Cash Flow Analysis

Cash flow statement is an important tool to analyze the cash position of business firm. It can
denote changes in cash position during two financial years. A firm’s cash flow position can
greatly affect its ability to remain in business. These effects may not be apparent from a cost-
benefit analysis. The statement can be as simple as a one-page analysis or may involve
several schedules that feed information into a central statement. The cash flow statement
traces the various sources which bring in cash, such as operations, sale of current and fixed
assets, issuance of share capital and long term borrowings etc. and the applications which
cause outflow of cash, such as, purchase of current and fixed assets, redemption of
debentures, preference shares for cash and so on. This statement is designed for account for
the change in cash.

Utility of Cash Flow Statement

The importance of cash flow statement lies in the fact that it explains the changes in cash and
gives insight to the company’s operating, investing and financial activities. Also, cash flow
statement will unveil the company’s ability to generate cash to meet its short-term
obligations, thereby assessing if company’s liquidity and solvency position is sound.
Cash flow notion is based loosely on cash flow statement accounting standards. It's flexible
as it can refer to time intervals spanning over past-future. It can refer to the total of all flows
involved or a subset of those flows. Subset terms include net cash flow, operating cash flow
and free cash flow

Advantages of cash flow statement

1. Disclose the inward and outward movement
The primary function carried out by a cash flow statement is to disclose the inward
and outward movement i.e. inflow and outflow of cash. It indicates all possible
changes in cash position of a firm in quantitative terms accompanied by the reasons to
support such changes. Hence, a cash management can exercise full control over cash
movement with the help of cash flow statement.
2. It plays a vital role in short-term financial planning
It helps in forecasting cash requirements, determining the quantity of required cash in
advance, the amount that can be generated form internal sources and the volume
expected to be acquired from outside sources. Thus, the future course of action related
to cash can be planned in the light of cash flow statement.
3. Help to management in formulating policies related to internal financial
management
Aids Internal Financial Management Cash flow statement is of great help to
management in formulating policies related to internal financial management. Since,
any information pertaining to the availability of cash from operations can be obtained
by means of cash flow statement. Thus, a management can make important decisions
involving dividend policy, replacement of assets, repayment of long-term loans etc.

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 4. Reveals Success or Failure of Cash Planning
It reveals the extent of success or failure of cash planning. As a management may
hold comparison of cash flow of current year with projected cash budget of that
period, variations, if any with relevant cause may be detected and necessary remedial
actions can be initiated.
5. Adds Efficiency to Cash Management
Cash is the very foundation of all business operations. Therefore, a projected cash
flow statement provides sufficient guidelines to the management for planning and
coordinating financial operations properly, effectively and efficiently.
6. Helps to determine the likely flow of cash
Projected cash flow statements help the management to determine the likely inflow or
outflow of cash from operations and the amount of cash required to be raised from
other sources to meet the future needs of the business.
7. Supplemental to funds flow statement
Cash flow analysis supplements the analysis provided by funds flow statement, as
cash is a part of the working capital.
8. Better tool of analysis
For payment of liabilities, which are likely to be matured in the near future, cash is
more important than the working capital. As such, cash flow statement is certainly a
better tool of analysis than funds flow statement for short-term analysis.

Limitation of Cash Flow Statement

Cash flow statement is an important analytical tool. Yet, it is advised to employ this
technique with care and precautions for the purpose of analysis due to the limitations attached
to it. These limitations are as follows–
1. Cash flow statement does not measure the economic efficiency of one company in
relation to another
Usually a company with heavy capital investment will have more cash inflow.
Therefore, inter-industry comparison of cash flow statement may be misleading.
2. Misleading comparison over a period of time
Just because the company's cash flow has increased in the current year, a company may not
be better off than the previous year. Thus, the comparison over a period can be misleading.
3. Misleading inter-firm comparison
The terms of up-chases and sales will differ from firm to firm; Moreover, cash inflow
does not always mean profit. Therefore, inter-firm comparison of cash flows may also
be misleading.
4. Influenced by changes in management policies
The ash balance as disclosed by the cash flow statement may to represent the real
liquidity position of the business. The cash can be easily influenced by purchases and

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 sales policies, by making certain advance payments or by postponing certain
payments.
5. Cannot be equated with income statements
Cash flow statement cannot be equated with the income Statement. An income
statement takes into account both cash as well as non-cash items. Hence ne: cash
flow does not necessarily mean net income of the business.
6. Not a replacement of other statements
Cash flow statement is only a supplement of funds flow statement and cannot replace
the income statement or the funds flow statement as each one has its own function or
purpose of preparation.
7. Net cash flow does not necessarily imply the net income of the business.
As unlike income statement, cash flow statement takes into account only cash
discarding non-cash items from its preview. Cash flow statement no doubt depicts the
cash position but the cash balance shown by cash flow statement may not be the true
representative of real liquid position of the business and it can be easily influenced by
postponing purchase and other payments.
Despite the drawbacks, of cash flow statement, it is a useful supplementary accounting
instrument serving as a barometer in evaluating profitability and financial position of an
enterprise.

Operating Cash Flow Ratio

Cash flow analysis uses ratios that focus on the company's cash flow and how solvent, liquid,
and viable the company is. The ratios derived in financial reports for a company are used to
establish comparisons either over time or in relation to other data in the report. A ratio takes
one number and divides it into another number to determine a decimal that can later be
converted to a percentage, if desired.
For example, a debt-to-equity ratio looks at the debt liabilities of the company and divides it
by the asset equity. If a company has $200,000 in debt and $100,000 in equity, the debt-to-
equity ratio is two ($200,000 / $100,000 = 2). This means the company has $1 dollar of
equity for every $2 of debt. In this case, the larger the ratio over one is interpreted as an
increasing debt problem that could lead to long-term financial problems for the company.
Following are some of the most important cash flow ratios with their calculations and
interpretation.
1. Operating Cash Flow Ratio
The operating cash flow ratio is one of the most important cash flow ratios. Cash flow is an
indication of how money moves into and out of the company and how the company pays its
bills.
Operating cash flow considers cash flows that a company accrues from operations as related
to its current debt. It measures how liquid a firm is in the short run since it shows whether or
not cash flows from operations can cover its liabilities.

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Operating Cash Flows Ratio = Cash Flows from Operations/Current Liabilities
Cash Flows from Operations comes off the Statement of Cash Flows and Current Liabilities
comes off the Balance Sheet
If the Operating Cash Flow Ratio for a company is less than 1.0, the company is not
generating enough cash to pay off its short-term debt which is a serious situation. It is
possible that the firm may not be able to continue to operate.
2. Price/Cash Flow Ratio
The price to cash flow ratio is often considered a better indication of a company's value than
the price to earnings ratio. It is a really useful ratio for a company to know, particularly if the
company is publicly traded. It compares the company's share price to the cash flow the
company generates on a per share basis.
Calculate the price/cash flow ratio as follows:
Price/cash flow ratio = Share price/Operating cash flow per share
Share price is usually the closing price of the stock on a particular day and operating cash
flow is taken from the Statement of Cash Flows. Some business owners use free cash flow in
the denominator instead of operating cash flow.
It should be noted that most analysts still use price/earnings ratio in valuation analysis.
3. Cash Flow Margin Ratio
The Cash Flow Margin ratio is an important ratio as it expresses the relationship between
cash generated from operations and sales.
The company needs cash to pay dividends, suppliers, service its debt, and invest in new
capital assets, so cash is just as important as profit to a business firm.
The Cash Flow Margin ratio measures the ability of a firm to translate sales into cash. The
calculation is:
Cash flow from operating cash flows/Net sales = _____percent
The numerator of the equation comes from the firm's Statement of Cash Flows. The
denominator comes from the Income Statement. The larger the percentage, the better.
4. Cash Flow from Operations/Average Total Liabilities
Cash flow from Operations/Average total liabilities is a similar ratio to the commonly-used
total debt/total assets ratio. Both measure the solvency of a company or its ability to pay its
debts and keep its head above water. The former is better, however, as it measures this ability
over a period of time rather than at a point in time since it uses average figures.
This ratio is calculated as follows:
Cash flow from Operations/Average Total Liabilities = _______percent

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Cash flow from operations is taken from the Statement of Cash Flows and average total
liabilities is an average of total liabilities from several time periods of liabilities taken from
balance sheets.
The higher the ratio, the better the firm's financial flexibility and its ability to pay its debts.
5. Current Ratio
The current ratio is the simplest of the cash flow ratios. It tells the business owner if current
assets are sufficient to meet the company's current debt. The ratio is calculated as follows:
Current Ratio = Current Assets/Current Liabilities = ______
Both parts of the formula come from the company's balance sheet. The answer shows how
many times over a company can meet its short-term debt and is a measure of the firm's
liquidity.
6. Quick Ratio (Acid-Test)
The quick ratio, or acid test, is a more specific test of liquidity than the current ratio. It takes
inventory out of the equation and measures the firm's liquidity if it doesn't have inventory to
sell to meet its short-term debt obligations.
If the quick ratio is less than 1.0 times, then it has to sell inventory to meet short-term debt,
which is not a good position for the firm to be in.
Calculate the quick ratio as follows:
Quick Ratio = Current Assets - Inventory/Current Liabilities where all terms are taken
off the firm's balance sheet.

Interpreting Financial Ratios

There are dozens of financial ratios and their meanings help business owners evaluate the
financial health of a company. Financial ratios can be broken into six key areas of analysis:
liquidity, profitability, debt, operating performance, cash flow and investment valuation.
Interpreting financial ratios requires understanding income statements and balance sheets.
Evaluating the key financial indicators is something every business owner should become
well versed in. By understanding what each key financial ratio is assessing, you can more
easily derive the ratios with a quick look at the financial statements.
 Liquidity Measurement Ratios: These ratios define if a company is able to meet
short-term financial obligations. It takes into consideration liquid assets to short-term
liabilities. 
 Profitability Indicator Ratios: These ratios consider the amount of profit derived
from the cost of goods sold or the operating expenses. There are both gross and net
profit margin ratios. 
 Debt Ratios: Debt ratios are like the debt-to-equity ratio described above that
consider how much debt a company has and the assets it possesses to pay debts off. 

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  Operating Performance Ratios: These ratios look at numbers like the fixed asset
turnover or sales-to-revenue per employee numbers to determine efficiency. An
efficient company generally improves profitability. 
 Cash Flow Indicator Ratios: Companies need to generate enough cash flow to pay
operating expenses, grow the business and create a safety net of retained earnings.
Operating cash flow divided by sales ratio determines how much it costs to acquire
new clients. 
 Investment Valuation Ratios: These ratios help investors determine the viability of
existing or new investment into a company. For example, the price-to-earnings ratio
provides the amount a company is paying per $1 of earnings to shareholders. 
Companies large and small use ratios to evaluate internal trends in the company and define
growth over time. While a publicly traded company may have much larger numbers, every
business owner can use the same data to strategically plan for the next company fiscal cycle.

Financial Ratio Analysis and Interpretation

Analyzing and interpreting financial ratios is logical when you stop to think about what the
numbers tell you. When it comes to debt, a company is financially stronger when there is less
debt and more assets. Thus, a ratio less than one is stronger than a ratio of 5. However, it may
be strategically advantageous to take on debt during growth periods as long as it is controlled.
A cash flow margin ratio calculates how well a company can translate sales into actual cash.
It is calculated by taking the operating cash flow and dividing it by net sales found on the
income statement. The higher the operating cash flow ratio or percentage, the better.
The same is true with profit margin ratios. If it costs $20 to make a product and it is sold for
$45, the gross profit margin is calculated by subtracting the cost of goods sold from revenue
and dividing this result by the revenue [0.55 = ($45- $20) / $45]. The higher this ratio is, the
more profit there is per product.