Cash flow statement is about where the money came or will come from, where it went and will go. In short, cash flow statements show the predictability, timing and amount of cash-inflows and cash-outflows. Furthermore, it is also used in business planning and budgeting. Accounting personnel are interested in knowing organization's ability to cover payroll and other immediate expenses while creditors or potential lenders would like to see the company's able to repay or not. In addition, potential investors have to judge company's finance and contractors or potential employees that happy to know the company is able to afford compensation.
2.1.1 Classification of Cash Flow
In cash flow statements, it has three distinct activities that are operations, financing and investing.
Operation cash flow indicates the cash used and provided by a company's general operations. It generates cash internally. This cash flow figures show the ability of the company to be consistent in generating positive cash flow from operations activities. Operations activities are the core business of the company.
Investing activities are gaining and expenses of property, plant and equipment, investment, collecting the loans and lending money. Cash flows in investing include all the cash used or provided by the purchasing and selling of assets that produce income. Cash flow from investing usually generates cash outflows. For example, activities like business, acquisitions, purchase of investment securities and capital expenditures for plant, property and equipment. On the other hand, inflows generated from the company's trading, investment securities and transfer of asset. Capital expenditure is what investor would like to look at. Investors think that it is necessary to ensure proper maintenance of assets of the company and support company's operation efficiency and competitiveness.
Financing activities generate cash from issuing debt, repurchasing shares, repaying the amounts borrowed, paying dividend and get cash from stockholders. In financing activities, the cash flow is calculated with flow of cash between creditors and owners and its firm. Negative figures may illustrate the company paid dividends and repurchase stock but it also may shows the company is servicing debt. Debt and equity transactions are in financing activities. Stock is not being issued so often. Cash dividends paid is the most important for investors.
2.1.2 Different methods in Cash Flow
Different methods are used in different cash flow statements' format. One of the methods is indirect method while the other is direct method. Adjusting net income for items that do not affect cash is the indirect method. This method is more widely used by companies because to prepare, it is not so hard to do and the cost is lower. Moreover, it shows the difference between net operating cash flow and net income. But operating cash receipts and payments are shown in direct method which makes direct methods to be consistent with the cash flow statement's objective.
2.1.3 Cash Flow versus Income
It is vital to able to see and differentiate between being profitable and having positive cash flow transactions. It is wrong to think that a company did not bring in cash is not making profit. Unable to understand it will cause untold confusion and problems. The fact is many businessmen has problem to differentiate it. The misunderstood is caused as when they saw net income is in the positive figures, they think that net cash flow will be certainly positive. The cash flow is may be actually in the negative. In addition, banks borrow money not on income statements but are on cash flow statements. The survival of a company is because positive cash flows and not because reported net income.
For example, a manufacturing company sells off half of its factory equipment because low product demand. Cash will be received from the buyer for the used equipment. Manufacturing company is actually losing money on the sale. Equipment is manufacture products to earn an operating profit would be preferable. Best choice only left to sell it off at low price. Thus the year it sold the equipment will seem like having strong positive cash flow. The profitability may be negative when cash flow positive.
2.2 Financial Stability
A company may be said as financial stable if it has abilities in risk managing, shock absorbing and economic processes assisting and improving. Financial system enables the financial intermediation process which facilitate and the flow of funds between savers and borrowers which ensure that financial resources can efficiently towards promoting economic growth and development. Positive cash flow ensures good flow of funds. Good cash flow will show good liquidity ratio and acid test ratio.
Financial stability is important to evaluate the risks within a financial product such as in matching re-investment requirements, evaluating default risk, cash requirements and others. Financial statements are accrued based accounting that includes non-cash items. It hopes to reflect the financial health of company. But accrual accounting may sometimes not clear actual amount of cash generated. Operating cash flow ratio shows the ability of company to service its interest and loans payments. Even a slight change in the cash flow statement can jeopardize its loan payments, therefore company will bare more risk if compare with stronger cash flow levels companies.
Liquidity ratio is how is ability of a company in meeting its short-term obligations achieved through financial variables' comparison. It expresses a company's ability to repay short-term creditors out of its total cash and shows the number of times short-term liabilities are covered by cash. A lot of cash or capital is tied up in high levels. Accrual accounting concepts is believed that do not represent economic realities. For example, a company's cash flow may show profitable but actually they might generate additional operating cash by raising additional debt finance or issuing shares. Therefore, cash flow is used to evaluate income generated by accrual accounting.
As we acknowledged, the main purpose of business is earning a lot of cash, the trading and exchange of value between two or more parties. Hence, it is very obvious that some industries are more cash intensive as business that not generating positive cash flow per share is unable to survive in the long run. Long-term cash inflows of a company are necessary to more than its long term cash outflows to get a positive cash flow. User of cash flow statement should first look at net increase or net decrease in cash and cash equivalent as since the figures states the overall change in the cash and equivalents of a company over the last period
2.3 Financial Performance
There are many different ways to indicate financial performance. It is important to note that all measures should be taken as whole. Line items such as revenue from operations, operating income or cash flow from operations and total units sales can be used. Furthermore, the investor or analyst desires to look deeper into financial statements and seek our margin growth rates or any declining debt. It is vital to know and understand with the key elements of financial performance appraisal. In the process of checking the company's condition and performance, the top management in the company will be helped by the financial statements.
There are three financial performance variables. The company's performance should be able to meet their current financial objectives. Moreover, past performance is needed to see how the trends developed over the time to do a financial performance evaluation. The measuring also needs to be done within industry to easily examine the level of the competitiveness of a company in the open market. Evaluation of recent company's financial condition and operating results achievement is important. Cash flows statement enables management to see the flow of incoming and outgoing funds.
2.4 Financial Planning
Financial Planning is used to estimate the capital needed and determine its competition. Moreover it is also framing objectives, policies, procedures, program and budgets about investment, procurement and administration of funds of an enterprise. Financial planning helps you manage your financial affairs so you can build wealth and achieve financial security. Financial Planning is about investment. In addition, financial planning maintains the balance between inflow and outflow of funds. For investment, enough cash flow is important to generate more cash. The investment value is easily found in the balance sheet and cash flow.
It is important to determine a project's rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such net present value and internal rate of return. Business decisions might be affected by the cash flow projection as it highlight the time that will short of cash which enable time saving in thinking ways to secure the fund. Cash flow projection is a good planning tool. It show the cash inflow and outflow of business on next year or future year. This will enable user to make financial decisions to avoid full blown crisis.
Jonathan Moreland states a very brief evaluation of how to differentiate between cash and earnings in "Individual Investor" in August 1995. Many investors routinely ignore importance of the cash flow statement. They usually just look at income statement.
2.5 Cash flow ratios
In many cases, cash flow ratios indicate a more precise measurement to stock's value than the price to earnings ratio, P/E. Cash flow ratios examine the flow of money into a company, it can help to identify struggling companies and in turn, struggling stocks. Price to earnings is a very important ratio because when is very high or low, it usually makes a splash on the financial pages. Price to earnings ratio is valuable metric and can help a successful investor with his or her stock technical analysis, but it is only one technical analysis tool and should be considered as such. While the same can be said for each of the cash flow ratios, these give insight into the money coming in and going out of a company. A company can demonstrate earnings, but if more money is pouring out a company than pouring in, there will fiscal problems in the future.
Profits are very vital for the survival of a company. But sometimes, companies look like very profitable may actually opposite what you seen. It might encounter financial risk if little cash are generated from these profits. The example is a company can look profitable if they sales on credit and have not received cash for the sales that hurt their financial health since they obliged to pay. Cash flow indicator ratios use cash flow as denominator or numerator and not like financial ratios which use other company metrics. They are used to determine amount of cash generated from their sales or free and clear, and the how much cash they have to cover obligations. The ratio that will be looked at are operating cash flow/sales ratio, free cash flow/operating, cash flow coverage ratios, cash flow ratio and others that related with cash flow.
Operating Cash Flow/Sales Ratio is expressed as a percentage. It is calculated by compares a company's operating cash flow divides with net sales or divides with revenues. This ratio provides investors a suggestion of the ability of the company to turn sales into cash. Investor would worry if saw sales grow of the company is not a parallel growth with operating cash flow. This indicator will show the changes in a company's terms of sale or the collection experience of its accounts receivable whether in positive or negative. In this ratio, figures of operating cash flow that frequently named in cash flow report as cash flow, cash flow from operating activities, cash flow provided by operations and net cash provided by operating activities.
The net income figure in the operation activities section in cash flow statement is adjusted for increases or decreases in the working capital items and non-cash charges in a current assets and liabilities of the company. The most important source of generating of cash in a company is reconciliation results in an operating cash flow figure. For the amount of operating cash flow is the higher the better. Generally, the ratios with consistent or improving percentage trends show good investment qualities.
The free cash flow/operating cash flow ratio is calculated by free cash flow divided with operating cash flow. Operating cash flow minus capital expenditures will get free cash flow. This ratio is crucial in maintaining competitiveness and efficiency of a company. The usage of free cash flow is for acquisitions, expanding and to maintain company's stability when having bad market conditions. This ratio measures the financial strength of the company, also is the higher percentage, the better.
In addition, cash flow coverage ratios identified the operating cash flow's ability of the company in meeting its obligations that include ongoing concern costs or liabilities. The greater the operating cash flow coverage, the better. This ratio identifies the ability of a company in meeting its obligations and more cash flow provided to expand business, able to hang on when got difficulty, no debt servicing's burden and no restrictions like credit agreements.
Dividend payout ratio indicates the percentage of earnings per common share allocated to paying cash dividends to shareholders. It is an indicator that states how well earnings sustaining the dividend payment. Cash flows statement recorded the payment of cash dividend under the "financing activities" section.
One of the important cash flow ratios is operating cash flow ratio. It is because cash flow statement indicates how money flows out and in of the company and how bills are paid. Operating cash flow is side by side to cash flows that accrual of a company from operations to its current debt. The liquidity of a company will be measured in the short run since the relation of it with cash flows from operations and current debt. The formula is:
Operating Cash Flows Ratio = cash flows from operations/current liabilities
Cash flows from operations are from the operation activities of cash flows statement and current liabilities is from the Balance Sheet. If this ratio is less than 1.0, it means that cash generated by the company is not sufficient to settle its short-term debt. It will cause serious situation as possibility of the firm to discontinue operation becomes higher.
Compare to price to earnings ratio, price to cash flow ratio shows as a better indicator to value of a company. It is especially useful for publicly traded company. This ratio evaluates the share price of a company to the cash flow generated per share. The formula is:
Price/cash flow ratio = Share price/Operating cash flow per share
Share price is normally price of the stock closing on a day and operating cash flow is comes from the cash flows statement. Some people will change the denominator to free cash flow.
The Cash Flow Margin ratio demonstrates the connection between cash generated from sales and cash generated from operations. Cash is vital to profit of the company as supplier, dividends, investing in new capital assets and service debt needed to pay with cash. The Cash Flow Margin ratio identifies a company's ability to translate sales into cash. The formula is:
Cash flow from operating cash flows/Net sales = _____%.
The numerator of the formula is taken from cash flows statement. The denominator is taken from the income statement. The higher percentage, the better ratio is it.
Cash flow from operations/average total liabilities is similar to the ratio of total debt/total assets ratio. These two ratios calculate a company's solvency or its ability to settle it debts. But the ability is measured over a period of time and not at a point in time. The formula is:
Cash flow from Operations/Average Total Liabilities = _______%
Cash flow from operations comes from the cash flow statement while average total liabilities is total liabilities average in several time periods and it comes from balance sheets. The greater ratio indicates the better the financial flexibility and paying debt ability of a company.
2.6 Economic Growth
Economic growth means changing in the goods' and services' level of production over a certain period of time by a country is positive. The main causes of economic growth are advances in technology, increase in the capital stock and improvement in the quality and level of literacy.
Cash flow is defined as internal flow of generation and money used over a particular time. Accordingly, variations of cash flow affect the firm's production decisions. Production will probably increase if there is a cash flow's increase, and it will indirectly enhance economic activity.
2.7 Summary
Cash flow statement is about where the money came or will come from, where it went and will go. In short, cash flow statements show the predictability, timing and amount of cash-inflows and cash-outflows. Furthermore, it is also used in business planning and budgeting. Accounting personnel are interested in knowing organization's ability to cover payroll and other immediate expenses while creditors or potential lenders would like to see the company's able to repay or not. In addition, potential investors have to judge company's finance and contractors or potential employees that happy to know the company is able to afford compensation. The cash flows statement states the cash payments and cash receipts as well as net change in cash during a period from financing, investing and operating activities. This information should help investors, creditors and other people that will use it. Ability to generate future cash flow can be seen through by determining relationships between figures in the cash flows statement as better predictions of the timing, insecurity and how much future cash flows can be made than accrual basis data. Moreover, it also determined ability of a company to pay dividends and meet obligations. Enough cash are required to pay dividends, settle debts, or pay debts. It lets user to further understand why assets and liabilities changed of financing and cash investing transaction during the period.
Other than cash flow statement, there are other two important parts of a company's financial statements which are the balance sheet and income statement. Balance sheet provides a clear preview of a company's assets and liabilities while the income statement shows the profit of a business. The reason of cash flow statement different from other financial statements is it reconciles the income statement and balance sheet that acts like corporate checkbook. Cash flow does not necessarily indicate all the expenses as accrued expenses of company not paid directly now. Before expenses being paid, it will not be recorded as cash outflow. Cash flow only gives a little room for manipulation because under the Securities and Exchange Commission, every company filing reports required its quarterly and annual reports of cash flow. Cash flows statement also shows how the spending trend of a company and where the money comes from.
By looking all the dependent variables, it is important to able to relate independent variables and dependent variables.
