Cash flow statement example

The statement of cash flows has been a required part of annual financial statements for more than two years. While there has been considerable support for this statement since its proposal in 1986, little has been written or developed on the effective use or analysis of it. This article provides suggested ratios that can be used by financial statement users to analyze and evaluate corporate cash flows.

Analysts have traditionally evaluated financial statements using financial ratios. Any text on corporate reporting or any analyst's report contains ratios comparing information from the balance sheet and income statement. These ratios are used for comparison with prior years, other companies or industry norms. To date, neither text writers nor analysts have developed ratios for effective evaluation of the statement of cash flows. Such ratios, used in conjunction with traditional balance sheet and income statement ratios, should lead to a better understanding of the financial strengths and weaknesses of the underlying entity.

PURPOSE OF THE STATEMENT

OF CASH FLOWS

The Financial Accounting Standards Board, which issued Statement no. 95, Statement of Cash Flows, in November 1987, describes the primary purpose of the cash flow statement as providing relevant information about an enterprise's cash receipts and payments during a particular period. The FASB suggests this statement be used by investors, creditors and others to assess

* An enterprise's ability to generate future positive net cash flows.

* An enterprise's ability to meet its obligations and pay dividends, and its needs for external financing.

* The reasons for differences between net income and associated cash receipts and payments.

* The effects on an enterprise's financial position of both its cash and noncash investing and financing transactions during the period.

If cash flow information is useful but unused, the logical conclusion is the business world is not analyzing available data properly. The solution is to develop tools that allow comparison of companies on a year-to-year basis and across companies. Although this article limits its approach for measuring performance to cash flow ratios, use of trend analysis and an evaluation of traditional accrual-based ratios are equally important in the analysis of financial statements.

CONTENTS OF CASH FLOWS

The statement of cash flows requires cash flow disclosure by the functional areas of operating, investing and financing. While cash flows from investing and financing are important components, the most scrutinized figure is likely to be cash flow from operations. While this is a key figure, it is important to consider the impact of abnormal transactions such as those related to unusual events, discontinued operations or extraordinary items it may contain. When using ratios to predict future cash flows, the inclusion of such items obviously would distort continuing cash flows and could mislead potential investors. Similar problems exist if unusual one-time transactions are included in cash flows from operations.

The important point is that cash flow from operations, just like income from operations, can include a diverse mix of transactions representing a variety of unusual events. Analysis should include cash provided by normal operating activities only. This approach has been adopted when defining cash flow from operations in the ratios discussed below.

ASSESSING SOLVENCY

AND LIQUIDITY

One objective of Statement no. 95 is the assessment of an enterprise's ability to meet its obligations and pay dividends. An analysis should determine whether the enterprise is able to generate enough cash to do this. Recommended cash flow ratios that analyze a company's ability to meet these obligations include cash interest coverage, cash debt coverage and cash dividend coverage. These ratios are illustrated in exhibit 1, page 67.

Cash interest coverage. The cash interest coverage ratio should complement the traditional interest coverage ratio. The ratio tells investors the number of times cash outflows for interest are covered by cash flows from operations. The ratio, when compared with the industry norm, indicates company liquidity and its ability to meet interest commitments. It also helps investors and creditors determine the extent to which cash flows could fall before the company risks default on its interest payments.

The traditional accrual-based interest coverage ratio uses income before interest and taxes divided by interest expense. Accrual-based income includes many non-cash-flow items, such as write-down of assets or gains on the sale of operating assets, and therefore may not clearly show a company's ability to meet actual interest payments. A better measure would be cash flows from operations before interest and taxes divided by interest payments.

Statement no. 95 makes the adjustment for interest and taxes easier by requiring separate disclosure of these cash flows. Unfortunately, this information may not be entirely accurate. Many companies have adopted the practice of showing cash flows for interest net of capitalized interest, which understates the true cash outflows associated with interest costs. It is essential, therefore, to evaluate the provided footnote disclosure figures carefully to determine whether additional adjustments should be made.

Cash debt coverage. A company's ability to continue as a going concern is dependent not only on meeting current interest payments but also on repayment of debt principal. Two measures used by bankers to determine an entity's ability to repay its debt are the ratio of retained operating cash flow to total debt and the ratio of retained operating cash flow to current maturities of debt. Retained operating cash flow measures the cash available for reinvestment that was generated by operations. It normally is defined as cash flow from operations less all dividend payments.

Both ratios indicate the time period required to free the company from its obligations using retained cash flows from operations to repay the debt. The first ratio takes total debt into consideration and thus shows the number of years current cash flows will be needed to meet this obligation. The second ratio indicates whether retained operating cash flow is sufficient to meet current maturities of long-term debt.

An alternative formulation of these two ratios could include existing cash and cash equivalents with retained operating cash flow. The argument here is these funds also are available to meet payment of debt. Additional modification of these ratios can include adding current liabilities or other fixed commitments such as lease obligations to the debt portion of the ratio.

Varying compositions of debt or liability commitments, or both, can result in a substantial number of ratios that measure the company's ability to meet future commitments. A consensus should be reached on which definition produces the most relevant ratio.

Cash dividend coverage. The cash dividend coverage ratio provides evidence of the ability to meet current dividends from normal operating cash flow. This ratio can evaluate a company's ability to pay all dividends or its ability to pay dividends to common stockholders. The ability of the company to pay all dividends is reflected by cash flow from operations divided by total dividend payments. To compute cash dividend coverage for common stockholders, dividends to preferred stockholders and minority stockholders in subsidiary companies are subtracted from cash flow from operations and the result is divided by cash payments to common stockholders.

Different approaches can be used to define dividend payments. The approach used is a function of whether dividend coverage is based on the ability to meet current dividends or future dividends. If the company has followed a policy of not regularly increasing dividends, it can use the cash paid for ordinary dividends as reported in the cash flow statement. Alternatively, if dividends are increasing constantly, the total dividends declared in the current year should be employed as a more up-to-date measure of prospective cash dividend requirements.

QUALITY OF INCOME

A second major reason cited in Statement no. 95 for requiring a statement of cash flows is it will assist users in determining reasons for differences between net income and associated cash receipts and payments. The reasons for these differences provide a basis for evaluating the quality of income. The measurement of cash flows is perceived as being more reliable and more objective than the measurement of income because the latter involves more judgment about accruals, allocations and valuations. Ratios that could be used to evaluate the quality of income are cash quality of sales and cash quality of income. These are illustrated in exhibit 2, below.