What is cash flow analysis?

Analyzing cash flow is a simple process that helps you avoid the problems of a cash shortage. A cash crunch doesn’t necessarily mean you are broke, but it is a situation you should avoid if possible. Cash flow analysis is a common practice at most businesses, whether large or small. In fact, you’ll find a cash flow statement in every company’s annual report. Cash flow is analyzed by separately tallying all of the inflows and outflows within a given time period, often a month, quarter, or year. Subtracting the total outflow from total inflow provides your “net cash flow” for the period.

Tracking cash flow measures your level of financial solvency

Tracking cash flow differs from tracking income and expenses. Cash flow analysis looks at when you actually receive or disburse money. Note that income is seldom received at the moment it’s earned because employers pay weekly, biweekly, or monthly. Similarly, buying with credit permits paying for goods or services after you receive them, sometimes long after. Surprisingly, it is possible to earn more than you spend and still have a negative cash flow.

Example: Jane, a popular family dentist, has a large, successful practice. Her success leads her to expand and modernize her office suite, a costly proposition. But her patients, feeling the impact of a slowing economy, are becoming ever later in their payments. While Jane has earned sufficient income to pay for her office renovation, she is falling short of the cash needed to make her monthly payments.

Cash flow analysis compares the net result of cash inflow and outflow on a period by period basis

Cash flow analysis fulfills two purposes. Most importantly, it tells you whether your money is coming in faster than it’s going out (preferable) or vice versa (highly undesirable). Further, it shows, at a glance, the inflows and outflows for a given period, thereby enabling you to quickly spot problem and opportunity areas.
What are cash inflows?

Cash inflows include all money actually received within the given period. The money can be in the form of cash or checks that you could cash or deposit in an account. The source of the inflow is irrelevant for a cash flow analysis. Sources could include tax refunds, rent received on investment property, dividends, capital gains, gifts, and even prize winnings.

Caution: If you receive loan proceeds as a check made out to you, it is a cash inflow. If the check is made out to someone else from whom you purchased goods or services, it is really their cash inflow, not yours. If you receive a check and endorse it over to someone else, it is technically an inflow plus a matching outflow, and it therefore has no effect at all on total cash flow.

What are cash outflows?

Cash outflows include all money disbursed within the period, whether by cash, check, or electronic funds transfer. If you withdraw money from a bank account, it is not technically a cash outflow until you spend it, but for practical purposes, it is often easier to consider it an outflow when withdrawn. When you write a check that will be paid from money in your account, it is a cash outflow.

Caution: Using credit to get cash (otherwise known as a cash advance) does not cause a cash outflow until you actually repay the lender. Many banks offer overdraft protection and other forms of credit closely linked to checking accounts. A check that draws on the bank’s money instead of yours is really credit, so it is not a cash outflow until you repay it.

What is net cash flow?

Combining total cash inflow with total outflow for a selected period gives net cash flow. When outflows exceed inflows, net cash flow is negative. Conversely, a positive cash flow means that a cash surplus is accumulating. Typically, net cash flow is positive during your earning years and negative during retirement, when your nest egg provides your support. Cash flow alone tells just part of the story. Credit makes it easy to overspend, piling up debt even while cash flow remains positive (a common scenario that soon leads to problems).
Cash flow analysis is just part of your complete financial picture

Cash flow analysis is one of several useful tools in budgeting. Together with an income/expense statement and a net worth statement, it can give a clear picture of your present financial situation. Reviewing these tools together usually reveals where changes can or must be made to achieve your short- and long-term budget objectives.

Reviewing cash flow over time reveals trends, good and bad

Calculating net cash flow for the most recent period tells you how you’re currently faring. Comparing cash flow analyses for a sequence of equal periods (e.g., the last 6 or 12 months) will reveal trends. Not only does this process show whether a trend is positive or negative, but how rapidly the situation is changing.

Tip: Save your cash flow analyses for future comparisons.

Projecting cash flows can help to identify upcoming problems in time to avoid them

Projecting what your cash flow will likely be in the upcoming month, quarter, or year is an important aspect of budgeting. Once you’ve completed a cash flow analysis for the most recent period, use it as the basis for projecting the next. Estimate what the inflows and outflows will be, then combine them to get a net cash flow forecast. You will then learn whether your cash flow is likely to deteriorate or improve. You can then adjust some of the controllable items right on the worksheet to see how they alter the net cash flow forecast.

Tip: Computer software for spreadsheets and budgeting enables the making of changes with instant recalculation of results. Moreover, such software permits you to print a given page before making further changes. Still, a pencil, eraser, and calculator are nearly as fast if your changes aren’t too numerous.