Cash Flow: A Good Predictive Indicator

One of the most overlooked accounting statements is the Statement of Cash Flows.  Using this can help transform a static balance sheet and accrual based income statement into a dynamic assessment of the company’s health.  An analysis of cash flow helps you know who did what to whom in the financial sense and an accurate cash budget is a good roadmap for what will occur in the future.

The reason behind looking at cash flows is simple, as net income is a creation of accrual accounting.  While this is subject to well defined rules, which are sometimes violated by the small business, accrual accounting is open to interpretation by those that use it in company financial reporting.  The primary purpose of the statement is to provide relevant information regarding cash receipts and cash payments for a certain period of time.  The user can see the ability of the company to generate cash flow, both now and in the future with the use of a cash budget.  Cash is important to understand since obligations are paid for with cash.

The Statement of Cash Flows is divided up into three sections each focusing on a different classification of a source and use of cash:  operations, investing, and financing activities.  Cash flow from operations shows the receipt and disbursement of cash from items that occur in the course of business.  It will reconcile to net operating income once changes in receivables, inventories and payables are taken into account.  

The second section covers cash flows from investing activities. This would cover monies the company pays to purchase equipment, assets, or property.  Purchases are shown as a use of cash and receipts from sale of assets are shown as a source of cash.  It is valuable for the lender to inspect several years of cash flow statements to uncover reoccurring cash expenses for assets used in the production of income. A good example here would be a hotel.  The hotel would have a lot of items like beds, desks, chairs, dressers, carpet, and tables that are necessary in the production of income.  These items need to be replaced every so often.  Understanding when these cash expenditures are needed will help the lender see future cash requirements of the business.

The last section covers cash flows from financing activities.  Here cash paid out for loan payments, dividends, or owner distributions are shown as a use of cash while new borrowings and capital injections are a source of cash.  Understanding if a company requires a constant injection of cash from financing activities will lead the lender to analyze the probability of those funds continuing in the future. 

There are several different ratios that can be derived from the statement to give a picture of the health of the company:

Cash Power of Sales = Cash Flow from Operations / Sales.  This indicates how changes in sales impact cash flow and how much of each sales dollar is available to management.

Quality of Income = Cash Flow from Operations / Net Income.  Determines how much cash flow is represented by each dollar of net income.

Interest Coverage = (Cash Flow from Operations + Interest Paid + Taxes Paid) / Interest Paid.  This assesses a firm’s ability to keep its interest requirements current.

Comfort Level = Cash Flow from Operations / Financing & Investing Outflows.  This shows the borrower’s ability to meet its financing and investment commitments from cash generated internally.

Management Factor = (Cash Flow from Operations – Debt Repayment) / Cash Flow from Operations.  This determines just how much internal cash flow is left to management discretion. 

High cash flows and earnings are characteristic of financially strong companies.  On the other hand, weak earnings reports and miserable cash flow are symptoms of a weak company.  Young, fast growing profitable companies may tend to realize sizeable costs in order to keep receivables and inventory growing.  Cash flows from operations may fall short of net income in their start-up years.  Well-established companies may periodically encounter the same situation when experiencing a growth spurt, but it could show the potential for bankruptcy if this becomes an ongoing trend.  Measuring the strength in cash flow is the most effective means of using financial statements as a predictive tool of future performance and must be used by the lender in making the credit decision.--Phil Love