Financial Due Diligence is required in any kind of investment or business dealing with mergers...
Running out of cash is the most common reason to go out of business. Regular inspection of cash position by means of cash flow analysis can help to tackle such situation. Cash Flow Analysis is the technique practiced by investors and interest holders to determine the value of a business. It can provide significant details about the performance of the entity after studying the cash flow statement.
Cash flow statement reveals the events of inflow and outflow of cash during a set of time. It shows the amount of cash that went out of the business and came into the business for a particular period and also helps to determine an entity’s cash position. Additionally, it tracks the transactions where businesses spent money and the sources of cash for the business.
A cash flow analysis is the in-depth study of cash flow statements and driving a helpful conclusion from them. It helps to analyze the liquidity and long term solvency position of a company.
The cash flow analysis plays an important part in the valuation of the performance of the business. The reason cited for this is the flaw in the accrual basis of accounting. The accrual basis of accounting provides provision to match the revenue and expenses but does not specify the amount received by the company from profits on a real-time basis.
To elaborate, a company may seem as profitable in its balance sheet but maybe having a shortage of cash to pay its bills. The amount of profit shown on the balance sheet may be Accrued Income. Accrued income is the one that is being earned by the business but is yet to be received from the other party. Therefore it becomes inevitable to conduct a cash flow analysis to understand the real-time cash position of the company.
Financial statements record the inflow and outflow of cash on the basis of receipt and payment principle. However, it is the cash flow statement that depicts the real inflow and outflow of money. Hence, it acts as a bridge between the profit and loss statements and the balance sheet.
An increase in cash inflow does not mean that the entity is performing well. In fact, the situation can be adverse, what if the company became cash deficit and had to sale a large portion of its assets. The inflow of cash in the records might be a result of such kind of transaction. Therefore, it requires the process of cash flow analysis to understand the reasons for the movement of cash and its impact on the organization.
A good analysis will scrutinize the cash flow statement in detail and determine the reason for the movements of cash. The analysis helps to determine the performance of the organization.
Positive cash flow doesn’t necessarily mean that the business is profitable. Analysis of cash flow is necessary to establish the real financial position of the entity.
Cash flow analysis is extremely beneficial for every entity irrespective of the size and nature of the business. It provides fact base grounds to stay away from a cash crisis situation. For example, if cash flow analysis provides a conclusion that you are running short of funds, then you implement the appropriate measures to tackle it. Cost-cutting, cutting staff, opt for short term finance, speed up debt recovery, etc.
If your cash flow analysis shows extra cash, then you can invest in new technology, new equipment, investment options, etc. Saving for the future is another beneficiary option. It also helps to balance the future cash deficits.
The format of the cash flow statement comprises three parts. They are cash from working activities, cash from investing activities, and cash from financing activities.
The cash flow from operating activities is the amount of cash coming in or going out from the day to day operations of an entity. It includes money that is received from sales activities and the money paid to suppliers, employees, etc. Additionally, it includes depreciation or taxes that are not related to investing or financing.
It is an important measure to learn the vitality of the current business plan and operation strategy. This measurement sheds light on the capacity of the business to generate cash from its core business activities. A business can understand its profit value and investment valuation before going to debt or asset-backed finance.
The cash generated from operations is further compared to the profit generated from operation to understand the quality of profits secured
The very first step is to figure out the movements in operations that are responsible for the end figure. If there is a big increase in the number of receivables or stock, then it is a risky situation for the business. This means that the company is under heavy debt or large order has been taken by the entity.
Additionally, look for a heavy increase in the amount of payables. It is good to have positive cash flow, but a significant increase in positive cash flow can suggest otherwise. There exists a possibility that the company is showing high profits because it is delaying the payment of its suppliers.
The cash generated should be in positive figures to ensure that the company has positive cash flow even after payment of taxes and dividends.
Investing activities refers to the sale or purchase of assets. It is not related to working capital activities. The money spent on purchasing assets is marked as an outflow of cash. The money gained from the selling of assets is considered a money outflow.
The investing activities include only long term assets of the company, like building, machinery, land, etc. This does not include current assets.
Also, Read: Cash Flow Forecasting in Financial Model.
If the cash flow shows an increase in money inflow by the sale of an asset, it can be both good and bad sign for the business. If the asset is being sold to replace it with another asset, then it is considered to be a good move for the business. However, if the asset is being sold to survive in the situation of cash shortage, then it depicts a poor picture of the health of the business.
The sale of the assets should not be a means to fund the operation of the business. If it is happening, then it can be concluded that the company is not growing but having negative growth.
The financing activities include the cash flow coming in or going out for activities related to the financing of the business. For example, issuing shares, buyback of shares, distribution of dividends are all examples of financing activities. Getting a loan for your business is considered as an inflow of cash. However, payment of loan would be recorded as the outflow of cash.
If the source of buying assets is from the profits of the business, then it is considered as an ideal situation. This signifies that the company is generating sufficient profits necessary for its growth. Taking long term loans or raising funds against the issue of shares is also considered a positive sign for the company.
However, if the finance is taken by way of loans at regular intervals, it is considered that it is not able to generate enough profits. At the same time, loans and advances have consequences that can hurt the future interests of the company. For example, raising loans will charge interest rates that can be a liability to pay for the company in the long run or if the rate of interest is competitive with the earning potential of the company.
Having high debt makes investors reluctant to invest in such an entity. Additionally, raising funds by issuing shares will impact the retained earnings of the entity. more of shareholders will task way a higher amount of dividend from the company’s profit.
Also, Read: Cash Flow Forecasting in Financial Model.