Academic journal article Journal of Business and Behavior Sciences

Toward Effective Use of the Statement of Cash Flows

Academic journal article Journal of Business and Behavior Sciences

Toward Effective Use of the Statement of Cash Flows

Article excerpt

INTRODUCTION

Financial analysis utilizes ratios based on financial statements to standardize financial data for comparison of internal and external performance. The usefulness of financial statements for financial analysis is of utmost importance to academic researchers, investors and regulators. In the Statement of Financial Accounting Concepts No. 2, the Financial Accounting Standards Board (FASB) examines the qualities that make accounting information (FASB, 1980) and lists the key qualitative characteristics for usefulness as relevance and reliability. FASB states that, in order to be relevant, information must be capable of making a difference in a decision and should have predictive value.

In 1987, the Financial Accounting Standards Board, to address the qualitative characteristic of relevance, required the statement of cash flows to be included in financial reporting. The statement of cash flows incorporates information from the balance sheet and income statement in three major categories to calculate cash flow. The statement has been included in corporate quarterly and annual reports since 1988 (Mautz & Angell, 2009) and requires the classification of cash payments and receipts according to their attribution from operating, investing, or financing activities (FASB, 1987). However, a review of 13 current textbooks in the discipline of Finance shows that much of the financial analysis as presented in these textbooks is predominantly based on the balance sheet and income statement data (Bodie, Kane, & Marcus, 2013; Block, Hirt, & Danielsen, 2011; Brigham & Davies, 2013; Brigham & Ehrhardt, 2014; Brigham & Houston, 2013; Cornett, Adair, Nofsinger, 2012; Gitman, 2009; Keown, Martin, & Petty, 2014; Lasher, 2011; Melicher, & Norton, 2011; Ross, Westerfield, & Jaffe, 2013; Ross, Westerfield, & Jordan, 2013; Titman, Keown, & Martin, 2011). The statement of cash flows is rarely utilized in ratio analysis. Essentially, three decades after the introduction of the statement of cash flows, almost all financial ratios are based on elements from the income statement and/or balance sheet. The present focus of financial analysis is on income and assets/liabilities rather than on corporate cash flows. In contrast, the statement of cash flows concentrates on financial liquidity, corporate sustainability, and durability.

Greater utilization of the statement of cash flows in financial analysis could supplement traditional balance sheet and income statement analysis in providing new direction for creditors, investors, and managers. In conducting a literature review of peer-reviewed journals, 2,855 articles were located using the search terms "balance sheet analysis" and "income statement analysis," but only104 papers were identified through "statement of cash flows analysis." Virtually none of the journal articles were focused on financial analysis utilizing the statement of cash flows' data to create cash flow-based ratios to evaluate and compare corporate firms' performance. This paucity of peer-reviewed research using statement of cash flows in financial analysis indicates a need for further study in this specific area.

This paper presents an overview of approaches to financial analysis that utilize the information presented by the statement of cash flows to supplement and enhance the extant financial analysis tools. The paper reviews statement of cash flows ratios and proposes a common-size methodology as an initial framework for financial analysis using the statement of cash flows. The statement of cash flows, when presented in a common-size format, provides more useful and easily understandable information to compare financial performance, both internally and externally.

Eight statement of cash flows ratios are reviewed and illustrated as simple diagnostic tools to identify a firm's relative strengths and weaknesses. Also, four distinct common-size models are offered and illustrated for comparison relating to their relative merits and disadvantages. …

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