Why Cash Flow Analysis is Important - Pt. 2

In the first part of this article we understood the difference between profit and cash, from which derives the importance of entering into the perspective of periodically carrying out careful monitoring of company liquidity.

To analyze whether the company is creating or absorbing liquidity, and whether it is doing so in a healthy way , it is necessary to prepare the Cash Flow Statement .

This is a document that is as useful as it is underestimated by most (Italian!) companies, as the Civil Code requires it only for companies that draw up their balance sheet in extended form .

We are talking about companies that in two consecutive financial years exceed at least two of the following parameters:

• assets greater than 4.4 million;
• revenues greater than 8.0 million;
• average number of employees greater than 50.

This could lead one to believe – erroneously! – that such compliance is superfluous for smaller entities, a sterile exercise that is an end in itself.

But that's not the case!

The Financial Statement displays its effects in terms of information even with much smaller entities, to the point that at all levels it can undoubtedly be considered an indispensable tool for correct business management.

This is even more true in recent years, in which the attention of operators (including the legislator with the full entry into force of the Crisis Code, the banks with the entry into force of the EBA guidelines, the Tax Authorities, etc.) has increasingly shifted from economic dynamics (easily altered with more or less underhanded "budget policies") to financial dynamics (more difficult to manipulate).

This is because, as a rather widespread adage among experts in the sector goes, " balance sheets are drawn up on an accrual basis, but bankruptcies are drawn up on a cash basis! "

Returning to the Cash Flow Statement, the cash flows are grouped into 3 distinct reference areas:

• operating activity: this highlights the liquidity created or absorbed by the company solely through its operations, i.e. by selling its products and services on the market, net of the costs incurred;
• investment activities: the liquidity flows relating to the management of fixed assets are highlighted here; there will therefore be investments, represented by negative, outgoing flows, and/or disinvestments, represented by positive, incoming flows;
• financing activity: it represents the positive flows relating to new financing obtained, and/or the negative flows relating to repaid financing.

The sum of the flows generated by each area during year t represents the cash flow generated or absorbed during the year, and coincides with the variation in liquid assets from time t–1 to time t .

In the third part of the article we will understand how the Financial Statement can be used by the entrepreneur, his consultant, the CFO or anyone interested, to acquire valuable information on the financial health of the company.