Cash Flow Analysis

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Cash flow analysis is so crucial because cash is king! When evaluating a company’s performance, most stakeholders whether internal or external, are interested in how well the company is generating cash. Having a strong grasp of cash flow analysis can give you great insights into the company’s past, present and future performance. There are a few types of cash flow analysis and in a series of tutorials we will explore the cash flow statement, cash flow ratios, discounted cash flow and free cash flow.

Cash Flow Analysis

Understanding the Cash Flow Statement:

The cash flow statement is divided into 3 parts and can be compiled using the Income Statement and 2 years worth of Balance Sheet data. Let’s use the financial statements below for XYZ Company to put together our Cash Flow Statement. Note that there are two methods of figuring out cash flow: the direct and indirect methods. The direct method is more labor intensive but provides a more thorough analysis of a company’s cash position. However, most companies utilize the indirect method which is less labor intensive and still provides plenty of insight into the company’s financial health.

Now, on to the financial statements …

Cash Flow Analysis Step 1: Get a grasp of the income statement & balance sheet

cash flow analysis

Cash Flow Analysis Step 1A: The Income Statement:

For the purposes of figuring doing cash flow analysis, the income statement provides two elements that allow us to reconcile between the accrual and cash basis of accounting. The first obvious one would be Net Income and the other is any expense that is not cash based. As you scan through the income statement for XYZ Company, there is only one item in this case: depreciation expense. Depreciation is used to match the usefulness of an asset over its life as that asset is used to generate revenue. The idea is to basically allocate the total cost less salvage value across the expected life of the asset. To learn more about depreciating fixed assets, read the tutorial on Depreciation of Fixed Assets.  Though not presented here, other non-cash expenses that can appear on the income statement are for example, amortization of intangible assets and goodwill impairment.

Once you’ve taken the necessary line items from the income statement (here it’s $846M in net income and $117M in depreciation expense), you next need to account for the changes year over year in the balance sheet so you can do cash flow analysis via the cash flow statement.

Cash Flow Analysis Step 1B: The Balance Sheet:

When it comes to the balance sheet, year over year changes in all of the line items need to be taken into account.  Those changes feed the cash flow statement as either ‘sources’ or ‘uses’ of cash.  Before doing the exercise, think about specific items and how changes in those items would affect a company’s cash position.

Let’s take long term debt for example. (continue reading)

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