Basic Accounting:
The Benefits of the Cash Flow Statement
For this last article in the series on the Cash Flow statement, let's do a brief review of the importance and benefits we have discussed of the Cash Flow Statement.
The Statement of Cash Flows is the final document prepared in the Financial Report set, and provides information that is a direct flow of information from the Income Statement, Owner Equity Statement and Balance Sheet; therefore, this report adds validity and accountability to the Financial Statements.
Analysts, investors, stockholders, potential investors and lenders use these reports in order to assess the financial health of a business. Therefore, it is tremendously advantageous to use the standard method for generating the Statement of Cash Flows and provide the additional credibility to the financial information.
In the area of "operating activities" there are some numbers that will give you an indication of the daily operations of the business, and if the business is profitable. The bottom line in this section titled "net cash from operating activities" includes some information from the statement of earnings such as:
- Net earnings, or the company's profit or loss
- Depreciation expense
Net earnings figures in the operating activities information is hard to dispute; either the business was profitable, or it was not.
This line also includes information that is calculated on the statement of owner's equity such as:
- Changes in inventory
- Changes in accounts receivable
- Changes in accounts payable.
A number here that seems particularly out of line with the industry norm would be a red flag to investigate further. The figure might be the result of increased profitability, in which case the general prognosis would be a healthy company. But what if the number is a result of excess obsolete inventory, or extremely high accounts payable figures? Any of these reasons would indicate problems, and if you're reviewing the cash flows to purchase the business, this would be a tip off to investigate and delve deeper.
Of course, as we discussed earlier, significant changes in
the totals for investing or financing activities would indicate that there are
either capital improvements, or a need to pay investor dividends; either
situation would at first glance look appealing. However, examination
of the notes that accompany the statement should also shed light on the true
meaning of the number changes. Be wary of these notes, read them and cross
reference them to the other statements included in the annual report.
And as a final note, the interdependence shared by the Balance Sheet and the Statement of Cash Flows can be found in the investing and financing section of the Statement of Cash Flows and the Assets and Liabilities areas of the Balance Sheet.
When changes occur in the assets of a business, these changes are reflected in the asset values reported on the Balance sheet. Quite often, purchases of equipment, machinery, buildings, and property are necessary. A purchase increases the fixed asset value of the company; it is also a change that is reflected in the Net Cash from investing activity. When a company spends money to purchase equipment, machinery, buildings or property, if the money spent is taken from cash, there will be a significant change in this area of the Statement of Cash Flows. If the money is borrowed, there will be a significant change in the Net Cash from financing activity.
Changes found in these areas should flag the need for further examination of the Balance sheet in order to accurately assess the actual financial condition of the business. When you see significant changes in the balances for the financing and investing totals, there should also be changes in the assets and liabilities area of the Balance sheet.
Also, read the Annual report. There is information within the report that might work in conjunction with the financial statements to give an indication as to the true state of the financial health.
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.