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Users of financial statements can obtain helpful information about a company by analyzing its cash flow statement. This can help them understand the company’s business and earnings and predict its future cash flows.
The common-size analysis of the cash flow statement also makes it easier for an analyst to identify cash flow trends than if they merely looked at the total reported amount.
Evaluation of the cash flow statement involves the assessment of the sources. It uses cash in a company’s operating, investing, and financing activities and the assessment of the main drivers of cash flow within each activity. This may be done in the ways discussed below.
Common-sizing the cash flow statement can help to quickly tell if a company has sufficient cash to undertake certain activities, such as capital expenditures and debt repayment.
There are two approaches to the common-size analysis of a cash flow statement. The first approach involves the expression of each line item of cash inflow as a percentage of total cash inflows and each cash outflow as a percentage of the total cash outflow. However, when a cash flow statement is presented using the indirect method, the operating cash inflows and outflows are not presented separately. As a result, the common-size cash flow statement will only show the net operating cash flow as a percentage of the total inflows or outflows (dependent on whether or not the net amount was a cash inflow or outflow).
The second approach to common-sizing the cash flow statement entails the expression of each line item on the cash flow statement as a percentage of net revenue.
Question 1
Which of the following statements is most accurate?
- For mature companies, it would be preferable for financing activities to be the primary source of cash flows.
- If a company has a significant net income despite its negative operating cash flow, this may be a sign of poor earnings quality.
- One approach to the common-size analysis of the cash flow statement involves expressing each cash flow (inflows and outflows) as a percentage of total cash inflows.
Solution
The correct answer is B.
If a company has a negative operating cash flow and still has a significant net income, this is a manifestation of the poor quality of the company’s earnings.
A is incorrect. For a mature company, operating activities, not financing activities, should be the primary source of cash flows.
C is incorrect. Common-sizing the cash flow statement entails the expression of each line item of cash inflow as a percentage of total cash inflows and each cash outflow as a percentage of total cash outflow.
Question 2
Which of the following ratios most likely indicates that a company has earnings of high quality?
- Operating cash flow/Net income > 1.
- Investing cash flow/Net income > 1.
- Financing cash flow/Net income > 1.
Solution
The correct answer is A.
An operating cash flow or net income of one or more indicates that all the earnings recognized on an accrual basis on the income statement have also been recognized on a cash basis on the cash flow statement. The cash realization of earnings gives these earnings a higher value than similar earnings with less corresponding cash from operations since the latter earnings are less likely to be realized in cash.