The Statement of Cash Flow Is Not Redundant and Necessary for Investment Decision Making
The manager of Dowlais Iron Company, made a new financial statement called “comparison balance sheet”, in 1863 to explain the reason for the inability to invest was due to the holding of too much inventory, despite the profit made. This was the beginning of the cash flow statement, which was later made compulsory by the Financial Accounting Standard Boards (FASB) under Generally Accepted Accounting Principles (GAAP). This step was followed by International Accounting Standard Boards (IASB) when they issue IAS 7 Cash Flow Statement.
The Cash Flow Statement only reported transactions that took place by the use of cash or cash equivalents, and discarded anything that was recorded on accrual basis in Balance Sheet (Statement of Financial Position) and the Profit and Loss Statement (Statement of Comprehensive Income). The construction of the Cash Flow Statement is divided into three; cash flow from operating, investing and financing activities. With two approaches in constructing Cash Flow Statement; direct and indirect approach, the difference is basically on the construction of the first part, operating activities.
Cash flow from operating activities are cash flow from principal revenue-producing activities of the company and other activities that are not investing or financing activities. In using the direct method approach, it would have to start from scratch; what are the cash receipts and cash payments made during the period, while the indirect method approach would start with the profit before tax figure and later, adjustments are made, i. e. depreciation, increase or decrease in inventories, receivables, payables, etc.
The other two activities (financing and investing) remain the same regardless of methods used. Financing activities are activities that result in changes in the size and composition of the equity capital and borrowings of the enterprise. For example, the issuance of the company’s shares, payment of dividends, borrowings, etc. With regard to the investing activities, it consists of any activities of investment for capital assets, financial markets, and even operating subsidiaries.
Although the existence of the Cash Flow Statement is considered quite new in the accounting world (which starts around 1490s by Luca Pacioli, that was called “bookkeeping”), it is agreed that there are a lot of benefits with the presence of the Cash Flow Statement. This position paper will touch on a couple of them just to be firm on the topic, that is “The Statement of Cash Flow is not Redundant and Necessary for Investment Decision Making”. Cash Flow Statement as a Tool for Investment Decision
This ratio is slightly similar to the Current Ratio, but the use of Cash Flow from Operations to replace Current Assets is simply more logical to measure the liquidity, because the Current Asset includes Inventories and Receivables which are not of the high liquidity compared to cash. The investors can make a reasonable and justifiable decision based on this ratio, simply because it gives a better view of liquidity than the Balance Sheet (Statement of Financial Position). The second ratio that could help investors decision making is the Price/Cash Flow Ratio.
Even though this ratio is not widely use as the Price Earnings Ratio, this ratio is often considered as the better indication of the company’s value. This mainly was due to the formula itself, which the Earnings per Share in the Price Earnings Ratio is changed to the Operation Cash Flow per Share. With this change, the value of the company relies on the cash flow from the principal revenue-producing activities, and not the Net Income which was derived on accrual basis, which the revenue and xpenses may or may not have been received and paid. With the information from Cash Flow Statement, investors are able to make a wiser decision as to valuation of the companies because the cash is of the same importance as the profit, and sometimes may be regarded as more important. The next ratio is to help in measuring the solvency of a company, it is the Cash Flow from Operations/Average Total Liabilities Ratio. From the name itself, we can figure that the formula would look like below: Cash Flow from Operations ?
Average Total Liabilities As mentioned, this ratio is to measure the solvency of the company, similar to Total Debt/Total Assets Ratio as both are to know the ability of the company to pay its debts. However, this ratio is better in terms of that it measures for the whole period, and not at a point of time. To explain this, know that the cash flow from operations are generated from the start of the period until the end of the period, and it uses the average of total liabilities which does not focus on that point of time only.
On the other hand, the Total Debt/Total Assets Ratio uses the total assets and total debts at the end of the period, the ones reported on balance sheet. Thus, one might increase their inventories or promote credit sales towards the end of the period, just to boost up the total assets figure, which later would give the indication the company has the ability to pay its debt, due to the high total assets figure. Apart from these ratios that are derived from information in the Cash Flow Statement, the elements in the statement itself can be helpful for investors to make decisions, without even the need to calculate any ratio.
For example, a company may be having a negative total cash flow(total outflow), but if the cash flow from operating activities is positive, it may still be a good sign, as the negative cash flow is derived from the investing or financing activities. If the negative cash flow comes from heavy investing and causes a negative flow from investing activities, it may still be a good sign simply because the company might be considering an expansion in the future.
Thus, the elements in the Cash Flow Statement itself can give information for the investors to make decisions, without even the fuss of computing ratios. Overall View of the Company’s Activities Before looking at the future perspective of the company, which we have discussed earlier on how Cash Flow Statement is very helpful in making investment decision, the investors are more likely wanting to know the financial management of the company. Having a good future perspective may not always give profit to investors, if there is a bad financial management.
With the elements laid out with such organization in the Cash Flow Statement, the investors would have a glimpse or overview of the company’s activities throughout the year, what decision have they(company) made, what are the odds for the company paying the dividends, etc. As mentioned previously, the total cash flow may not necessarily give the right interpretation of what is happening to the company. This is because if it does, then there is no need of the Cash Flow Statement, as the amount are present in the Balance Sheet (Statement of Financial Position).
Usually the increase in Inventories and Receivables would give an indication that the company is being illiquid compared to last period. Taking the Dowlais Iron Company (mentioned in the Introduction) as an example, the company were making profits, but they were unable to do any investment. The reason being was that their assets are illiquid and are composed by high amount in inventories. This might also be an alarming situation as it gives the signal of the company being unable to collect their debts. Other elements has their own story respectively. Let’s move a step further in our discussion, comparing elements.
Taking the investing activities as an instance, the sale or disposal of assets by itself may be read as a hint of the company wanting to get rid of the old machines in order to buy a new one that is more productive in their expansion plan. However, if it is synchronized with the decrease in investment in subsidiaries, it may give a different story. There is a huge possibility that the company is closing down and try to let go as much assets as possible. Previously, we have compare the positive cash flow from operating with the negative cash flow from investing (in previous point).
Now, let’s compare elements in the investing activities with the elements in the financing activities. Firstly, the issuance of shares would obviously bring the positive vibe to investors as it is often read as expansion of the business. Business seems to be growing and thus, there were investors interested and bought the shares which in the statements would report an increase in number of shares. The twist in this comparison would be the decrease in amount payable or repayments to directors/shareholders is around the amount if shares issued.
Without reading the complimentary notes, it can be assumed that the company is capitalising their debts, that is paying their debts through issuance of shares. This can be affirmed by reading the complimentary notes. When this happens, it gives an extreme situation of the inability of the company to pay their debts, up to the extend they have to exchange it with the shares (sense of ownership to the company). The Cash Flow Statement should be analysed thoroughly, it gives lots of information. Real Life Case
All these theoretical can be easily argued and rejected by certain parties, especially those who does not want to have hassle to prepare another financial statement. This point will give the flavour of the real life situation, when the Cash Flow Statement was not prepared, by using the W. T. Grant Company back in the 1970s. From the surface, it has the similar picture of the Dowlais Iron Company; making profit, good assets amount, but no cash. Having mentioned that, the Dowlais Iron Company took the trouble to make a comparison balance sheet, while the W.
T. Grant Company runs as though there was no problem. By purely looking at the Net Income amount, the investors were keen to invest in W. T. Grant Company as it seems promising and the earnings look tempting. Little did the investors know, the company was not generating any cash, instead they are the net user of cash. This problem does not happen within a financial year, it started a decade before the downfall of the company. There were decreasing trends of the company’s liquidity, profitability and even turnover. However, all these problems were left ntouched and thus, the investors were not given any hint that the W. T. Grant Company was facing bankruptcy. The company was said to exhaust its liquid assets before using external markets for funds which later just grew bigger. These can be easily detected with the use of Cash Flow Statement. Apart from the negative cash flow from operating activities, the company and investors could be alarmed by the amount of payables that kept on increasing, and even the shares that were sold above the value of the company, simply because the market thought the company was doing fine.
The upward trend of sales still does not manage to generate cash for the company, and this could be detected by the increase in the Receivables, which shows the inability to collect debt. All these problems can be detected years before the liquidation of the company and could be avoided, with the presence of Cash Flow Statement. Conclusion With Cash Flow Statement, these elements are laid down in such manner that it is easier for the users of financial statement to understand the story, compare to merely reading the Balance Sheet (Statement of Financial Position) and the Profit and Loss Statement (Statement of Comprehensive Income).
