Direct Approach to Cash Flows Enhances Credit Analysis
Cornell, David W., Apostolou, Barbara, Business Credit
Credit analysts tend to agree that the direct presentation of operating cash flows in the statement of cash flows is the preferred approach. This view has been supported by the Accounting Policy Committee (APC) of Robert Morris Associates (RMA), which lobbied the Financial Accounting Standards Boards (FASB) during its deliberations on requiring the statement of cash flows. Despite the show of support for the direct method, the FASB elected to recommend rather than require its use.
For this reason, a majority of firms continue to report cash flows from operations using the indirect method. As a result, credit analysts may not have access to the information disclosed under the direct method. This information is particularly useful in estimating future cash flows, assessing earnings quality, and predicting bankruptcy.
Additionally, the Uniform Credit Analysis systems, like the indirect method, results in limitations to credit analysis.
Estimating Future Operating Cash Flows
Estimating future operating cash flows is important in answering the primary question facing creditors: Will the borrower generate sufficient cash from operations to service its debt? There are three primary methods of estimating future cash flows: (1) use of borrower's estimates; (2) trend analysis; and (3) estimation of fixed and variable cash flows.
Each of the methods can be used regardless of the presentation of operating cash flows, though the results may be constrained by the information available. The only operating cash flow figure disclosed under the indirect format is the net amount for the accounting period, with little detail of the components of that figure. (The disclosures under the indirect method are supplemented by the required disclosure of the amount of income taxes and interest paid during the period.)
As such, estimates must be based on the net amount only, which ignores potentially valuable information supplied by the components. Alternatively, the direct method emphasizes the cash flows of the borrower and provides detail on the components of net operating cash flows. The information on the components provides additional accuracy to the projection.
Use of Borrower's Estimates
The borrower's input should be sought to estimate future cash flows. The assumptions on which those estimates are based must be critically examined to determine how reasonable they are. Any significant deviations from past trends should be supported by marketing plans or other documentation. Additionally, the borrower should provide a range of estimates. A best and worst case scenario, as well as the one most expected, should be prepared. This approach allows for sensitivity analysis and is particularly relevant when the borrower is only marginally qualified for the loan.
Prospective financial statements should be produced by the borrower as a result of the strategic planning and budgeting process. Professional accounting literature distinguishes prospective financial information as consisting of forecasts and projections. A forecast is the best estimate of future financial information based upon prevailing economic and market conditions. A projection is a "what if" scenario. For example, projected financial statements will reflect estimates based on the borrower obtaining financing, acquiring a subsidiary, or adding a new product line. The creditor should request either or both as dictated by the particular needs of the borrower.
The production of prospective statements is relatively easy with the proliferation of accounting software packages that generate prospective financial statements. Additionally, stand-alone cash flow software packages are available for the forecasting of cash flows and financial statements. The credibility of the prospective financial statements can be enhanced by association with an independent accountant. Figure 1 (on page 10) summarizes the different levels of association that current accounting standards permit for independent accountants. …