LOS H requires us to:
analyze and interpret both reported and common-size cash flow statements.
In order to analyze and interpret the cash flow statement, we need to note the following important things:
1. Major Sources and Uses of Funds
The first step in the analysis of the cash flow statement is to identify and analyze the major uses and sources of funds of the firm.
The uses and the sources of funds differ across different entities and across the stages of growth of the firm. In the early stage, usually, the cash flows from operations are negative. This negative cash flow is financed by the cash from financing activities. Whereas, when the firm grows or as it reaches its maturity the cash from operations is not only positive but also exceeds the cash from investing and financing activities taken together.
Thus, the degree of cash flow from the operating activities, financing activities, and investing activities reflect not only the solvency and liquidity of the firm; but also reflects the stage of maturity.
2. Operating Cash Flow
An analyst needs to:
a. Identify if the operating cash flows are the sources or use of cash, and once they are identified then determine how they are used.
b. Compare the cash from operations with the net income; it is an indicator of the quality of earnings (high net income is only useful if it gets translated into cash flow from operations).
c. Compare the net income with cash from operations to assess the degree of maturity of the firm.
d. Look for the consistency of cash from operations; this gives an idea about the degree of risk associated with the firm.
3. Investing Cash Flow
While analyzing the cash from investing activities an analyst needs to:
a. the sources and uses of cash,
b. if the cash from operations is sufficient to cover the capital expenditure, or the firm needs other sources of finance,
c. if the cash from investing activities is positive, then identify the assets sold during the year (this will clear question about the going concern status of the firm).
4. Financing Cash Flows
The financing cash flow gives a good idea about the:
a. whether the firm is raising or repaying the capital,
b. the reasons for doing the same, and
c. if the firm is repurchasing shares:
i. are there no other investment opportunities, or
ii. is the firm replacing the dividends with the capital gains to the investors?
5. Common-Sized Cash Flow Statements
Like the common-sized balance sheet and common-sized income statement, a firm can also prepare a common-sized cash flow statement. This can be done in two ways:
a. Taking the total cash inflows as a base (as 100 %) and calculating all the other items as a percentage of it; and
b. Taking the total cash outflows as a base (as 100 %) and calculating all the other items as a percentage of it.
As per the direct method inflows and outflows are already separated, however in the indirect method, the inflows and outflows are mixed. They need to be separated first and then we can go ahead with preparing a common-sized cash flow statement.
Another way of preparing a common-sized cash flow statement is by expressing each line item as a percentage of net revenues. This is a pretty simpler way of preparing the common-sized cash flow statement.
Common sized cash flow statements are very useful in the sense:
a. It makes it easy to identify the trends and
b. Help in better forecasting of cash flow.