows, and better security for maintaining control over data and processes. 

Conclusion: getting the most out of cash flow analysis

Integrating advanced software tools into the FP&A process streamlines cash flow analysis and every other planning activity. A system like Cube can boost decision-making, improve forecasting, streamline metrics tracking, and fine-tune budget processes—all leading to more accurate reporting and cash flow statement analysis. 

Ready to join FP&A leaders in adopting these better strategies using the best software tools? Request a free demo of Cube today.