Analysis of a cash flow system includes an overall analysis of sources and uses of cash, common-size analysis, and calculation of free cash flows and cash flow ratios.

Evaluation of the sources and uses of cash

Analysis of the cash flow statement involves an overall assessment of the sources and use of cash between the three main categories: operating, investing and financing. The relative proportion of different sources and uses of cash flow vary with a company’s stage of growth. For a new or growth stage company, operating cash flow may be negative for some period of time. However, this cannot be sustained for long. Eventually, a company must start generating positive operating cash flow which should ideally be enough to make capital investments and to pay the cash back to the providers of capital.

Analysis of operating cash flows

In analyzing the cash flows from operating activities, an analyst must examine the most significant determinants of operating cash flow. Operating cash flow should exceed net income because of the non-cash items. Further, the relationship between net income and operating cash flow should be sustainable because it is also an indicator of earnings quality.

Analysis of investing cash flows

In assessing cash flows from investing activities, we need to find out whether a company is engaging in significant purchases of capital, acquisition of subsidiaries, etc. or it is disposing of them to generate. We also need to know whether capital investments are financed using operating cash flow or by raising new debt or issuing stock.

Analysis of financing cash flows

The financing activities section of the cash flow statement provides information about whether a company is raising new debt or equity, or it is paying it down. This provides information about the expected future capital structure, dividend policy, financial leverage, etc.

Common-size analysis of the statement of cash flows

There are two options in creating a common-size statement of cash flows:

  • Express each cash inflow (outflow) as a percentage of total cash inflows (outflows) or
  • Express each line item as a percentage of net revenue.

If a company uses the indirect format, only the net cash flows from operating cash flow is shown as a percentage of total inflows or outflows. However, when preparing a common-size cash flow statement based on net revenue, all line items can be shown as a percentage. These percentages are useful because in forecasting a company’s cash flows, it is easier to apply the percentage of depreciation to net revenue to revenue to arrive at forecasted non-cash items, etc.

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