The importance of analyzing cash flows is designated by the limited resources of the enterprise, as well as an unstable financial condition that is inherent in any business, especially at the beginning of its growth. Analysis of cash flows helps reduce insolvency risks and identify possible factors that can raise the level of the company’s financial management efficiency.
The purpose of the cash flow analysis is to reveal the causes of the deficit, if any, and to identify additional sources of cash flow efficiency improvement. The analysis results should be used to organize a regular monitoring of current liquidity and solvency of the enterprise.
A special emphasis in the cash flow analysis is made on the predicted nature of the calculations. The purpose of almost all financial assessments is the obtaining of some economic benefits in the future, as well as the forecasting the net increase/decrease of funds from all activities of the enterprise. In this case, the improvement of the monetary form of assets is the basis for improving the working capital.
Analysis of the cash flow dynamics and structure
The analysis of cash flows begins with the separation of cash flow by the type of activity. It means the cash flows from Cash Flow Statement, which consists of three types of activities, are carefully examined. The cash flow is additionally divided into the input, output and net ones. The calculation of cash balances, which are formed at the end of the reporting period is another important matter in the analysis of cash flows. This amount of money allows settle current payments and obligations of the company.
Let’s consider the structure of the Cash Flow Statement. Please note it may be composed using a direct or indirect method.
Structure of the Cash Flow Statement according to the indirect method
The main strength of this report is that its value can be obtained analyzing the balance sheet and the statement of financial results. It shows the formation of cash flow on the basis of changes in the assets of the enterprise.
Structure of the Cash Flow Statement according to the direct method
The main advantage of this report is its simplicity of understanding and compliance with the statement of financial results. With this report, it is easy to determine the monetary portion of the financial results.
Methods for analyzing the cash flow formation
In order to begin the analysis of the cash flow formation, it is necessary to collect all indicators of the Cash Flow Statement in a single table, where they will be divided into the incoming cash flows, outcoming cash flows and net cash flow.
Analysis of the incoming cash flows is made by the types of activity. Within the table’s framework, the list of all indicators that form the input cash flows is prepared and a horizontal and vertical analysis is conducted. A similar method is used to analyze the outcoming and net cash flow.
Horizontal financial analysis
Horizontal analysis is based on the study of the cash flow dynamics in time. In the complex analysis system, the most common types of horizontal financial analysis are the comparison of cash flow figures of the current year with the indicators of the previous one as well as comparing the indicators of the current year to the average metrics of the studied period.
Almost all studies of cash flow dynamics are carried out in comparison with the factors of influence on them. The results of the studies allow build our own factor models, which are used in future for the planning of cash flows.
Carrying out a horizontal analysis, it is necessary to determine an absolute deviation (AD) according to the formula as follows:
AD = R1-R0,
where R1 is the indicator for the current year; R0 is the basic indicator.
Relative deviation (RD) is determined by the formula:
RD = R1 / R0 * 100%.
Growth rate (GR) is determined by the formula:
GR = (R1-R0) / R0 * 100%.
Vertical financial analysis
This type of analysis is based on the structural division of the main indicators of the company’s financial statements. During the vertical analysis, we study the following matters:
• structure of incoming cash flows;
• structure of outcoming cash flows;
• net cash flow structure;
• structure of cash flows by the types of activity.
Vertical financial analysis is based on the Cash Flow Statement. All types of cash flows generated by an enterprise are used for such research.
Studying the basic parameters of cash flows
Cash flows consist of the movement of cash from various financial and business operations. Net cash flow is the main indicator that indicates the cash flow effectiveness.
Net cash flow (CF)
The cash flow may be positive or negative. A negative cash flow shows the company lacks money to carry out business operations. At the same time, not every positive cash flow indicates the activity is effective, since it’s amount should be sufficient to cover the company’s mandatory and urgent payments. Net cash flow is formed by the net cash flows from operating, investment and financial activities.
Cash Flow from Operating Activity (CFO)
This indicator is as important as the net cash flow, since its value reflects the effectiveness of the company’s main activity. The higher the value of the net operating cash flow indicator, the better the performance of the enterprise.
Cash Flow from Investing Activity (CFI)
For enterprise, the value of this indicator is quite significant, because its financial independence along with the possibility of growth depends on how much money is invested in business development. As a rule, the value of CFI for the enterprise is negative, but this only means the enterprise is constantly developing. An enterprise should generate the amount of the net operating cash flow that it is enough to cover investment payments.
Cash Flow from Financial Activity (CFF)
At the initial stages of the company’s life cycle, a net financial flow may be positive, since business owners invest their own funds in the business development until it starts generating enough funds to finance the activity. If the value of the indicator is negative, it means the enterprise uses attracted funds (loans or lending) for its development. In general, business growth is impossible without attracting external funds. Moreover, using the attracted funds, managers are more interested in the effective management of cash flows because indebtedness causes additional payments for the enterprise. That’s why a negative net financial cash flow is a normal thing provided the company generates sufficient funds to repay it.
Input and output cash flows are equally important for the analysis. Let’s consider them too.
Incoming Cash Flows (ICF)
This indicator is not fixed in the Cash Flow Statement but it can be calculated by putting together incoming operating, financial and investment cash flows. Incoming cash flows largely derive from operating activities. The presence of income in investment activity signals about other activities of the enterprise that are not related to the main one. The presence of income in financial activity indicates the company increases its capital.
Incoming Cash Flows from Operating Activity (ICFO)
This indicator is not defined in the Cash Flow Statement. It is calculated by adding all incomes from operating activity, if the analysis is made on the basis of the Cash Flow Statement compiled by the direct method. In an indirectly compiled statement, the ICFO indicator is formed by the metrics that are displayed in the Revenue column as well as in the lines describing operational activity.
Incoming Cash Flows from Investing Activity (ICFI)
The indicator is also not calculated in the Cash Flow Statement. Its value is formed by the sum of all revenues from the investment activity.
Incoming Cash Flows from Financial Activity (ICFF)
The indicator is not defined in the Cash Flow Statement. It is calculated by the sum of all revenues from the financial activity with the positive value.
Outcoming Cash Flows (OCF)
Like the indicator of incoming cash flows, the outcoming one isn’t recorded in the Cash Flow Statement too. It is necessary to calculate the sum of the initial cash flows from operational, investment and financial activity to determine it. For enterprises, cash outflows consist mainly of operating cash flows. However, depending on the enterprise’s investment policy or the stage of the company’s life cycle, the investment flows can play a significant role in shaping the outcoming flows.
Outcoming Cash Flows from Operational Activity (OCFO)
The indicator is not defined in the Cash Flow Statement. In the indirectly compiled statement, the indicator is determined by the sum of the operating payments.
Outcoming Cash Flows from Investing Activity (OCFI)
This indicator is very important for enterprises. It is used to assess the activity effectiveness and investments in business development. The higher the value of this indicator, the greater the possibility of increasing the cash flow from operating activities in the future under a correct financial policy.
Outcoming Cash Flows from Financial Activity (OCFF)
To determine the indicator, it is necessary to sum up the negative values of the financial activity data from the Cash Flow Statement compiled by the direct and indirect method.
Gross Cash Flow (GCF)
It is determined as the sum of incoming and outcoming cash flows. Remember that in the foreign business literature, the gross cash flow is another name for the net cash flow. The gross cash flow represented as the sum of positive and negative cash flows is of no practical use in the international financial analysis.
Free Cash Flow (FCF)
These are the funds that remain as a result of operating activity and investments in the fixed capital. In fact, this is the part of the cash flow that remains for the investors. The indicator is calculated as the difference between the net operating cash flow and capital expenditures (CAPEX).
Net Free Cash Flow (NFCF)
These funds remain from operating activity after covering the capital investments, repayment of urgent long-term debts and dividends for the investors. The indicator is calculated as the difference between the net cash flow, investments, dividend costs and repayment of long-term urgent debt.
The analysis of these 15 indicators should be conducted in dynamics and in comparison with each other. Horizontal financial analysis is the main tool for doing this.