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Financial Statement Analysis 101: Cash Flow Statement

Anonymous . IOMA's Report on Managing Credit, Receivables & Collections ; New York Vol. 10, Iss. 10, (Oct 2010): 10-12.

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Any conscientious credit professional can - with a little hard work - develop the basic skills needed to look through a financial statement and determine whether, how much, and under what terms to extend trade credit to that company. The cash flow statement entails the following: 1. Cash flow from operating activities; 2. Cash flow from investing activities; and 3. Cash flow from financing activities.

The cash flow statement reconciles the net effect of these flows with the difference in its cash holdings at the beginning and end dates of the reporting period.

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One of the more challenging responsibilities facing any credit professional is analyzing customers' (or suppliers') financial statements in order to determine their creditworthiness. Financial statements are often complicated and can be written to make a company look more financially sound than it actually is. In addition, all those tricky footnotes can be potential minefields.

That said, any conscientious creditprofessional can- with alittlehard work- develop the basic skills needed to look through a financial statement and determine whether, how much, and under what terms to extend trade credit to that company. To begin with, there are three basic components to a financial statement:

* Income statement;

* Balance sheet; and

* Cash flow statement.

In this article we will examine the cash flow statement, the income statement was covered in the August 2010 issue of MCRC ("Financial Statement Analysis 101: Income Statement") and the balance sheet in September's MCRC ("Financial Statement Analysis 101: Balance Sheet).

In addition to exploring the ins and outs of the cash flow statement, this article will conclude with an explanation of how all three components of the financial statement are interlinked.

Statement of Cash Flows

While the income statement and balance sheet have been required reporting for many years, the statement of cash flows is a relative newcomer. It has been included in corporate annual reports only since the 1970s.

Also sometimes called the "sources and uses of funds statement" or the "statement of changes in financial position," this part of a financial statement contains three sections:

* Cash flow from operating activities;

* Cash flow from investing activities; and

* Cash flow from financing activities (see accompanying Exhibit 1).

The cash flow statement reconciles the net effect of these flows with the difference in its cash holdings at the beginning and end dates of the reporting period.

After careful scrutiny of a statement of cash flows, credit pros might find themselves scratching their heads and wondering if they're missing something- or asking what the point of this statement is. Is there something here beyond the obvious "sources and uses of funds"?

No, the statement of cash flows is simply that- the cash the company either made or spent in three areas:

1) selling goods and services;

2) selling stocks and bonds; and

3) investing in its future growth.

So what's the point of this information from a credit pro's perspective? Investors simply like to see that the company can cover its spending with cash from operations, without having to turn to financing. That's about the sum of it.

Financial Statement Key Concepts

Financial statements are typically consolidated-very consolidated. However, the accounting that lies behind them is far more complicated than might appear from simply looking at an income statement or balance sheet.

The effort to keep track of the cash and accrual process keeps an entire department of any significant business very busy.

To successfully analyze financial statements, it's important, for example, to understand what is meant by the cash or accrual process.

There are two important concepts that you must know to understand the workings of the financial statements:

1) the matching principle; and

2) accrual accounting.

Matching Principle

For the majority of businesses, the income statement is governed by the so-called "matching principle." Generally accepted accounting principles (GAAP) requires companies to recognize revenues in the period that they are earned and to recognize the costs associated with producing those revenues in the same time period.

This means that the matching principle is applied independently of the cash transactions associated with earning the same revenues or paying the same costs. The income statement is in no way driven by cash transactions . Inflows and outflows of cash are captured on the statement of cash flows, and the balance sheet is the scorecard that keeps track of the differences between the two.

Accrual Accounting

Using the matching principle gives rise to the need for a system to keep track of what has been paid and what is owed. The system, or set of accounting techniques, is called "accrual accounting." The accounts created through using this system are stored in the general ledger (GL) .

To understand how this is done, credit pros first need to get a better picture of how accrual accounting works between the income statement and balance sheet (see Exhibit 2). To understand this graphic, MCRC readers need to understand two simple definitions from accrual accounting:

* An accrual is the recognition of revenue or an expense before the actual cash has either come in or gone out the door.

* Conversely, a deferral is the postponement of a revenue payment received in advance of the revenue being earned, or payment of an expense in advance of it being recognized.

Exhibit 2 illustrates the relationship between revenue and expenses from the income statement and assets and liabilities from the balance sheet.

How the Statements are Linked

As Exhibit 3 illustrates, the three parts of the financial statement are all interconnected in some way.

For example, Net Income from the Income Statement is connected to Retained Earnings. In the same way, retained earnings is connected to the balance sheet. It also becomes clear how cash on the balance sheet is connected to ending cash on the statement of cash flows.

When the statements connect up properly, you have the entire body of the company's finances.

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