chapter 16
Financial Analysis and the Statement of Cash Flows
goals   discussion   goals achievement  fill in the blanks   multiple choice   problems    check list and key terms 

Your goals for this "analysis and cash flows" chapter are to learn about:

• Tools for financial statement analysis.
• Evaluating cash flow and the cash flow statement.
• Categories of business activity: operating, investing, and financing.
• Noncash investing/financing activities.
• The direct approach to preparing a statement of cash flows.
• The indirect approach to presenting operating activities.
• Using a worksheet to prepare a statement of cash flows.

DISCUSSION

FINANCIAL STATEMENT ANALYSIS

THE IMPORTANCE OF ANALYSIS:  As you know, this website provides a substantial amount of material about accounting principles, and anyone wishing to study it with due diligence can learn valuable insights about accounting.  Does the mere fact that this website exists mean that everyone with internet access now knows about accounting principles?  Obviously not.  Does it mean that everyone who happens to "click by" will learn about accounting?  Again, no.  By analogy, the same can be said about financial information.  Companies, especially public companies, spend substantial amounts of money preparing and presenting financial statements that are readily available (the reports for U.S. public companies are freely available at www.sec.gov).  Does this mean that everyone with internet access now has in-depth knowledge about these companies?  For that matter, if you print the annual report of a company that you find interesting, does this really help you?  My point is that some degree of study is required to benefit from information.

It is important for you to know that CPAs and the SEC provide safeguards to protect the integrity of reported information, but this is entirely different than suggesting that reporting companies are necessarily good investments.  For example, a company could report that its revenue stream is in decline, expenses are on the rise, and significant debt is coming due without a viable plan for making the payments.  The financial statements may fully report this predicament with perfect integrity, painting a rather gloomy picture.  But, if financial statement users choose to ignore that report, only they are to blame.

The moral of the preceding point is that you must be very thorough in examining the financial statements of companies in which you are considering making an investment.  It is not sufficient to merely determine that reports exist and look nice; you must study them, drill down in the detail, and think carefully about what you are observing.  Sometimes, the evaluation of complex situations can be assisted by utilization of key metrics or ratios.  For example, a doctor will consider your health in conjunction with measurements of your blood pressure, heart rate, cholesterol level, etc.  Likewise, you measure a company's health by considering certain important ratios.

The following ratios have been presented throughout this book, and are summarized below.  You can click on the chapter reference to link to the full discussion of the ratio and its application/interpretation:

COMPREHENSIVE ILLUSTRATION:  At this point, it may be helpful to consider these ratios as they relate to a comprehensive illustration.  Presented below are financial statements for Emerson Corporation.  Study them carefully.  Then, examine the ratio calculations for Emerson Corporation that can be found immediately following the financial statements.

RATIOS FOR EMERSON CORPORATION
AS OF DECEMBER 31, 20X5

Additional facts:  No dividends were due or paid on the $300,000 of preferred stock which was issued in exchange for a building in late 20X5.  Average common equity is assumed to be $2,095,000 ((($2,910,000 - $300,000) + $1,580,000)/2).  Assume most other balance sheet items change uniformly throughout the year (e.g., average receivables = ($600,000 + $850,000)/2 = $725,000, etc.).  The year end market value of the common was $10 per share, and the cash dividend was paid on shares outstanding at the end of the year ($50,000/910,000 shares = $0.055 per share). 

In examining the ratios of Emerson, it would appear that the company is doing fairly well.  Its liquidity suggests no problem in meeting obligations, the debt is at a manageable level, receivables and inventory appear to be turning reasonably well, and profits are good.

TREND ANALYSIS:  Financial statement data are often reproduced in percentage terms.  For example, Emerson's cash is 17% of total assets ($700,000/$4,100,000).  Such percentage data can be monitored closely, year after year.  This provides sharp investors and managers with a keen sense of subtle shifts that can foretell changes in the underlying business environment.

CASH FLOWS AND THE CASH FLOW STATEMENT

CASH FLOWS:  Accounting is based upon accrual concepts that report revenues as earned and expenses as incurred, rather than when received and paid.  Accrual information is perhaps the best indicator of business success or failure.  However, one cannot ignore the importance of cash flows.  For example, a rapidly growing successful business can be profitable and still experience cash flow difficulties in trying to keep up with the need for expanded facilities and inventory.  On the other hand, a business may appear profitable on an accrual basis, but may be experiencing delays in collecting receivables, and this can impose severe liquidity constraints.  Or, a business may be paying generous dividends, but only because cash is being produced from the disposal of core assets.  Sophisticated analysis of the balance sheet and income statement will often reveal such issues.

THE STATEMENT OF CASH FLOWS:  Rather than depending upon sophisticated financial statement users to do their own detailed cash flow analysis, the accounting profession has seen fit to require another financial statement that clearly highlights the cash flows of a business entity.  This required financial statement is appropriately named the Statement of Cash Flows.  The Statement of Cash Flows can be seen as an outgrowth of the FASB's conceptual framework.  In the previous chapter, it was pointed out that the FASB cited one objective of financial reporting as follows: Information should be helpful in assessing the amounts, timing, and uncertainty of an organization's cash inflows and outflows.  The applicable rules require that the statement of cash flows provide three broad categories that reveal information about operating activities, investing activities, and financing activities.  In addition, businesses are required to reveal significant noncash investing/financing transactions.

CASH AND CASH EQUIVALENTS:  In preparing the statement of cash flows, companies broadly define "cash" to consist of cash and items that are equivalent to cash.  As a general rule, cash equivalents are short-term, highly liquid investments that mature in 90 days or less.

OPERATING, INVESTING, AND FINANCING ACTIVITIES

OPERATING ACTIVITIES:  Cash inflows from operating activities consist of receipts from customers for providing goods and services, and cash received from interest and dividend income (as well as the proceeds received upon the sale of "trading securities").  Cash outflows consist of payments for inventory, employee salaries and wages, taxes, interest, and other normal business expenses (and the cost of "trading securities" purchased).  To generalize, cash from operating activities is generally linked to those transactions and events that enter into the determination of income.  However, another way to view "operating" cash flows is to include anything that is not an "investing" or "financing" cash flow as described below.

INVESTING ACTIVITIES:  Cash inflows from investing activities result from items such as the sale of stock and bond investments (other than "trading securities"), disposal of long-term productive assets, and receipt of principal repayments on loans made to others.  Cash outflows from investing activities include payments made to acquire long-term assets or long-term investments (other than "trading securities") in other firms, loans made by the entity to others, and similar items.

FINANCING ACTIVITIES:  Cash inflows from financing activities relate to the proceeds received when a company issues its own stock or bonds, borrowings under mortgage notes and loans, and so forth.  Cash outflows for financing activities include repayments of amounts borrowed, acquisitions of treasury stock, and dividend distributions to shareholders.

NONCASH INVESTING AND FINANCING ACTIVITIES

NONCASH EVENTS:  A select set of important investing and financing activities occur without generating or consuming any cash.  For example, a company may exchange common stock for land, or acquire a building in exchange for a note payable.  While these transactions do not entail a direct inflow or outflow of cash, they do pertain to significant investing and/or financing events.  When the FASB designed the statement of cash flows, they decided to require a separate section reporting these noncash items.  Thus, the statement of cash flows is actually enhanced beyond its "title;" revealing the totality of investing and financing activities, whether or not cash is actually involved.

DIRECT APPROACH TO THE STATEMENT OF CASH FLOWS

EXAMINING A STATEMENT OF CASH FLOWS:  Earlier in this chapter, you studied the income statement, statement of retained earnings, and balance sheet for Emerson Corporation.  Before proceeding, spend just a few moments reviewing those financial statements.  Then, examine the following statement of cash flows for Emerson Corporation.  Everything within this cash flow statement is derived from the data and additional comments presented earlier for Emerson.  At first, some of the cash flow statement will seem a bit mysterious, but a "line by line" explanation will follow.  The tan bar at the left is not part of the statement; it is to facilitate the "line by line" discussion"  (e.g. line F4 will refer to the 4th line in the financing activities section).

METHODS TO PREPARE A STATEMENT OF CASH FLOWS:  There are several ways to go about preparing a statement of cash flows.  You may hear about a "T" account approach or a "worksheet" approach for organizing data to present the statement.  But, trying to learn the statement of cash flows by focusing on the specific method for its preparation can actually obscure your understanding of the statement.  Let's first focus on our "line by line" understanding of how the content for Emerson's statement is derived.  As you proceed, try to focus on understanding not memorization.  The statement of cash flows draws on your complete understanding of accounting, and it is quite common for students to initially struggle with the statement; do not despair and do not give up!

OPERATING ACTIVITIES

LINE O1 -- CASH FLOWS FROM OPERATING ACTIVITIES:  This line merely identifies the section:

LINE O2 -- CASH RECEIVED FROM CUSTOMERS:  Emerson's customers paid $3,000,000 in cash:

How do we know this?  Emerson's information system could be sufficiently robust that a "data base query" could produce this number for us.  On the other hand, we can also infer this by reference to sales and receivables data found within the income statement and balance sheet:

Cash Received From Customers = Total Sales Minus the Increase in Net Receivables (or, plus a decrease in net receivables)

Cash Received From Customers = $3,250,000 - ($850,000 - $600,000)

Cash Received From Customers = $3,000,000

Thinking about this calculation, we note that accounts receivable increased by $250,000 during the year ($850,000 - $600,000).  This means that of the total sales of $3,250,000, a net $250,000 went uncollected during the year.  Thus, cash received from customers only came to $3,000,000.  If net receivables had decreased instead, cash collected would have actually exceeded sales.

Determining the cash paid for inventory is perhaps one of the trickier calculations.  Bear in mind that cost of goods sold is the dollar amount of inventory sold during the year.  But, the amount of inventory actually purchased will be less than this amount if inventory on the balance sheet decreased during the year.  This would mean that some of the cost of goods sold came from existing stock on hand rather than having all been purchased during the year.  Conversely, purchases would be greater than cost of goods sold if inventory increased:

Inventory Purchased = Cost of Goods Sold Minus the Decrease in Inventory (or, plus an increase in inventory)

Inventory Purchased = $1,160,000 - ($220,000 - $180,000)

Inventory Purchased = $1,120,000

Now, the inventory purchased is only the starting point for determining cash paid for inventory.  Inventory purchased must be adjusted for the portion that was purchased on credit.  Notice that Emerson's accounts payable increased by $70,000 ($270,000 - $200,000).  This means that cash paid for inventory purchases was $70,000 less than total inventory purchased:

Cash Paid for Inventory = Inventory Purchases Minus the Increase in Accounts Payable (or, plus a decrease in accounts payable)

Cash Paid for Inventory = $1,120,000 - ($270,000 - $200,000)

Cash Paid for Inventory = $1,050,000

Emerson's payroll records would indicate the amount of cash paid for wages, but this number can also be determined by reference to wages expense in the income statement and wages payable on the balance sheet:

Cash Paid for Wages = Wages Expense Plus the Decrease in Wages Payable (or, minus an increase in wages payable)

Cash Paid for Wages = $450,000 + ($50,000 - $20,000)

Cash Paid for Wages = $480,000

Emerson not only paid out enough cash to cover wages expense, but an additional $30,000 as reflected by the overall decrease in wages payable.  If wages payable had increased, the cash paid would have been less than wages expense.

You may have noticed that two items within the income statement were not listed in the operating activities section of the cash flow statement.  Specifically:

• Depreciation expense is in the income statement, but it is not an operating cash flow item.  The reason is very simple; it is a noncash expense.  Remember that depreciation is recorded via a debit to Deprecation Expense and a credit to Accumulated Depreciation.  No cash is impacted by this expense entry (the "investing" cash outflow occurred when the asset was purchased), and
• The gain on sale of land in the income statement does not appear in the operating cash flows section.  While the land sale may have produced cash, the entire proceeds will be listed in the investing activities section; it is a "nonoperating" item, and its full cash effect is listed elsewhere.

INVESTING ACTIVITIES

In actuality, it would be pretty easy to look up this transaction in the journal.  The entry would look like this:

But, it is not necessary to refer to the journal.  Notice that land on the balance sheet decreased by $600,000 ($1,400,000 - $800,000), and that the income statement included a $150,000 gain.  Applying a little "forensic" accounting allows you to deduce that $600,000 in land was sold for $750,000, to produce the $150,000 gain.

Notice that equipment on the balance sheet increased by $150,000 ($1,050,000 - $900,000).  We could confirm that this was a cash purchase by reference to the journal; such is assumed in this case.

FINANCING ACTIVITIES

CASH FLOW RECAP

LINE C1, C2, C3 -- THE CHANGE IN CASH:  Emerson's cash flow statement reveals a $530,000 increase in cash during the year ($800,000 from positive operating cash flow, $600,000 from positive investing cash flow, and $870,000 from negative financing cash flow).  This change in cash is confirmed by reference to the beginning and ending cash balances on the balance sheet:

NONCASH INVESTING/FINANCING ACTIVITIES

LINE N1, N2 -- NONCASH INVESTING AND FINANCING ACTIVITIES:  Emerson issued $300,000 of preferred stock for a building.  This falls into the special section for revealing the noncash investing and financing events:

RECONCILIATION OF INCOME TO OPERATING CASH FLOWS:  The statement of cash flows just presented is specifically known as the "direct approach."  The direct approach is the preferred approach.  It is so named because the cash items entering into the determination of operating cash flow are specifically identified.  In many respects, this presentation of operating cash flows resembles a cash basis income statement.  An alternative "indirect" approach will be presented shortly.

But first, be aware that companies who choose to use the direct approach must supplement the cash flow statement with a reconciliation of income to cash from operations:

Notice that this reconciliation starts with the net income, and adjusts to the $800,000 net cash from operations.  Some explanation may prove helpful:

• Depreciation is added back to net income, because it reduced income but did not consume any cash.
• Gain on sale of land is subtracted, because it increased income, but is not related to operations (remember, it is an investing item and the "gain" is not the sales price).
• Increase in accounts receivable is subtracted, because it represents uncollected sales included in income.
• Decrease in inventory is added, because it represents cost of sales from existing inventory (not a new cash purchase).
• Increase in accounts payable is added, because it represents expenses not paid.
• Decrease in wages payable is subtracted, because it represents a cash payment for something expensed in an earlier period.

Now, this can get rather confusing.  Let's try to simplify it a bit.  First, you can probably see why depreciation is added back.

But, the gain is likely fuzzy.  It must be subtracted because you are trying to remove it from the operating number; it increased net income, but it is viewed as something other than operating, and that is why it is backed out.  Conversely, a loss on such a transaction would be added.

The increase in accounts receivable represents sales that increased income but not cash.  That is why it is subtracted.  If you can relate to the receivables, a pattern will develop for the other items:

Increases in current assets related to operations will be subtracted, but decreases will be added

and, vice versa:

Increases in current liabilities related to operations will be added, but decreases will be subtracted

Examine this pattern to satisfy yourself that it works for the inventory, accounts payable, and wages payable.  Now, you can logically extend the pattern to most any other operating adjustment that pertains to a current asset or current liability.

As a reminder, this reconciliation of income to operating cash is intended to supplement the direct approach to the statement of cash flows.  You will likely find the reconciliation in notes to the financial statements.

INDIRECT APPROACH TO PRESENTING OPERATING ACTIVITIES

INDIRECT METHOD:  As an alternative to the direct approach, companies may present an indirect statement of cash flows.  The indirect approach is mostly a repackaging of the information found in the direct approach.  It is so named because the "reconciliation" replaces the direct presentation of the operating cash flows.  The indirect approach is presented below.  Except for the shaded areas, this statement is identical to the direct approach:

The first shaded area reflects the substitution of the operating cash flow calculations.  The second shaded area reflects a rule that the indirect approach must be supplemented with information about cash paid for interest and taxes (these amounts are found in the operating activities section of the direct approach).

USING A WORKSHEET TO PREPARE A STATEMENT OF CASH FLOWS

THE WORKSHEET:  Given enough time and careful thought, one can generally prepare a statement of cash flows by putting together a rough shell that approximates the statements illustrated throughout this chapter, and then filling in all of the bits and pieces that can be found.  Ultimately, the correct solution is reached when the change in cash is fully explained.  This is like working a puzzle without reference to a supporting picture.  But, complex tasks are simplified by taking a more organized approach.  To that end, consider the value of a worksheet for preparing the statement of cash flows.

The worksheet examines the change in each balance sheet account and relates it to any cash flow statement impacts.  Once each line in the balance sheet is contemplated, the ingredients of the cash flow statement will be found!  Below is such a worksheet.

In this worksheet, the upper portion is the balance sheet information, and the lower portion is the cash flow statement information.  The change in each balance sheet row is evaluated and keyed to a change(s) in the cash flow statement.  When you have explained the change in each balance sheet line, you should have accumulated (in the lower portion) the information necessary to prepare a statement of cash flows.  Specific explanations for each keyed item follow:

The cash flow statement explanations are color coded such that blue is the final balancing step, red is cash outflow, black is cash inflow, and green is special.