Ask the Expert: An MBA’s Guide to Cash Flow Analysis

Research from Bank of America tells us that of all the businesses that conduct yearly cash flow analyses and forecasts, only 36% succeed. That number jumps to 80% for companies that perform this exercise monthly.

That begs the question: If performing a monthly cash flow analysis more than doubles a company’s chance of survival, why don’t business owners jump at the chance to do exactly that?

“No one starts a business because they want to read financial statements,” says Mike Milan, financial management instructor and co-founder of Simplex Financials and CashFlowMike.com. “People start a business because they have a passion, or they think they can do something better, or they want a different type of lifestyle. Financial statements are just the result.”

We caught up with Milan to find out why he says that cash flow analysis is the most effective habit a business owner can practice, what one of these studies should look like, and how to perform one yourself.

What is a cash flow analysis?

When a business leader assesses their net cash from the “operating activities” portion of their cash flow statement, they’ve located what investors call a company’s current cash flow. A cash flow analysis takes this review a step further. It is a look at the speed by which money moves in and out of the company and a series of ratios that determine a venture’s viability:

• Cash-debt ratio. This ratio reveals whether a business can cover their liabilities using funds specifically from their operations.
• Cash flow margin ratio. This ratio doesn’t include cash from financing or investing activities, so it’s a crystal-clear representation of how your sales convert directly to liquid cash. In his book, Business Ratios and Formulas, Steven Bragg calls the cash flow margin ratio a more reliable metric than even net profit.
• Price-to-cash-flow ratio. Market analyst and author Tom Bulkowski found that 78% of the time, stocks of companies with a low price-to-cash-flow (P/CF) ratio outperform those with a high P/CF. That’s likely because P/CF exposes liquidity (or lack of) in a company and their value, unlike earnings, which can be inflated.

Mid-market, commercial, and enterprise companies often conduct an even more thorough cash flow analysis that involves additional ratios, but they still eye these fundamental metrics as foundational to a business’s financial health.

There is only one problem with these ratios, says Milan, and that is the snapshot-style static data.

A true cash flow analysis isn’t just a point-in-time nugget of information but also an understanding of the dynamic speed of cash and how money moves through your company. Without that, your regular cash flow analysis only depicts what has already happened (past tense). It won’t show what’s happening (present tense) or what can happen in the next weeks, months, and years.

Another problem with traditional cash flow analysis is the lack of insight into how operating, financing, and investing work together. Envision pistons in a motor: they hit separately — but in harmony — to keep the whole business machine humming.

“Your money has to come and go from these three places,” says Milan. “A plus means money came in from there. A minus means money went out from there. And when you put them in this three-symbol pattern, there are only eight different possibilities or different configurations, which tells you exactly what that business is doing.”

Understanding your statement of cash flows, analyzing the ratios, and assessing activities from all three inflow/outflow categories (in tandem) is a cash flow analysis. And it’s an essential skill set for business owners.

Why is cash flow analysis essential for small businesses?

An occasional cash flow analysis is better than none. But only regular, monthly cash flow analyses let leaders both sidestep hazards (many catastrophic) while also leveraging advantages. Here’s why.

IT ALLOWS YOU A VARIETY OF COURSE-CHANGING OPTIONS

Regular cash flow analysis removes the element of surprise from many business scenarios.

“Cash flow issues are stressful, and sometimes you just don’t ‘want to know,’” writes DryRun CEO Blaine Bertsch in his new book, Pandemic: Cash Flow. “But knowing helps you plan.”

For example, let’s say you have three months of cash in reserve. You also have enough cash saved up to target a growth opportunity in a new geographic market. But before hiring new people to cover the growth, you conduct your usual cash flow analysis, only to find your cash-debt ratio has been creeping up steadily for four months straight. Instead of allocating the full amount budgeted toward your new market, you hold half of the cash back to cover a majority of that debt… just in case. This move ensures a variety of scenarios, including the failure of your new geography to bear fruit or the need to pay debts earlier than expected.

As you can see, when you analyze your cash flow statements regularly, you can spot an anomaly or trend early. And when that happens, you can mull over an array of choices instead of being boxed into one or two uncomfortable, pressurized options.

Imagine, for example, knowing your financing options ahead of an economic crisis, so you don’t have to jump at government relief. Many small business owners rushed into loan programs recently without understanding all the terms. This came from the mindset that leaders should get their portion “before the funds all ran out.” It’s a direct indication of our collective lack of cash flow certainty.

Another real-life example of this is Airstrike Martial Arts, a gym in Wichita, KS. This team was in the habit of conducting regular cash flow analyses. Business was steady, waxing and waning, but they never looked to aggressively double or triple overnight.

Then the 2020 pandemic arrived. Airstrike had already noticed the pre-pandemic consumer shift to hybrid in-home and onsite gym routines, and they knew they’d need to act quickly to give fitness enthusiasts the community they crave. They saw the Covid-19 disruption as the catalyst that could prompt loyal users to switch to other, more agile trainers online. They also noticed they had the opportunity to beat competing kickboxing gyms to the proverbial punch.

So, they invested in moving to online classes immediately while other gyms delayed. Audiences flocked to the more agile Airstrike. Their routine cash flow analysis showed them how feasible it was to pivot to digital offerings.

IT GIVES YOU CONFIDENCE

Over two-thirds of small business owners admit to staying up at night because of ongoing stress from cash flow uncertainties. The more options leaders have — and the earlier — the better they can feel navigating their day-to-day operations. Regular cash flow analyses do exactly that: they give you wiggle room that provides a feeling of confidence and relief.

This matters because, according to experts at Granite State University, leaders who believe they’ll perform well tend to outperform those who anticipate failure. The researchers also found that same confidence leads to better collaboration, smarter decision-making, and more decisive action. So, more cash flow confidence means better, faster decision-making.

IT HELPS YOU FORECAST

Milan tells the story of a hotel staffing company whose leader had a tendency to “wing it.” The business was profitable and growing rapidly, so rapidly, in fact, that the owner had no time to analyze his statement of cash flows, scrutinize what factors made up the totals, or project those findings into the future.

He paid employees every two weeks for work performed in the past two weeks. Meanwhile, the invoices from their client, Marriott, dallied 60 days before review, then payment took an additional two weeks. This created a “cash gap” our hapless leader couldn’t see until the very day he was unable to pay his 100 employees. The tragedy could have been prevented with foresight provided by a routine cash flow analysis.

“When you drive a car, which direction do you face?” quips Milan. “The front? Or do you stare at the rear-view mirror while you’re driving? [Looking at] financial statements is like looking in the rear-view mirror. Those are decisions that you made 90 days ago. Those are the things you already did, that snapshot is the result.”

If a business leader already performs a routine cash flow analysis, then forecasting is a natural extension of that. The rear-view glance gives you a clear look into what the totals were, where they are currently, and what they will be, assuming no changes are made. Extending each figure’s trajectory into the future shows you a helpful image of upcoming events.

“You don’t drive your car backwards,” says Milan. “So, why drive your business backwards? That’s where the forecast comes into play.”

How to conduct a cash flow analysis

Now you know what a cash flow analysis is, why regularly performing this exercise is key, and what happens to businesses that do and don’t conduct their own. The last thing to learn is exactly how to do a cash flow analysis on your own financial reports.

• Locate and identify the “current cash flow” figure on your cash flow statement. It’s the operating category’s net cash, sometimes labeled “net operating cash flow.”
• Plug that number into your three cash flow analysis ratios:
  • Cash-debt ratio: To calculate this indicator, your current cash flow is simply divided by the average current liabilities.
  • Cash flow margin ratio: To calculate this indicator, just divide your current cash flow by net sales.
  • Price-to-cash-flow ratio: To calculate this indicator, divide the company’s share price by operating cash flow per share.
• Compare these ratios with the previous month’s and contextual factors like seasonal surges, periods of “growth mode,” or the onboarding “freshman class” of new hires. Here are some guidelines to help.
  • A “comfortable” cash-debt ratio must be calculated in the context of a business’s industry standard. However, investors typically consider 1:1 to be a healthy cash-debt ratio.
  • Don’t be discouraged if your cash flow margin ratio fluctuates as a small business. However, aim for a steadily increasing percentage. Anything over 50% is considered a (standalone) sign of financial health.
  • The price-to-cash-flow ratio should also be compared against your industry standard, which is usually displayed as a percentage. A company in the energy sector, for example, may have a wildly lower P/CF than one in eCommerce, although both businesses are financially healthy. Usually, though, anything under 10% is widely accepted as another (independent) signal of robust vitality.
• Envision defensive and offensive moves your business can make based on these numbers. Determine what actions, if any, to take based on the changes from period to period.
• Take your cash flow analysis a step further with an informal forecast. Map your trajectory onto the next month (or two) and decide whether you like what you see. If not, consider implementing small course corrections now to position yourself onto a more favorable path long before the minor issues become crises.

The cash flow analysis demystified

Small businesses have their choice: a 36% chance of success or an 80% chance of success. It all depends on how often they analyze their statement of cash flows.

“Accounting is the language of business,” says Milan. “We don’t learn the language of business unless we’re forced. That’s why people have an aversion to financial statements. It’s a whole new language, a whole new set of skills. So, I take the language that they already know, and apply it to some more sophisticated financial concepts, like the cash flow analysis.”

As you learn this new language, you shouldn’t be slowed down by the tedious administrative tasks of entering and reconciling transactions. Consider automating these repetitive and time-consuming tasks with Neat, so you can focus on more strategic financials — like a cash flow analysis.

Already using Neat? Upgrade to Neat’s Automated Insights now to see monthly cash flow insights on your main dashboard. From there, you’ll be able to see exactly where cash came in from and where it went. You’ll also be able to plan for the many things coming your way in both the near and distant future.