Cash flow analysis is a critical aspect of financial management for businesses, investors, and financial professionals.

Understanding cash flow is crucial as it helps identify profitable aspects of your business, detect any inefficiencies, and understand when it might be the right time to expand or seek assistance. 

Whilst we may be familiar with the traditional cash flow statement and its role in providing valuable insights into a company’s liquidity, there is a more comprehensive tool known as the “3-Way Cash Flow” analysis. 

What is 3-Way Cash Flow analysis?

It is an integrated model that forecasts an organisation’s income statements, balance sheets and cash flow statements.  A 3-Way Cash Flow analysis is a great way to ensure that you properly reap the benefits of planning for business.

More often now, we see these 3-Way Cash Flows being requested by lenders and creditors to better understand how a business is likely to perform, repay obligations and ensure viability.  But they shouldn’t just be for external parties – the primary importance is to the business owner to get a complete understanding of how the business is likely to operate.

For SMEs, 3-Way Cash Flows are the best way to measure performance  – because they tell the user not only whether the business can kick the goals of achieving growth and sustainability but also whether the business is able to responsibly manage the resultant changes in assets and liabilities, especially the cash!  In that way, it is also a better way of measuring actual against expected performance and can help highlight areas that might need improvement – maybe you hit the sales target,  Still, debtor collections need some work, for example.

This article explains how a “3-Way Cash Flow” works, its components, and its significance in financial decision-making.

What makes up a 3-Way Cash Flow?

Firstly, we need to understand the three components:

1. Income Statement: The income statement, also known as the profit and loss statement (P&L), summarises a company’s revenues, expenses, and net income (or net loss) over a specific period, typically a month, quarter, or year. It provides a snapshot of a company’s operating performance by detailing revenues earned and costs incurred.

2. Balance Sheet: The balance sheet, often referred to as the statement of financial position, offers a snapshot of a company’s financial position at a specific point in time. It presents assets (what the company owns), liabilities (what the company owes), and shareholders’ equity (the residual interest in assets after deducting liabilities).

3. Cash Flow Statement: The cash flow statement tracks the cash movement into and out of a company during a given period. It categorises cash flows into three sections: operating activities (cash generated or used by core business operations), investing activities (cash flows from buying and selling assets), and financing activities (cash flows from borrowing, repaying debt, issuing or repurchasing stock). 

By the way, a cash flow statement shouldn’t just be the summary of total cash movements you see in published annual returns.  To be useful, it needs to show a breakdown of where the cash is coming from and going to.

The Mechanics of a 3-Way Cash Flow

Now, let’s explore how these three components interact in a 3-Way Cash Flow analysis – the mechanics, in other words!

1. Starting Point: The starting point of a 3-Way Cash Flow analysis is typically the balance sheet at the beginning of the period. The balance sheet provides the initial financial position, including the cash and cash equivalents balance, which is the basis for the cash flow statement.

2. Operating Activities: The first step in the 3-Way Cash Flow analysis involves reconciling the changes in the balance sheet items related to operating activities. This means adjusting for items, such as accounts receivable, accounts payable, and inventory changes. The goal is to determine how these balance sheet changes impact cash flow from operating activities, as reflected in the cash flow statement.  Some of the key accounts in any cash flow are:

– Accounts Receivable: An increase in accounts receivable (money owed to the company by customers) reduces cash flow, while a decrease increases cash flow.

– Accounts Payable: An increase in accounts payable (money the company owes to suppliers) increases cash flow, while a decrease reduces cash flow.

– Inventory: An increase in inventory decreases cash flow, as it ties up cash in unsold goods, while a decrease increases cash flow.

3. Income Statement Integration: The next step involves integrating the income statement with the cash flow statement. This is accomplished by adjusting for non-cash items in the income statement, such as depreciation and amortisation, which do not impact cash flow but affect net income. The adjustment reconciles net income with cash flow from operating activities.

4. Investing Activities: The 3-Way Cash Flow analysis considers the impact of investing activities on cash flow. This includes cash flows related to the purchase or sale of assets, such as property, plant, and equipment (PP&E), as well as investments in securities or other companies. These cash flows are reported in the cash flow statement’s investing activities section, including:

– Purchase of Assets: Acquiring new assets, such as machinery or real estate, reduces cash flow while selling assets increases cash flow.

– Investments: Purchasing investments, like stocks or bonds, decreases cash flow while selling investments or receiving dividends increases cash flow.

5. Financing Activities: The final component of 3-Way Cash Flow analysis examines financing activities, involving cash flows related to the company’s capital structure and funding sources. This includes cash flows from borrowing or repaying debt, issuing or buying back stock, and distributing dividends:

– Borrowing: Taking on debt increases cash flow while repaying debt decreases cash flow.

– Stock Issuance/Repurchase: Issuing new shares reduces cash flow while repurchasing shares increases cash flow. – Dividends: Paying dividends to shareholders decreases cash flow while receiving dividends from investments increases cash flow.

Significance of 3-Way Cash Flow analysis

So, there is a fair bit of work involved in the mechanics of a 3-Way Cash Flow, but the benefits are in understanding the significance of what the cash flow is telling you.

1. Holistic Financial Assessment: 3-Way Cash Flow analysis provides a holistic view of a company’s financial performance by integrating income, balance sheet changes, and cash flow. This comprehensive perspective aids in assessing the company’s overall financial health.  For example, if the business grows too rapidly, that might be good for profits, but not good for cash if too much investment is in accounts receivable.  Looking at trading results and the impact on cash and the balance sheet is a great way to forecast appropriate trading levels.

2. Improved Decision-Making: By reconciling financial statements and cash flow data, 3-Way Cash Flow analysis facilitates more informed decision-making. Businesses can better understand the sources and uses of cash, assess liquidity, and identify areas for improvement.  Can you improve on credit terms with customers and suppliers, for example?  Or could you offer discounts to increase cash?

3. Accurate Forecasting: 3-Way Cash Flow analysis enhances financial forecasting and planning. It enables businesses to anticipate future cash needs, evaluate the impact of various scenarios, and make strategic decisions that align with their financial goals.

4. Stakeholder Communication: Investors, lenders, and shareholders often require detailed financial information. 3-Way Cash Flow analysis provides a transparent and comprehensive view of a company’s financial performance, promoting effective communication and trust-building.

Conclusion

A 3-Way Cash Flow analysis is a powerful tool that combines the income statement, balance sheet, and cash flow statement to comprehensively understand a company’s financial health.

By reconciling these three components, businesses can make more informed decisions, improve financial forecasting, and communicate effectively with stakeholders. In a complex and dynamic financial landscape, mastering the mechanics of 3-Way Cash Flow analysis is crucial for ensuring the success and sustainability of businesses.

You may also like to read our recent article on the importance of budgeting and forecasting for business owners. 

All businesses should have 3-Way Cash Flows on their regular business planning agenda.  To discuss how we can help you in your planning, contact Suelen McCallum of dVT Group on (02) 9633 3333 or by email at mail@dvtgroup.com.au.

dVT Group is a business advisory firm that specialises in business turnaround, insolvency (both corporate and personal), business valuations and business strategy support.