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Understanding the Cash Flow Statement

Originally Published: May 2010


The Cash Flow Statement – also referred to as statement of cash flows or funds flow statement – is one of the three financial statements commonly used to gauge a company’s performance and overall health. The other two financial statements -- Balance Sheet and Income Statement -- have been addressed in previous articles.

As the name implies, the Cash Flow Statement provides information about an organization’s cash inflows and outflows over a specified time period. Simply put, it reveals how a company spends its money (cash outflows) and where that money comes from (cash inflows).

The Cash Flow Statement is the best resource for testing a company’s liquidity because it shows changes over time, rather than absolute dollar amounts at a specific point in time. It's also useful in determining the short-term viability of a company.

It's important to note that the Cash Flow Statement reflects a firm’s liquidity. It does not show profitability – the Income Statement does that.

How the Cash Flow Statement is Prepared

There are two methods of preparing the Cash Flow Statement: direct and indirect.

  1. The direct method utilizes actual cash flow information from the company’s operations. It presents major classes of gross cash receipts and payments. The direct method would most likely be used by small firms doing their accounting on a cash rather than an accrual basis.

  2. The indirect method derives the data from the Income Statement and from changes on the Balance Sheet from one period to the next. Both the Income Statement and the Balance Sheet are based on accrual accounting.
Note #1: Net Income on the LLH 2009 Consolidated Statement of Cash Flows is $26,924,000. This number was taken from Net Income as listed on the LLH 2009 Consolidated Statements of Income.
Note #2: The 2009 Net Increase in Cash and Cash Equivalents ($536,000) on LLH’s Consolidated Statement of Cash Flows (third line from bottom) is actually the difference between the 2009 and 2008 Cash and Cash Equivalents ($35,675,000 minus $35,139,000 = $536,000) on LLH’s Consolidated Balance Sheets.

The U.S. GAAP (Generally Accepted Accounting Principles) requires that a Cash Flow Statement prepared by the indirect method be included in financial statements, even if it is also prepared by the direct method. Therefore, most companies use the indirect method and the rest of this article refers only to the indirect method.

Components of the Cash Flow Statement and What They Tell Us

The Cash Flow Statement organizes and reports cash in three categories: operating, investing and financing.

Operating Activities

This represents the key source of an organization’s cash generation. It's considered by many to be the most important information on the Cash Flow Statement.

This section of the Cash Flow Statement shows how much cash is generated from a company’s core products or services. A strong, positive cash flow from operations (especially over time) is a good sign of a healthy company.

Operating Activities starts with the Net Income number from the Income Statement.

Example #1: LLH’s Net Income number on the Income Statement and the Cash Flow Statement are the same.

  2009 2008 2007
Net Income (Income Statement, line 10) 26,924,000 22,149,000 11,326,000
Net Income (Cash Flow Statement, line 1-Operating Activities) 26,924,000 22,149,000 11,326,000


If all of a company’s operating revenues and expenses were in cash, then Net Cash Provided by Operating Activities (Cash Flow Statement) would equal Net Income (Income Statement). However, this is rarely the case. Typically, the Net Income must be adjusted on the Cash Flow Statement based on an increase or decrease in cash calculated from changes on the Balance Sheet from one period to the next.

Example #2: Merchandise Inventories on LLH’s Consolidated Balance Sheet

Merchandise Inventories (Balance Sheet)  2009 =
133,342,000
2008 =
88,731,000
Difference in inventory 2009 over 2008
(recorded on Cash Flow Statement)
133,342,000 -
88,731,000 =
+ $44,611,000

The increase in merchandise inventories in 2009 results in a negative adjustment of the same amount ( $44,511,000) on the 2009 LLH Consolidated Statement of Cash Flows.

Most of these adjustment items can either result in an increase or decrease in cash from operating activities. Exceptions would be adjustments for depreciation and amortization, which are always an increase to Net Income on the Cash Flow Statement.

Look for consistent levels of cash flow from Operating Activities over time, indicating the company will probably continue to be able to fund its operations.

Investing Activities

This section records changes in equipment, assets or investments.

Cash changes from investing are generally considered “cash outflows” because cash is used to purchase equipment, buildings, or short-term assets. When a company divests an asset, the transaction is considered a “cash inflow”. A healthy company generally invests continually in plant, equipment, land and other fixed assets.

Financing Activities

Changes in debt, loans or stock options, long-term borrowings, etc. are accounted for under Financing Activities.

When capital is raised, it is considered “cash in”; when dividends are paid or debt is reduced, “cash out”. The Financing Activities section shows how borrowing affects the company’s cash flow.

“Bottom Line”

The bottom line on the Cash Flow Statement is the Net Increase (Decrease) in Cash and Cash Equivalents. It's determined by calculating the total cash inflows and outflows for each of the three sections in the Cash Flow Statement.

The 2009 Net Increase (Decrease) in Cash and Cash Equivalents on the Cash Flow Statement should equal the difference between the 2009 and 2008 Cash and Cash Equivalents figures on the Balance Sheet.


Example #3: LLH Balance Sheet Year Ended December 31, 2009

Net Increase (Decrease) in Cash and Cash Equivalents
Net Cash Provided by Operating Activities 
 minus Net Cash Used in Investing Activities 
 plus Net Cash Provided by Financing Activities

2009 Statement of Cash Flows    2009 Balance Sheet
(cash and cash equivalents)
7,812,000 (operating)
-11,433,000 (investing)
+4,157,000 (financing)
= 35,675,000 (2009)
-35,139,000 (2008)
536,000 (bottom line) = 536,000

The last two lines on the LLH Consolidated Statement of Cash Flows are simply a reiteration of the Cash and Cash Equivalents figures from the Balance Sheet.

Supplemental Information

There is a fourth section, titled “Supplemental Information”, which is often included with the primary three sections of the Cash Flow Statement. It reports the exchange of significant items, such as company stock for company bonds, which did not involve cash.

This section also records the amount of income taxes and interest paid. The LLH Consolidated Statement of Cash Flows does not include Supplemental Information.

Using the Cash Flow Statement to Determine the Financial Health of an Organization

The Cash Flow Statement shows how a company raised money (cash) and how it spent those funds during a given period. It's a tool that measures a company’s ability to cover its expenses in the near term.

Generally, a company is considered to be in “good shape” if it consistently brings in more cash than it spends.

Note #3: Note the Net Increase in Cash and Cash Equivalents figures on the LLH Consolidated Statement of Cash Flows. For the last 3 years (2009, 2008, 2007), LLH has consistently brought in more cash than it has spent. However, there has been a steady and precipitous decline from $29,203,000 positive cash flow in 2007 to just $536,000 positive cash flow in 2009.

Cash flow reflects a company’s financial health, and its ability to pay its bills and other liabilities.

In most cases, the more cash available for business operations, the better. However, a low or negative cash flow in one year could result from a company’s growth strategy – and, therefore, not be a real issue. As with all financial analysis, it's important to determine the company’s cash flow trend.

“High Quality” Net Income
To determine if a company’s net income is of “high quality”, compare the Net Cash Provided by Operating Activities to the Net Income. Both of these figures are found on the Cash Flow Statement. The Net Cash Provided by Operating Activities should be consistently (over time) greater than the Net Income.

Note #4: On LLH’s Consolidated Statement of Cash Flows, you can see that 2009 Net Cash Provided by Operating Activities is less than in 2007 and 2008. The largest difference with Net Income – $19,112,000 – also occurs in 2009. This is not a good sign. It's important to understand, however, where the decrease is coming from.

In 2009, the largest “cash outflow” ($44,611,000) is from Merchandise Inventories, probably meaning LLH has a lot of inventory on hand (more than the previous two years) that hasn’t yet been sold and turned into cash. The question to be answered is – Why is this the case?

Cash Flow-based Financial Ratios

The problem with using the Balance Sheet for liquidity analysis is that it only presents data that measures where the organization stands at a particular point in time.

The problem with the Income Statement is that it includes many non-cash allocations, accounting conventions, accruals and reserves that have nothing to do with cash.

Utilizing the Cash Flow Statement for liquidity analysis results in a more dynamic picture of the resources a company has to meet its current financial obligations.

Ratio #1: Cash Flow to Sales = Operating Cash Flow ÷ Net Sales

This ratio determines how much cash is being generated for each dollar of sales. Obviously, the higher the number, the better.

Example #4: LLH Cash Flow to Sales
Year  Cash Flow Statement
Net Cash Provided by Operating Activities
  Income Statement
Net Sales
  Cash Generated for Each Dollar of Sales
2009 7,812,000 ÷  544,568,000  $0.01
2008  9,361,000 ÷  482,179,000 =  $0.02
2007  8,512,000 ÷  405,307,000 =  $0.02

Is this good or bad? At first glance, just one or two cents cash generated by each one dollar of sales doesn't look good. To make a more accurate assessment, however, you should compare this performance to industry benchmarks. In addition, you'll want to determine why the cash generated is so low.

Ratio #2: Operation Index = Net Cash from Operations ÷ Net Income after income tax

This measures the relationship between operating cash flows and profit. The higher the percentage, the better.

Example #5: LLH Operation Index

Year  Cash Flow Statement
Net Cash Provided by Operating Activities
  Income Statement
Net Income
  Operation Index
2009 7,812,000 ÷  26,924,000 29.0%
2008  9,361,000 ÷  22,149,000 = 42.0%
2007  8,512,000 ÷  11,326,000 = 75.2%

 
Ratio #3: Operating Cash Flow Ratio = Cash Flow from Operations ÷ Current Liabilities

This ratio is used to assess whether an operation is generating enough cash to cover current liabilities.

If the ratio falls below 1.00, the company isn't bringing in enough cash and will have to find other sources to finance its operations.


Example #6: LLH Operating Cash Flow Ratio

Year  Cash Flow Statement
Net Cash Provided by Operating Activities
  Balance Sheet
Total Current Liabilities
  Operating Cash Flow Ratio
2009 7,812,000 ÷  55,261,000  0.14
2008  9,361,000 ÷  36,389,000 = 0.26




Conclusion

Looking at the Balance Sheet and Income Statement in previous articles, LLH Inc. seemed to be in pretty good shape. However, the overall impression from the Cash Flow Statement raises concern regarding LLH’s ability to pay its short-term liabilities (including payments due creditors).

The Income Statement and Balance Sheet are important tools for evaluating a company’s health. However, the Cash Flow Statement is an important complement to these, and should not be overlooked.

These articles give you a basic understanding and the tools you need. Use them to improve your credit decision-making process by examining all three of these financial statements to get the best idea of how a current or potential customer's company is doing.