What is cash flow analysis?

Cash flow is the simplest financial measure there is: what came in, what went out, what is left. Its value comes from being unarguable. Accounting judgments, accruals and valuations all involve choices. A bank statement records that a specific amount left the account on a specific day, and there is nothing to interpret.

Choosing the period

Monthly is the default because most commitments are monthly. If the account regularly approaches zero, switch to weekly, because a month that ends positive can still contain a week where a payment would have bounced. Businesses with large lumpy receipts often need both: weekly for survival, monthly for trend.

Inflows and outflows

Sum the credits, sum the debits, subtract. The one thing that must be handled carefully is internal transfers. Money moved from savings into checking appears as a credit, but nothing entered your finances. Counting it inflates income and, on the other side, inflates spending. Identify transfers by matching amounts across accounts within a day or two and exclude both legs.

Splitting the outflows

A single outflow total answers very little. The useful split is committed versus discretionary. Committed covers rent or mortgage, loan repayments, insurance, utilities, payroll, tax. These continue whether or not you decide anything. Discretionary is everything you could stop next month. The ratio between them is the real measure of financial flexibility: two households with identical income and identical net cash flow can be in completely different positions depending on how much of their spending they actually control.

Categories of cash flow

Businesses conventionally split cash flow three ways. Operating is cash from the actual trade: customer receipts less supplier and payroll payments. Investing is cash spent on or received from assets, such as equipment. Financing is cash from loans, repayments and owner contributions or withdrawals. The reason this matters is that positive total cash flow funded by a new loan is a very different situation from positive cash flow generated by trading, even though the bottom line is identical.

Reading the trend

Plot net cash flow by month and look for direction, volatility and floor. A gentle upward slope with small variance is healthy. A flat average hiding alternating large positives and negatives means the position depends on payments arriving in the expected order. The lowest balance reached during a period matters more than the closing balance, because that is the point at which something would have failed.

Profitable and out of cash

A consultancy invoices 30,000 in a quarter with 22,000 of costs, so the accounts show an 8,000 profit. Clients pay on 60-day terms while payroll and rent go out monthly. Cash flow for the quarter is negative because most of the invoiced revenue lands after the quarter ends. Both figures are correct and only one of them determines whether payroll clears.

The January squeeze

A household's monthly cash flow looks comfortably positive at an average across the year. Broken down by month, December and January are sharply negative because of holiday spending followed by annual insurance and a car tax renewal. The annual average concealed a two-month period that had to be funded by savings or a card balance.

Committed versus discretionary in practice

Two freelancers each bring in 5,000 a month and spend 4,500. One has 4,000 of committed costs and 500 of discretionary; the other has 2,500 committed and 2,000 discretionary. A month with no work is a crisis for the first and an inconvenience for the second. Net cash flow is identical.

• It is factual. Bank statements record movement. There is no estimation or judgment in the underlying data.
• It predicts failure earlier than profit does. Deteriorating cash flow shows up months before an accounting loss.
• It exposes timing risk. Seeing the lowest point in each month tells you how much slack you actually have.
• It is what lenders assess. Affordability decisions look at cash movement, not declared profit.
• It requires no accounting system. Statements are enough, which makes it available to anyone.

• Counting internal transfers. The most common error, and it distorts both sides of the calculation.
• Confusing cash flow with profit. They answer different questions and can point in opposite directions at the same time.
• Using only the closing balance. A month that ends well can contain a day where the balance nearly ran out.
• Excluding the credit card. If spending happens on a card, the current account only shows the monthly payment and the real pattern is invisible.
• Averaging away seasonality. An annual average hides exactly the months that cause problems.
• Treating a loan drawdown as income. It is cash in, but it is financing rather than earnings, and it has to be repaid.
• Ignoring tax accrual. Money sitting in the account that is owed in tax later is not available cash, even though it looks like it.