Introduction
In the United States of America, the Financial Accounting Standard Board (FASB) has worked to develop standards that ensure a common framework for financial accounting and reporting. As new needs and issues are identified, FASB revises current standards and develops new components. The Statement of Cash Flows is part of the overall financial accounting framework required by FASB in the United States. It is the cash reconciliation of the information on both the Balance Sheet and the Income Statement (Moorehead, 22).
Why require a separate Statement of Cash Flows? Because a company’s Balance Sheet, Income Statement, and Retained Earnings Statement do not always paint a complete picture of the financial condition of the company. For example, Balance Sheets show the increase in equipment for the year, but they do not spell out how that equipment was financed or purchased. The Income Statement shows the investor net income, but it does not tell the investor the actual amount of cash generated. The Retained Earnings Statement displays cash dividends declared but does not display the cash dividends paid for that year. The Statement of Cash Flows does: it presents a summary of where cash came from and tells the investment community how it was used (Weygandt, et al., 711).
History
In 1987, the FASB adopted the Statement of Financial Accounting Standard (SFAS) 95 entitled “Statement of Cash Flows.” This standard mandated the Statement of Cash Flow as a required subset of a company’s financial statements if the company’s financial statements are audited. Companies with non-audited financial statements may leave out this important statement. The Statement of Cash Flow was designed to bridge the information gap between the traditional accrual basis of accounting and an awareness of the cash flow activities of a company. Prior to SFAS 95, a previous gap existed because the accrual method of accounting neglected to provide relevant information to assess the amount, timing and uncertainty of future cash flows.
The Statement of Cash Flow’s predecessor was the Statement of Changes in Financial Position (SCFP). Problems with the SCFP were the fact that it had not made clear the primary categories of cash flow activities, the SCFP could be prepared with either cash or working capital, and the term “cash” had never been defined. With the development and publication of SFAS 95, the primary categories of cash flow are defined as operating, investing and financing activities. SFAS 95 also defined cash to include cash equivalents with maturities of 90 days or less, such as treasury bills, commercial paper and money market funds (Zeller & Stanko, 55).
Since its inception, the Statement of Cash Flow has become an invaluable tool. Owners of the company use it to ensure they get the maximum return for their investments. The company’s managers use it to highlight strengths and weaknesses within the company. Suppliers may use it to ensure that their customers can make their payments, and customers might even check it to make sure that key vendors and partners will be in business for awhile. Many people find the Statement of Cash Flow to be even more important than the income statement, because they believe that cash flow is less susceptible to management manipulation (Weygandt, et al., 712).
Components
The Statement of Cash Flow is organized into three parts: Cash from Operating Activities, Cash From Investing Activities, and Cash from Financing Activities (Business Week, 102).
Cash from Operating Activities can alert the investment community to future issues with sales and earnings. When reporting cash flows from operating activities, the company should use one of two methods:
1) The direct method, where major classes of gross cash receipts and cash payments are disclosed, or
2) The indirect method, whereby net profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expenses associated with investing or financing cash flows (Weygandt, et al., 718, 728).
Cash from Investing Activities provides the investor with a great deal of information, from how much the company earned in the stock market to whether it’s cutting back on capital expenditures. In Cash from Financing Activities, the investment community can determine if a company receives cash infusions from outsiders, such as banks or shareholders (Business Week, 102).
Usefulness
How can the Statement of Cash Flows be used by the investment community to determine how healthy a company may be? One primary use is to help determine future risk. A company generally will record the revenue that drives earnings when their customers receive their merchandise, whether the customer has paid for the merchandise or not. The Statement of Cash Flows can show the investment community how much cash is actually collected. So, if earnings are good yet cash collections are not, the investor should be worried: future earnings could be at risk if bad debt becomes an issue.
Investors can also get a feel for whether or not a company is playing earnings games by comparing net income on the Income Statement with Cash from Operating Activities from the Statement of Cash Flows. Investment analysts typically like to see a ratio of those two numbers close to one, because the closer it is to one, the higher-quality the earnings are considered.
Investment experts also like to compare the rates at which net income and operating cash are growing. If the two have historically moved at similar rates but cash is now slowing, it represents an early warning sign that the company may soon experience issues. Accounting experts pay a great deal of attention to accounts receivable, representing what customers owe the company. When receivables rise at a faster pace than sales, the company may be having trouble collecting what its customers owe. Since cash isn’t flowing in as it should be, a rise shows up as a negative on the cash-flow statement.
An analysis of the Statement of Cash Flows can also provide an early warning that demand for the company’s products are softening. Because the purchase of inventory requires cash, an increase in inventory causes cash to fall. On the other hand, when liabilities such as accounts payable increase, so should a company’s cash balances. By delaying payment to its creditors, management can free up cash. This is not always a good thing for the company to do, because it could be stringing its customers, partners, and vendors along (Business Week, 102).
Shortcomings
While the Statement of Cash Flow is considered harder to manipulate than earnings, it is still possible for a company to use tricks to keep its books in line with the investment community’s expectations. The tricks that are commonly used aren’t illegal, and they can’t be counted on to repeat. Therefore, it is important for potential investors to be aware of them. The most common ploy used is to inflate Cash from Operations (Business Week, 102).
Even though FASB began the requirement for Statement of Cash Flows in an attempt to provide investors with additional data about the financial health of a company, the full set of financial statements still does not protect the investor from his or her own misjudgment. Also, the full set of financial statements is not perfect and the investment community can still be tricked, even if only for a short period of time. Still, the mantra on Wall Street continues to be “Investor Beware”, as we have continued to see corporate scandals erupt (such as Enron) even after the implementation of SFAS 95.
Bibliography
“The Ins and Outs of Cash Flow.” Business Week 3716, Jan 22, 2001. p. 102.
Moorhead, Cindy. “The Workings of The Statement of Cash Flows.” Business Credit 103.8, Sept 2001 p. 22.
Weygandt, Jerry J., Kieso, Donald E., and Kimmel, Paul D. Accounting Principles, 7th Edition, John Wiley & Sons, Inc. 2005 pp. 711 – 712.
Zeller, T.L. & Stanko, B.B. 1994. “Operating Cash Flow Ratios Measure a Retail Firm’s ‘Ability to Pay'”. Journal of Applied Business Research, vol. 10(4), pp. 51-59.
