How to Do a Cash Flow Analysis

A cash flow analysis answers three questions: where did the cash come from, where did it go, and what does the pattern say about the next twelve months? It starts with the statement of cash flows but does not stop there. The real work is tracing the gap between profit and cash, checking whether operations pay for the business or lenders do, and finding which working capital lines are driving the change. This guide walks through the steps with a worked example using one set of numbers, then shows how to turn the findings into actions. It sits within cash flow management and feeds the ratios in cash flow ratios and cash flow margin.

What you need

If statements are prepared under different accounting rules, or the period boundaries differ, align them first. The analysis is only as reliable as the underlying books.

Direct and indirect methods

The statement of cash flows can be prepared two ways. The indirect method starts with net income and adjusts for non-cash items and working capital changes, as in the example below. It is the format most companies publish, and it is best for explaining why profit and cash differ. The direct method lists actual cash receipts from customers and payments to suppliers, employees and others. It is closer to how a 13-week forecast is built and easier to understand for non-accountants. For analysis, use the indirect statement for history and a direct-style view for the short-term forecast, and reconcile the two. See the 13-week cash flow forecast.

Step 1: Read the statement in three parts

The statement of cash flows has three sections.

Worked example

A hypothetical company, in thousands of dollars, for one year:

Check: operations 95 + investing (-60) + financing (-10) = 25. Opening 80 + 25 = 105.

Net income was 120, but operating cash was 95. The 25 gap comes from working capital: receivables and inventory rose by 70 in total, partly offset by a 15 increase in payables, and depreciation added back 30. Profit and cash differ for explainable reasons. The analysis names them.

Step 2: Trace profit to cash

The bridge from net income to operating cash is where most of the insight lies.

1. Start with net income.
2. Add non-cash charges (depreciation, amortization, stock compensation).
3. Adjust for changes in working capital: increases in receivables and inventory use cash; increases in payables provide it.
4. Note one-off items: asset sales, legal settlements, unusual taxes.

In the example: 120 + 30 = 150 before working capital, then 150 - 45 - 25 + 15 = 95. Receivables used the most cash (45). Ask why. Did sales grow, did customers slow down, or did terms change? Compare with the receivables aging. See days sales outstanding.

Step 3: Look at the trend, not one year

One year hides direction. Put three years side by side.

Revenue and profit are growing, yet operating cash is flat to down, and the ratio of cash to profit is falling. That is a pattern worth investigating: the business is turning more of each dollar of profit into receivables and inventory. Calculation: Year 1 100/900 = 11.1%; Year 2 85/1,050 = 8.1%; Year 3 95/1,200 = 7.9%.

Step 4: Find the working capital drivers

Break the working capital change into its parts and add the days metrics.

Each additional day of cycle ties up cash equal to a day's sales or cost. Here, with revenue of 1,200, one day of sales is about 3.3 (1,200 / 365). Twelve extra days therefore tie up roughly 39 of cash that profit has not turned into bank balance. See the cash conversion cycle and working capital.

Use the details to identify causes:

• Receivables: aging by customer, extended terms, disputes, concentration.
• Inventory: growth by category, slow-moving stock, purchase timing, forecast accuracy.
• Payables: payment practices, supplier terms changes, early payments.

Step 5: Test sustainability

Ask whether the business can fund itself.

If operations did not cover capital spending and distributions, the shortfall would have been funded by loans or reserves. A pattern of that is a warning. See liquidity ratios.

Step 6: Separate maintenance from growth

Split capital spending into what keeps the business running and what expands it. If maintenance is 40 of the 60 in the example, operating cash covers maintenance 2.4 times (95 / 40). Growth spending of 20 can be postponed if cash tightens. Knowing the split tells you how much flexibility you have.

Step 7: Look forward

History tells you the pattern. The forecast tells you what happens next.

1. Update the 13-week forecast with the latest actuals. See the 13-week cash flow forecast.
2. Extend to 12 months, using the days metrics from the trend.
3. Run a downside: sales fall 10 percent or collections slow by 10 days. See cash flow scenario planning.
4. Compare the low point with cash and credit.

Step 8: Report the findings

A cash flow analysis is only useful if it leads to decisions. A one-page summary might say:

• Finding: operating cash has not grown with profit for two years; the cash conversion cycle is 12 days longer.
• Cause: slower collections (7 days) and higher stock (6 days).
• Impact: about 39 of cash tied up compared with Year 1 days.
• Actions: tighten collections on the top five overdue accounts; set stock targets by category; review terms offered to large customers.
• Owner and date for each action.

Questions to ask of every analysis

1. Does operating cash cover capital spending and debt service without new borrowing?
2. Is operating cash growing as fast as revenue and profit? If not, which working capital line explains it?
3. How much of the cash came from timing items, such as stretched payables or customer prepayments, that will reverse?
4. What would cash look like if sales fell 10 percent or collections slowed by 10 days?
5. How much flexibility do we have in capital spending and distributions?
6. What do lenders see when they run the same numbers, and do any covenants come close?
7. Which two actions would release the most cash, and who owns them?

If you can answer these seven questions with numbers, the analysis is done. If not, the missing data tells you what to collect next.

Common analysis errors

• Reading one period in isolation.
• Treating the financing section as a source of strength.
• Ignoring the working capital detail.
• Mixing cash and accrual measures without a bridge.
• Forgetting seasonality when comparing quarters.
• Stopping at the ratios without finding the cause.
• Not linking the analysis to a forecast and actions.

For product companies

Inventory and receivables explain most of the gap between profit and cash in product businesses. The planning decisions behind them are forecast accuracy, purchase timing and safety stock. See demand planning and inventory optimization.

Related guides

For the ratios used in the analysis, see cash flow ratios and cash flow margin.

FAQs

What is a cash flow analysis?

A review of how cash moved through the business, from operations, investing and financing, including why cash differs from profit and whether the pattern is sustainable.

How do I analyze a statement of cash flows?

Read the three sections, trace net income to operating cash, compare several periods, break out working capital changes and test whether operations fund capital spending and distributions.

What does it mean if operating cash is lower than net income?

Often that profit is being absorbed by growth in receivables or inventory, or paid out in other uses. The cause should be identified.

How often should I do a cash flow analysis?

Quarterly for the historical view, with the 13-week forecast reviewed weekly.

What is the difference between cash flow analysis and a cash flow forecast?

The analysis explains what happened and why; the forecast projects what will happen next. Use the first to improve the second.