Financial Analysis and the Statement of Cash Flows

Financial Statement Analysis

Anyone wishing to study this textbook can learn valuable insights about accounting. Does the mere fact that this book exists mean that everyone knows about accounting principles? Obviously not. By analogy, the same can be said about financial information. Many companies spend substantial amounts of money preparing and presenting financial statements that are readily available(the reports for USA public companies can be found at www.sec.gov). Does this mean that everyone has in-depth knowledge about these companies? Again, no. Some degree of study is required to benefit from the information.
It is important 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. But, if financial statement users choose to ignore that report, only they are to blame.
Investors must be very thorough in examining the financial statements of companies in which they are considering making an investment. Sometimes, the evaluation of complex situations can be assisted by utilization of key metrics or ratios. For example, a doctor will consider a patient’s health by taking measurements of blood pressure, heart rate, cholesterol level, and so forth. Likewise, consideration of a company’s health can be measured with certain important ratios.

detailed example

This book has introduced financial statement ratios and analysis techniques throughout many of the previous chapters. The following tables include a recapitulation of those ratios, including cross references back to chapters where the ratios were first introduced. If any of the ratios are unclear, it may prove helpful to refer back to the earlier chapters for more detail on the calculation and interpretation of the ratios. The right hand column of the tables include specific calculations for Emerson Corporation. Comprehensive financial statements for Emerson follow the tables. Be sure to verify each ratio calculation to the data included in those financial statements.

balance Sheet

additional facts for emerson

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 stock 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).
It appears that Emerson is doing fairly well. Its liquidity suggests no problem in meeting obligations, the debt is manageable, receivables and inventory appear to be turning well, and profits are good.

statement of retained earnings

Income statement

TREND ANALYSIS

Analysts often reproduce financial statement data in percentage terms. For example, Emerson’s cash is 17% of total assets ($700,000/$4,100,000). These data provide investors and managers with a keen sense of subtle shifts that can foretell changes in the business environment. This approach is sometimes called “common size” financial statements, as applied to the balance sheet data below:

Cash Flow and the Statement of 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, but may be experiencing delays in collecting receivables, and this can impose liquidity constraints. Or, a business may be paying dividends, but only because cash is produced from the disposal of core assets. Sophisticated analysis will often reveal such issues.
Rather than depending upon 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.
One objective of financial reporting is to provide information that is helpful in assessing the amounts, timing, and uncertainty of an organization’s cash inflows and outflows. As a result, the statement of cash flows provides 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.

OPERATING, INVESTING, AND FINANCING 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 from the sale of “trading securities”). Cash outflows consist of payments for inventory, trading securities, employee salaries and wages, taxes, interest, and other normal business expenses. 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.
Cash inflows from investing activities result from items such as the sale of longer-term stock and bond investments, 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 plant assets or long-term investments in other firms, loans to others, and similar items.
Cash inflows from financing activities include proceeds from a company’s issuance of its own stock or bonds, borrowings under loans, and so forth. Cash outflows for financing activities include repayments of amounts borrowed, acquisitions of treasury stock, and dividend distributions.
There are potential distinctions between US GAAP and international accounting standards. IFRS permits interest received (paid) to be disclosed in the investing (financing) section of a cash flow statement. The global viewpoint also provides more flexibility in the classification of dividends received (and paid). Additionally, international standards encourage disclosures of cash flows that are necessary to maintain operating capacity, versus cash flows attributable to increasing capacity.

NONCASH INVESTING AND FINANCING ACTIVITIES

Some investing and financing activities occur without generating or consuming 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.
Under US GAAP, the statement of cash flows includes a separate section reporting these noncash items. Thus, the statement of cash flows is actually enhanced to reveal the totality of investing and financing activities, whether or not cash is actually involved. The international approach is to present such information in the notes to the financial statements.

Direct Approach to the Statement of Cash Flows

Spend just a few moments reviewing the preceding balance sheet, statement of retained earnings, and income statement for Emerson Corporation. Then, examine the following statement of cash flows. Everything within this cash flow statement is derived from the data and additional comments presented for Emerson. The tan bar on the left is not part of the statement; it is to facilitate the “line by line” explanation that follows.

OPERATING ACTIVITIES

Notice that Line 01 appears as follows:

Emerson’s customers paid $3,000,000 in cash. Emerson’s information system could be sufficiently robust that a “database query” could produce this number. On the other hand, one can infer this amount by reference to sales and receivables data found on 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)

=

$3,250,000 - ($850,000 - $600,000)

=

$3,000,000

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. Thus, cash received from customers was $3,000,000. If net receivables had decreased, cash collected would have exceeded sales.

Emerson paid $1,050,000 of cash for inventory. Bear in mind that cost of goods sold is the dollar amount of inventory sold. But, the amount of inventory actually purchased will be less than this amount if inventory on the balance sheet decreased. 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. On the other hand, 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)

=

$1,160,000 - ($220,000 - $180,000)

=

$1,120,000

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 Purchased Minus the Increase in Accounts Payable (or, plus a decrease in accounts payable)

=

$1,120,000 - ($270,000 - $200,000)

=

$1,050,000

Emerson paid $480,000 of cash for wages during the year. 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)

=

$450,000 + ($50,000 - $20,000)

=

$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.

Emerson’s cash payments for these items equaled the amount of expense in the income statement. Had there been related balance sheet accounts (e.g., interest payable, taxes payable, etc.), then the expense amounts would need to be adjusted in a manner similar to that illustrated for wages.
Overall, operations generated net positive cash flows of $800,000. Notice that two items within the income statement were not listed in the operating activities section of the cash flow statement:

• Depreciation is not an operating cash flow item. 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 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.

INVESTING ACTIVITIES

The next major section of the cash flow statement is the cash flows from investing activities. This section can include both inflows and outflows related to investment-related transactions. Emerson Corporation had one example of each; a cash inflow from sale of land, and a cash outflow for the purchase of equipment. The sale of land requires some thoughtful analysis. Notice that the statement of cash flows for Emerson reports the following line item:

This line item reports that $750,000 of cash was received from the sale of land during the year. In actuality, it would be possible to look up this transaction in the company’s journal. The journal entry would appear as follows:

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 one to deduce that $600,000 in land was sold for $750,000, to produce the $150,000 gain.

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

FINANCING ACTIVITIES

This line reveals that $80,000 was received from issuing common stock. This cash inflow is suggested by the $10,000 increase in common stock ($910,000 - $900,000) and $70,000 increase in additional paid-in capital ($370,000 - $300,000).

The statement of retained earnings reveals that Emerson declared $50,000 in dividends. Since there is no dividend payable on the balance sheet, one can assume that all of the dividends were paid.

The balance sheet reveals a $900,000 decrease in long-term debt ($1,800,000 - $900,000). This represented a significant use of cash.

CASH FLOW RECAP

Emerson had 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.

NONCASH INVESTING/FINANCING ACTIVITIES

The noncash investing and financing section reports that preferred stock was issued for a building.

RECONCILIATION

The statement of cash flows just presented is known as the direct 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 acceptable alternative is the “indirect” approach. Before moving on to the indirect approach, be aware that companies using the direct approach must supplement the cash flow statement with a reconciliation of income to cash from operations. This reconciliation may be found in notes accompanying the financial statements:

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.

This can become rather confusing. Most can probably see why depreciation is added back. But, the gain may be fuzzy. It must be subtracted because one is 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. Remember, the full proceeds of an asset sale are reported within investing activities, regardless of whether the sale produced a gain or loss.
The following drawing is useful in simplifying consideration of how changes in current assets and current liabilities result in reconciliations of net income to operating cash flows. Begin by thinking about a reconciling item that is fairly easy to grasp. Emerson’s accounts receivable increased on the balance sheet, but the amount of the increase was subtracted in the reconciliation (again, this increase reflects sales not yet collected in cash, and thus the subtracting effect). In the drawing below, consider that accounts receivable is a current asset, and it increased. This condition relates to the upper left quadrant; hence the increase is shown as “subtracted.”

Using the accounts receivable analysis as a benchmark, it then becomes logical that all increasing current assets result in subtractions in the reconciliation. This relationship is inversed for current liabilities, as shown in the upper right quadrant of the drawing. Similarly, these relationships are further inversed for account decreases as shown in the bottom half of the drawing. With the drawing it mind, it becomes a simple matter to examine changes in specific current accounts to determine whether they are generally added or subtracted in the reconciliation of net income to cash flows from operating activities. Using the Emerson example:

Indirect Approach to Presenting Operating Activities

Although accounting standards encourage the direct approach, most companies actually present an indirect statement of cash flows. The indirect approach is so named because the “reconciliation” replaces the direct presentation of the operating cash flows. 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 that the indirect approach must be supplemented with information about cash paid for interest and taxes.

Using a Worksheet to Prepare a Statement of Cash Flows

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! A sample worksheet for Emerson is presented on the following page.
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 one has explained the change in each balance sheet line, the accumulated offsets (in the lower portion) reflect the information necessary to prepare a statement of cash flows.
Specific explanations for each keyed item in the worksheet are found in the following table. 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.