Cash Flow Analysis: Assessing a Company's Liquidity

Say you’re considering investing in two companies that reported profits last year. Company A invested those funds in new factories, product development, and upgrading its supply chain. Meanwhile, Company B seemed to burn through cash faster than it could bring it in – constantly turning to new debt to keep operations afloat.

Which business would you feel more confident betting on for the long haul? If you picked A, you already think like a savvy cash flow analyst. You see, while profits are great, cash is the actual lifeblood of a business. And cash flow analysis is how you truly understand whether a company is financially fit. This guide will walk you through the need-to-know basics.

What’s Cash Flow?

Cash flow is a financial document that reveals the cold, hard truth about a company’s cash movements over time. You calculate it by taking the total cash inflows and then subtracting the cash outflows.

It’s different from accounting profits, which are earnings on paper. A business could be “profitable” by recognizing future revenues upfront, even if customers haven’t paid yet. On the other hand, cash flow shows the real dollars moving in and out the door.

A consistent positive cash flow gives a business solid financial footing, keeping the lights on and enabling growth. Conversely, persistent cash burns are a big red flag about potential liquidity issues looming.

The Cash Flow Statement

Public companies must report their cash flow situation through the cash flow statement. Consider it a laundry list of the company’s monies and where they went over that period. This financial document consists of three main categories:

Operating Activities:

This section covers the cash flows from a company’s daily business operations – cash received from customers and cash paid for inventory, wages, etc. It’s the make-or-break money that keeps operations humming.

The operating cash flow (OCF) starts with the firm’s net profit number from the income statement. Then, you adjust it for non-cash items like depreciation. It also factors in changes to working capital items like accounts receivable, accounts payable, etc.

Ideally, you want to see consistently positive OCF here. A sustained negative number could signal lackluster sales, bloated expenses, or problems collecting from customers.

Investing Activities:  

While the OFC represents the money spent keeping the business going, the investing section concerns the long-term cash paid (or received) on future growth. It captures things like:

• Purchases or sales of property, factories, equipment, etc.
• Buying or selling investment securities and other business assets
• Acquiring other companies or business units

A negative investing cash flow means the company spent more cash than it received. But before hitting the panic button, remember that these long-term investments are vital for growth. Tech companies like Amazon have notoriously high investing cash outflows as they build out capabilities for the future.

Financing Activities:

The final bucket covers the cash moving between a company and its owners (investors) or creditors (lenders). This section captures activities like: 

• Issuing new debt or paying debt off
• Issuing new equity for cash or buying back shares
• Paying cash dividends to shareholders

In simple terms, positive financing cash flow (FCC)  means the company raised more cash than it paid over that period. Meanwhile, a negative FCC means more went out the door for dividends, share buybacks, debt repayments, etc.

Analyzing Liquidity

Ultimately, cash flow analysis aims to determine a company’s liquidity – its ability to generate enough cash to fund operations consistently. Here are some key concepts and metrics that give you a window into the liquidity situation.

Operating Cash Flow

No surprises here. Consistent positive OCF from the core business operations is any company’s foremost liquidity goal. This helps cut its dependence on outside financing.

Free Cash Flow 

Free cash flow (FCF) takes OCF and subtracts the cash spent on long-term investments in the business. In other words, it’s the cash remaining after supporting day-to-day operations and future growth needs.  

A solidly positive FCF gives a company options like paying down debt, investing more, issuing dividends and buybacks, you name it. Conversely, a negative value over time alerts that the firm is burning more cash than it can replenish.

Cash Conversion Cycle

This metric measures the time it takes for a company to convert its product inventories and other resources into cold hard cash from sales. The shorter this cycle, the better – faster access to incoming cash to fund operations.  

For example, let’s say Company X has a 50-day cash conversion cycle, while their main competitor clocks in at 80 days. X can deploy incoming cash flows much more quickly, representing a potential liquidity advantage.

Cash Flow Ratios

These combine cash flow metrics with balance sheet numbers to show how easily a company can cover its obligations. Some examples include:

• Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities 
• Cash Flow Coverage Ratio = Operating Cash Flow / Total Debt

Importantly, you need to analyze these figures in the proper context. Some industries or rapidly growing businesses may temporarily show significant cash burn rates as they invest heavily. What matters is whether the overall liquidity and cash flow trend is sustainable.

Liquidity Red Flags

While no single metric tells the whole story, here are some common warning signs of potential liquidity strain:

• Declining operating cash flows period after period
• Consistently burning through more cash than is generated (negative free cash flow)
• Deteriorating cash flow coverage and liquidity ratios
• Lengthening cash conversion cycles

Of course, you need to look at these numbers through the lens of the company’s industry, growth stage, and forward prospects. For example, an established retailer showing some of these signs would be much more concerning than a rapidly scaling tech firm in growth mode.

How to Put Cash Flow Know-How Into Action

As an investor, the power of cash flow analysis comes in evaluating whether a company can execute its business plans, maintain operations, and still deliver returns to you as an owner. Here are some key things to look for:

• Consistent Positive Operating Cash Flow: You want solid positive cash generation from the core business activities over time. As seen earlier, a persistent negative OCF could signal fundamental operational issues.
• Sustainable Free Cash Flow Growth: Beyond supporting operations, is the company generating enough money after investments? An established company should grow its FCF over time, while you may afford more burn for a high-growth firm (though not indefinitely).
• Healthy Cash Flow Ratio Values: The OCF and cash coverage ratios, in line with or exceeding their industry averages, are another green flag about the company’s liquidity position.  

Remember that cash flow isn’t the end-all-be-all of company analysis. So, it’s vital to combine it with rigorous research into the company’s customer traction, competitive positioning, growth opportunities, and overall risks.

A Quick Example:

Let’s illustrate cash flow analysis with a simple example:  

According to their income statement, Acme Widgets had $10 million in net income for the year. Their cash flow statement reveals:

• Operating cash flow: $6 million  
• Investing cash flow: -$3 million (purchased new equipment)
• Financing cash flow: -$1 million (paid dividends)

So, while profitable on paper, Acme’s actual cash flow situation shows:

• Core operations generated $6 million in cash  
• It reinvested $3 million in the business 
• Another $1 million went to shareholders

That leaves only $2 million in cash despite $10 million in accounting profits. Further cash flow ratio analysis and a review of Acme’s cash balances would provide more context into its liquidity position.

Limitations of a Cash Flow Analysis

Like any financial analysis, cash flow has its limitations that you need to be aware of:

The Cash Flow Statement Doesn’t Tell the Full Story

This document ignores the business’s non-cash transaction details. As such, it doesn’t provide complete context around a company’s overall financial health. That’s why seasoned analysts cross-reference its numbers with other key financial reports and metrics for a richer perspective on the business.

The Risk of Manipulation 

Unfortunately, there’s also the possibility that companies could inflate or deflate some cash flow figures through some accounting practices and estimates. So you always need to look at its figures critically – is the quality of earnings and accounting straightforward? Getting to the truth behind the numbers is crucial for accurate analysis.

Cash Flow Is Retrospective, Not Predictive

Ultimately, cash flow statements report on what has already happened. That backward-looking nature is great for understanding history. But, it makes it unsuitable for predicting a company’s future cash projections and liquidity needs. 

The Takeaway

At this point, you know that cash is the fuel that powers companies to grow, innovate, and reward shareholders. So, understanding its sources and uses helps you to understand a business’s financial fitness. Cash flow analysis is a crucial piece in solving the company analysis puzzle. But don’t fall into the trap of single-metric analysis. Instead, cross-reference cash flow statements with other financial reports to get the entire picture.

FAQs

Is cash flow the same as profit?

No, cash flow and profit are not the same. Profit is a company’s earnings on paper after accounting for revenues and expenses. Meanwhile, cash flow is the actual cash movement in and out of the business.

What’s cash flow analysis?

Cash flow analysis studies a company’s cash flow statement to assess its liquidity.

How do you calculate cash flow?

You calculate cash flow by subtracting a company’s total cash outflows from its inflows.

What’s the importance of cash flow analysis?

Cash flow analysis provides vital insights into a business’s financial management, liquidity, and long-term sustainability.