Understanding Cash Flow Statements

Introduction

The cash flow statement provides information about a company’s cash receipts and cash payments during an accounting period. The cash-based information provided by the cash flow statement contrasts with the accrual-based information from the income statement. For example, the income statement reflects revenues when earned rather than when cash is collected; in contrast, the cash flow statement reflects cash receipts when collected as opposed to when the revenue was earned. A reconciliation between reported income and cash flows from operating activities provides useful information about when, whether, and how a company is able to generate cash from its operating activities. Although income is an important measure of the results of a company’s activities, cash flow is also essential. As an extreme illustration, a hypothetical company that makes all sales on account, without regard to whether it will ever collect its accounts receivable, would report healthy sales on its income statement and might well report significant income; however, with zero cash inflow, the company would not survive. The cash flow statement also provides a reconciliation of the beginning and ending cash on the balance sheet.

In addition to information about cash generated (or, alternatively, cash used) in operating activities, the cash flow statement provides information about cash provided (or used) in a company’s investing and financing activities. This information allows the analyst to answer such questions as:

• Does the company generate enough cash from its operations to pay for its new investments, or is the company relying on new debt issuance to finance them?

• Does the company pay its dividends to common stockholders using cash generated from operations, from selling assets, or from issuing debt?

Answers to these questions are important because, in theory, generating cash from operations can continue indefinitely, but generating cash from selling assets, for example, is possible only as long as there are assets to sell. Similarly, generating cash from debt financing is possible only as long as lenders are willing to lend, and the lending decision depends on expectations that the company will ultimately have adequate cash to repay its obligations. In summary, information about the sources and uses of cash helps creditors, investors, and other statement users evaluate the company’s liquidity, solvency, and financial flexibility.

This reading explains how cash flow activities are reflected in a company’s cash flow statement. The reading is organized as follows. Section 2 describes the components and format of the cash flow statement, including the classification of cash flows under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (GAAP) and the direct and indirect formats for presenting the cash flow statement. Section 3 discusses the linkages of the cash flow statement with the income statement and balance sheet and the steps in the preparation of the cash flow statement. Section 4 demonstrates the analysis of cash flow statements, including the conversion of an indirect cash flow statement to the direct method and how to use common-size cash flow analysis, free cash flow measures, and cash flow ratios used in security analysis. A summary of the key points and practice problems in the CFA Institute multiple-choice format conclude the reading.

The member should be able to:

1. compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items;

2. describe how non-cash investing and financing activities are reported;

3. contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP);

4. distinguish between the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method;

5. describe how the cash flow statement is linked to the income statement and the balance sheet;

6. describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data;

7. convert cash flows from the indirect to direct method;

8. analyze and interpret both reported and common-size cash flow statements;

9. calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.