Integrated Analysis of the Statement of Cash Flows

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1 Integrated Analysis of the Statement of Cash Flows YAN Huahong Capital University of Economics and Business, Abstract: Starting with the structural analysis of the statement of cash flows, this paper analyzes the net increase on cash and cash equivalents, cash flows from operating activities, cash flows from investing activities, cash flows from financing activities and the cash flow structure. After that, it makes detailed analysis of cash flows in combination with the balance sheet and the profit statement from various aspects, such as enterprise liquidity, return for shareholders and operating results. Finally, it further analyzes the statement of cash flows from such aspects as the ratio of net cash flow from operating activities to cash for investing activities, fixed investment recovery period, the ratio of cash inflows from financing activities to total assets, etc. in the hope of providing information for future development. Keywords: Statement of cash flows, integrated analysis Introduction The statement of cash flows is a kind of statement reflecting the cash inflows and outflows of an enterprise in a given period, through which users of accounting statements could obtain information on cash or cash equivalent inflows and outflows in a given period in order to know and evaluate an enterprise's ability of obtaining cash and cash equivalents and forecast the future cash flows of the enterprise. But the information obtained from the statement of cash flows is superficial and further analysis in combination with the objective circumstances, the balance sheet, the profit statement, etc. of the enterprise is necessary in order to obtain in-depth information. Text 1. Analysis of the Composition of the Statement of Cash Flows A statement of cash flows covers cash flows from operating activities, investing activities and financing activities and reflects them in cash inflows and cash outflows respectively. Therefore, it is necessary to start the analysis of cash flows with the composition of cash flows and mirror the operating status of an enterprise from the point of cash flows. 1.1 Analysis of net increase on cash and cash equivalents The net increase on cash and cash equivalents is the final conclusion provided in the statement of cash flows and is the key concern of statement users. Generally speaking, a positive number is expected. With normal production operation and stable investment scale, a greater net cash flow indicates a more energetic enterprise, because net cash flows are mostly generated from operating activities and a positive number means powerful ability of cash collection, minor bad debts risk and powerful marketing capability. If the net cash flow is a negative number, the circulating fund turnover may be affected, but the concrete reasons should be discovered. 1.2 Analysis of cash flows from operating activities The cash flows from operating activities can be analyzed from two perspectives: first, The cash received from selling commodities and rendering services are compared with the cash paid for purchasing commodities and accepting services and the received-cash to paid-cash ratio should be greater than 1 under normal conditions, indicating that the cash inflows from operating activities are greater than the 559

2 cash outflows, and a higher ratio indicates more powerful ability of getting cash from operating activities by enterprises; second, the cash received from selling commodities and rendering services are compared with the cash inflows from operating activities and the cash paid for purchasing commodities and accepting services are also compared with cash outflows from operating activities. Higher ratios indicate a higher share of the main business in total operating activities and more concentrated operation of an enterprise. 1.3 Analysis of cash flows from investing activities It may be unlucky if the net cash flows from investing activities is a positive number, as it shows that the enterprise fails to make efficient investment outward and may have huge idle fund. Here, specific reasons should be analyzed. It may be due to poor external investment environment, no suitable investment project or conservative investment policies. Or it may be caused by disposal of long-term investment, fixed assets and intangible assets by enterprises. If the positive number is generated under normal operation conditions, it shows that the enterprise is suffering a declining ability of production operation and needs to raise capital through disposal of long-term assets, or the enterprise has adjusted its investment orientation and development strategy. If the net cash flows from investing activities is a negative number, it shows that the external investment increases in the current period. Of course, the profits and risks of each investment project should be analyzed instead of rating investing activities in accordance with the net cash flows only. 1.4 Analysis of cash flows from financing activities Generally speaking, the cash flows from normal financing activities should be a positive number, namely enterprises could smoothly raise fund from external world in the current period, but the financing channels should be analyzed. Enterprises may face greater debt repayment pressure and financial risks if debt financing is adopted, while absorption of equity capital will not cause such pressure although it would decentralize shares. The equity capital and debenture capital should be arranged in reason upon fund raising in accordance with the practical situation of each enterprise. 1.5 Structural analysis of cash flows Firstly, the proportions of net cash flows from operating activities, investing activities, and financing activities in the total net cash flows should be worked out in order to know the sources and structure of net cash flows of an enterprise. Under normal conditions, net cash flows from operating activities should have the biggest share, showing stable business development and reasonable structure of net cash flows. Meanwhile, the proportions of net cash inflows from operating activities, investing activities, and financing activities in the total net cash inflows should be worked out in order to learn about the principal sources of cash inflows. Likewise, the cash inflows from operating activities should have the biggest share. Then the proportions of net cash outflows from operating activities, investing activities, and financing activities in the total net cash outflows should also be worked out, and cash outflows from operating activities should have the biggest share under normal conditions. Finally, the proportions of operating activities, investing activities and financing activities in the net cash flows, total cash inflows and total cash outflows would be compared. Generally speaking, there would be some differences among them and it should be analyzed whether such differences are normal or not and the reasons should be ascertained. 2. Integrated Analysis Together with Other Statements 2.1 Integrated analysis together with the balance sheet The balance sheet indicates the financial picture of an enterprise and shows the structure of assets, liabilities and owner's equity at the end of the period and changes as compared with that at the beginning of the period. The financial status of an enterprise can be better shown through comparative analysis of relevant data in the statement of cash flows and the balance sheet Analysis of enterprise liquidity 560

3 After granting loans to an enterprise, the creditors care about whether the principal and interest can be recovered on time, and they think more of the cash-paying ability than the book profit of the enterprise. An enterprise usually uses liquid ratio to show the liquidity, but liquid assets also contain some items that can be realized, such as idle inventory, accounts that may not be received, deferred and prepaid expenses, assets gain or loss in suspense, etc., and thus the liquid ratio can't truly reflect the liquidity of an enterprise. The enterprise liquidity can be analyzed with some new indices through comparative analysis of related data in the statement of cash flows and the balance sheet. a. Ratio of cash to current liabilities. It shows the ability of repaying current liabilities with net cash flows from operating activities in the current period and the computational formula is as follows: net cash flow from operating activities/current liabilities 100%. A higher ratio means higher short - term liquidity and a lower one means lower short - term liquidity of an enterprise. When this ratio is used, it should be kept in mind that the net cash flows are generated in the current period and current liabilities are repaid in later periods, so the net cash flows can be adjusted in accordance with the expectation for the future. b. Ratio of cash to current-period debt. It shows the ability of repaying the principal and interest of liabilities in the current period with the net cash flows from operating activities in the current period and the computational formula is as follows: net cash flows from operating activities/cash paid for repaying principle + cash paid for repaying interest) 100%. In the formula, the denominator and numerator data is obtained from the statement of cash flows. If the ratio is greater than or equal to 1, the due liabilities in the current period could be repaid with the cash flows from operating activities; if it is less than 1, not only the net cash flows from operating activities, but also the used balance at the beginning of the period, the fund raised or the fund obtained through disposing of long-term assets, would be used to repay liabilities. For enterprises, it is a warning signal if this ratio is less than 1. c. Ratio of cash to interest. It shows the ability of repaying interests with net cash flows form operating activities in the current period, and the computational formula is as follows: (net cash flows from operating activities + income tax paid) /cash paid for interests 100%. This ratio is transformed from the traditional interest coverage ratio, but it is more convincing as it eliminates the influence of non-cash factors. A higher ratio indicates higher ability of repaying loan interests. d. Ratio of total liabilities to cash. It shows the time required for repaying total liabilities with the net cash flows from operating activities, and the computational formula is as follows: total liabilities/net cash flows from operating activities. A lower ratio means shorter time of repaying total liabilities in accordance with the current cash making capability and stronger liquidity of an enterprise, while a bigger ratio means longer time of repaying total liabilities and poor liquidity. In such a case, the enterprise should try to increase the cash flows in order to shorten the debt-repaying period and guarantee financial safety Analysis of the return for shareholders The investors care about whether their investment could increase in value and whether they can profit from investment projects. The dividends received by investors each year are a key indicator of the profiting level and investors must care about the cash flows and dividend paying ability of an enterprise as the stock dividends are paid in cash. a. Cash flow per share. It shows the cash flows from per common share issued by the enterprise and the computational formula is as follows: net cash from operating activities- dividend on preferred stock/number of circulating common shares. As compared with the earnings per share, the cash flow per share shows the dividend paying ability of an enterprise more clearly and is usually higher, because it contains some items that have been deducted from the net profit, for instance, the depreciation cost. The nominator refers to the number of weighted mean common shares circulating all year around. Higher cash flow per share indicates powerful ability of paying dividends. b. Ratio of cash to dividend. It shows the ability of paying cash dividends with net cash flows from operating activities and the computational formula is as follows: net cash flows from operating activities/cash paid for dividends 100%. The nominator includes dividend on both common shares and preferred shares. A higher ratio means more powerful ability of paying cash dividend, but it does not mean that investment would result in more dividends. The sum of dividend is associated with the 561

4 dividend policy of relevant administrative authority. c. Ratio of cash to equity. It refers to the ability of creating net cash flows with the enterprise equity and the computational formula is as follows: net cash flows from operating activities/ equity 100%. A higher ratio means more powerful ability of creating net cash flows with equity and more powerful ability of the enterprise to pay for capital expenditure and cash dividends. 2.2 Integrated analysis together with the profit statement The profit statement shows the operating results of an enterprise in a given accounting period and presents the income, expenses and profits of an enterprise in the accrual basis of accounting. But the profit statement only shows the book profit instead of the cash created by the enterprise. To better reflect the operating results of an enterprise, the profit statement should be analyzed together with the statement of cash flows. a. Ratio of cash to profit. It shows the share of cash in the profit realized by an enterprise, and the computational formula is as follows: net cash flows from operating activities/ profit 100%. In the above formula, the profit may be operating profit or net profit as required. A higher ratio means a higher cash recovery rate of operating activities, while a lower one means there are more accounts receivable in the profit. But a higher ratio may not be better, as it may mean that the enterprise has a strict requirement for the credit of the other party and the sales may be affected. b. Sales income collection ratio. It shows the share of cash collected in the sales income of an enterprise and the computational formula is as follows: cash received from sales of commodities and service supply/operating income 100%. It is obvious that a higher ratio means a sound sales income collection. While a lower one indicates that the enterprise pays less attention to the credit of the other party when selling on credit or adopts improper payment collection measures, which deserves attentions of the administrative authority. c. Ratio of cash paid to cash collected. It is the ratio of the cash paid by an enterprise for purchasing commodities and accepting labor services to the cash received from selling commodities and rendering services, and the computational formula is as follows: cash paid for purchasing commodities and accepting labor services + cash paid to and for employees/ cash received from selling commodities and rendering services 100%. It is the cash flow form of the ratio of cost to sales and should be consistent with the ratio of cost to sales. Generally speaking, a lower ratio means better sales status. If this ratio is too high, the commodities purchased or produced by the enterprise are not well sold in the current period; if it is too low, the materials or commodities are in short supply in the current period. d. Ratio of cash to sales income. It shows the cashing status of the sales income, and the computational formula is as follows: net cash flows from operating activities/income from product sales 100%. It is a cash flow form of the profit ratio of sales and could better show the profitability of the sales income. A higher ratio indicates a higher profitability of sales income and a better sales status of the enterprise; while a lower ratio is due to low profit rate of products or high proportion of accounts receivable in the sales income. e. Ratio of cash to cost of sales. It shows the cashing ability of the sales cost and the computational formula is as follows: net cash flows from operating activities/cost of goods sold 100%. This ratio is a cash flow form of the ratio of cost to sales, but it could more directly show the profitability. A higher ratio means more net cash obtained from unit cost. 3. Analysis of Enterprise Future Enterprises conduct production and operating activities for both making profit in current period and making preparations for future periods, such as raising funds for expanding the business scale, improving the yield and market share and gaining greater benefits or making investment into long-term assets. Relevant data in the statement of cash flows can be used to analyze the future business of an enterprise. 562

5 3.1 Ratio of net cash flow from operating activities to cash for investing activities It is used to show whether enterprises could use the cash flows from operating activities to satisfy investing activities and the computational formula is as follows: net cash flow from operating activities/cash outflows of investing activities 100%. If this ratio is greater than or equal to 100%, the enterprise could meet the investment demand with the cash from operating activities and has no need of financing. If it is less than 100%, the enterprise couldn't meet the investment demand with the cash from operating and has to finance otherwise. Of course, being higher may not be the better. A high ratio may suggest that the enterprise has no good investment project and may affect its later development. 3.2 Fixed investment recovery period This ratio shows the time required for paying back the investment into fixed assets with the net cash flows from operating in the current period and the computational formula is as follows: total fixed assets/net cash flow from operating activities. This ratio should be compared with the serviceable life of fixed assets. If it is less than the serviceable life of fixed assets, the enterprise can recover the investment before retirement of fixed assets. A smaller ratio indicates that the enterprise could recover its investment at the earliest opportunity, while a bigger one suggests that a longer time is required to recover the investment. 3.3 Ratio of cash outflows from investing activities to total assets This ratio shows the share of cash outflows for equity investment and debt investment in the current period in the total assets, and the computational formula is as follows: net cash outflows from investing activities/ total assets 100%. It shows the long-term investment potentials of an enterprise in the current period. If the ratio is high, the enterprise enjoys a sound long-term investment prospect and may expand business scale hereafter; if the ratio is low, it is unfavorable to make external investment and the enterprises can but maintain its current status. When long-term investment is analyzed, both risks and profits should be considered and more cash outflows from investing activities are by not means the better. 3.4 Ratio of cash inflows from financing activities to total assets It shows the share of cash obtained from equity investment, issuing bonds and raising loans in the current period in the total assets and the computational formula is as follows: cash inflows from financing activities/total assets 100%. This ratio indicates the enterprise's ability of financing. A higher ratio indicates smooth financing channels for future business expansion, while a smaller one indicates difficult financing and shortage of capital. Of course, a higher ratio may not be better and various factors, such as market conditions, fund raising cost and enterprise capital structure, should be considered comprehensively. Conclusion It is observed from the above analysis that one or several financial indicators can be simply adopted to measure the financial status and operating results of an enterprise during the analysis of the statement of cash flows, and the market conditions and enterprise conditions should be considered fully and the statement of cash flows should be analyzed together with the balance sheet, the profit statement and other non-accounting factors in order to better reflect the enterprise status, help investors, creditors and other interested parties to know the enterprise ability of repaying debts, gaining profits and making further development, and help enterprise management authority improve operating management and economic benefits. 563

6 References [1]. Explanation of Accounting Standards for Business Enterprises 2006, the Writing Group of the Accounting Department of the Ministry of Finance, the People s Press, April 2007, First Edition [2]. ZHU Kaixi. On Company's Core Financial Competence and Its Statement, Accounting Research, 2002, 2: [3]. ZHAO Hong-jin and ZHANG Yun. Financial Statements Reading and Analysis, Shanghai University of Finance and Economics Press, Dec., 2008, First Edition [4]. YU Jiu-hong. Financial statements Compilation and Analysis, China Renmin University Press, Jan., 2008, First Edition 564

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