Academic journal article Journal of International Business Research

Cash Flow Ratios: Tools for Financial Analysis

Academic journal article Journal of International Business Research

Cash Flow Ratios: Tools for Financial Analysis

Article excerpt


One of the four major financial statements that are directly related to cash is the statement of cash flows. The purpose of the cash flows statement is to report inflows and outflows of cash for a given period of time. Cash flows related to operating, financing, and investing activities of a company are separately reported in the statement. This detailed disclosure of individual cash flows is important to users. Cash flows can show a company's ability to finance its expenditures from operations, pay its existing debts as they mature, and demonstrate a company's ability to meet unexpected obligations and to pursue business opportunities (Larson, Wild, & Chappetta, 2006). According to Statement of Financial Accounting Standards No. 95, "Statement of Cash Flows," the information in the statement, if used with information in other financial statements, can help investors, creditors, and others to assess an entity's ability to generate positive future net cash flows, and its ability to meet its obligations and to pay dividends, and determine its needs for external financing during the period.

Operating activities-one section of the statement of cash flows-refer to a company's basic business activities, whether it is selling, manufacturing, resale, renting, or rendering services. Positive cash flow from its operating activities is a good indicator of a company's performance. "Happiness is a positive cash flow," according to Kieso, Weygandt, and Warfield (2004), and if the cash flow is increasing through the years, it shows that the company is able to remain solvent and is able to meet its cash needs. A negative cash flow from operating activities, on the other hand, would indicate that the company is not performing well enough to sustain even its core functions.

The remaining sections of the statement of cash flows, those concerning investing (purchase and sale of assets other than the company's products) and financing (borrowings, repayments of borrowings, investments by owners, and distribution of dividends or profits to owners) reflect what the business does with its cash coming from operations, and the sufficiency of cash to meet other functions of the company. Users of financial statements look at where the company is getting its cash aside from operating activities. If most of the cash is acquired through financing activities, then the company might be in danger in the future if it could not pay off its debts. If money is used for investing activities, you can expect the money to return after some time depending on the payback period or the rate of return of the investment (White, 2004).

By examining the cash and non-cash investing and financing activities of a company, users can understand why assets and liabilities increased or decreased during a given period. It is easier to explain why there was an increase in the cash when the company was showing a net loss, the sources of funds for acquiring fixed assets, the reasons why dividends did not increase, how debts were retired, and how much money was borrowed (Kieso, et al., 2004).

In financial management, financial analyses rely primarily on ratios derived from the income statement and balance sheet data. Analyzing cash receipts and payment or sources and uses of cash are only a secondary basis for making managerial decisions and for predicting the outcome of future business activities. This stems from the belief that information from accrual accounting provided a better indication of a business's current and future ability to create favorable cash flows compared to analyzing cash receipts and payments (Bowen & Daley, 1986). However, the statement of cash flows has properties unique from income statements and balance sheets. As one of the four required financial statements, the statement of cash flows is believed to carry invaluable information essential for a complete analysis of the financial situation of a company. …

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