Reported and Common-size Cash Flow Statements

Users of financial statements can obtain useful information about a company by analyzing its cash flow statement. This can help them to understand the company’s business and earnings as well as predict its future cash flows.

The common-size analysis of the cash flow statement also makes it easier for an analyst to identify trends in cash flow than it would be if they merely looked at the total reported amount.

Analysis of Reported Cash Flow Statement

Evaluation of the cash flow statement involves assessment of the sources and uses of cash in a company’s operating, investing, and financing activities, and assessment of the main drivers of cash flow within each activity. This may be done in the ways discussed below.

Evaluation of Where the Major Sources and Uses of Cash Flow are Among the Operating, Investing, and Financing Activities

• The major sources of cash for a company tend to vary depending on its growth stage. For mature companies, it is expected and desirable for operating activities to be the primary source of cash flows.
• A company must generate cash flow from operations over the long term if it wants to remain in business. The cash that is generated from these operating activities can be used either in investing or financing activities.
• If a company has opportunities for investments or to grow its business, it should preferably use cash in the investment activities. Cash that does not have profitable investment opportunities, should be returned to the providers of capital. Such a move would be considered a financing activity.
• Cash flow from operating activities must also be sufficient to meet capital expenditures.

• Evaluation of the Primary Determinants of Operating Cash Flow

  • Increments and decrements in receivables, inventory, and payables can be examined closely to determine whether a company is using or generating cash in its operations and the possible reasons for this.
  • It is useful to compare a company’s operating cash flow with its net income. For mature companies, it would be desirable to have their operating cash flow exceed their net income. If a company has a large net income despite its poor operating cash flow, then this could be a sign of poor earnings quality.
  • The variability of earnings and cash flow should be examined. Further, the impact of the variability on a company’s risk profile as well as its ability to forecast future cash flows for valuation purposes should be interrogated.

• Evaluation of the Primary Determinants of Investing Cash Flow

  • Each line item in the investing activity section should be evaluated.
  • The evaluation should identify how much cash is being invested in property, plant, and equipment, how much is invested in stocks and bonds, and how much is used to make acquisitions.
  • It is useful to consider the sources of cash for major capital investments.
  • If assets are being sold, it is important to determine why this is happening. In addition, it is equally advisable to identify any effect disposal of assets may have on the company.

• Evaluation of the Primary Determinants of Financing Cash Flow

  • Each line item in the financing activity section should be evaluated to determine whether the company is raising capital or repaying capital. Besides, the evaluation should focus on the sources of capital for the company. If capital is being raised or repaid, it is important to determine why this is the case.
  • The date of repayment for borrowed money is especially important when a company is borrowing money every year.

Analysis of Common-size Cash Flow Statement

Common-sizing the cash flow statement can help to easily 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. When a cash flow statement is presented using the indirect method, however, 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?

A. For mature companies, it would be preferable for financing activities to be the primary source of cash flows.

B. If a company has a large net income despite its negative operating cash flow, then this may be a sign of poor earnings quality.

C. One approach to the common-size analysis of the cash flow statement involves expression of 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 large net income nevertheless, this is a manifestation of the poor quality of the company’s earnings.

A is incorrect because, for a mature company, operating activities, and not financing activities, should be the primary source of cash flows.

C is incorrect because 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?

1. Operating cash flow/Net income > 1.
2. Investing cash flow/Net income > 1.
3. 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 that have been 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 kind of earnings have a lower probability of being realized in cash.