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Financial Accounting Unit 10: Cash Flow Statement and Ratio Analysis

The statement of cash flows explains where a company's cash came from and where it went, and ratio analysis turns all four statements into measures of liquidity, solvency and profitability. This unit ties the whole course together.

Covers: Classifying cash flows, Indirect method, Direct method, Investing, financing and noncash activities, Free cash flow, Liquidity and solvency ratios, Profitability ratios, EPS and P/E, Horizontal, vertical and DuPont analysis

Study guide

The statement of cash flows explains the change in cash and cash equivalents during a period. It has three sections. Operating activities are the cash effects of transactions that determine net income: collections from customers and payments to suppliers, employees, interest and taxes. Investing activities involve buying and selling long-term assets, investments, and making or collecting loans to others. Financing activities involve owners and creditors: issuing or repurchasing stock, borrowing and repaying principal, and paying dividends. Under U.S. GAAP, interest and dividends received and interest paid are operating, while dividends paid are financing. Significant noncash investing and financing activities, such as buying land with a note, are disclosed separately.

Most companies prepare operating cash flow with the indirect method, which starts with net income and adjusts it to cash. Add back noncash expenses such as depreciation, amortization and impairment. Subtract gains and add losses on sales of long-term assets, because the full cash proceeds are reported in investing. Then adjust for changes in current operating assets and liabilities: subtract increases in receivables, inventory and prepaids, and add decreases; add increases in payables, accrued liabilities and unearned revenue, and subtract decreases. The direct method reports actual cash receipts and payments, such as cash collected from customers (sales minus the increase in receivables). Both methods give the same total.

Investing and financing sections come from analyzing changes in long-term accounts. For plant assets, compare beginning and ending balances and account for purchases, sales and depreciation; report the cash paid or received, not book value. For equity, the change in retained earnings reveals dividends declared, and the change in dividends payable shows how much was paid. The three sections sum to the net change in cash, which reconciles beginning to ending cash. Free cash flow, cash from operations minus capital expenditures and dividends, shows how much cash is available for growth, debt repayment or share buybacks without new financing.

Ratio analysis compares items to judge performance. Liquidity ratios measure short-term ability to pay: the current ratio, the acid-test or quick ratio (cash, short-term investments and receivables over current liabilities), receivables turnover and inventory turnover. Solvency ratios measure long-term survival: debt to assets (total liabilities ÷ total assets) and times interest earned (EBIT ÷ interest expense). Profitability ratios include profit margin (net income ÷ net sales), asset turnover, return on assets, return on common equity (net income minus preferred dividends, over average common equity), earnings per share and the price-earnings ratio. The DuPont relationship shows that ROE equals profit margin × asset turnover × financial leverage.

Ratios are only meaningful in comparison. Horizontal analysis compares each item with the same item in a base year, expressed as a percentage change. Vertical, or common-size, analysis expresses each item as a percentage of a base within the same statement: net sales for the income statement and total assets for the balance sheet. Compare a company with its own history, with competitors and with industry averages. Watch quality of earnings: when net income rises but operating cash flow stays weak, or when receivables and inventory grow faster than sales, earnings may rest on aggressive estimates. Differences in accounting choices such as FIFO versus LIFO or depreciation methods can also distort comparisons.

Key ideas

• Cash flows are classified as operating, investing or financing; noncash deals are disclosed separately.
• Under U.S. GAAP, interest paid is operating, and dividends paid are financing.
• The indirect method adds back noncash expenses and losses, subtracts gains, and adjusts for working capital changes.
• Increases in current operating assets reduce operating cash flow; increases in current liabilities raise it.
• Liquidity, solvency and profitability ratios each answer a different question about the company.
• ROE = Profit margin × Asset turnover × Financial leverage (DuPont).
• Horizontal analysis tracks changes over time; vertical analysis expresses items as a percentage of a base.

Formulas and rules

Common mistakes

• Adding a gain on sale of equipment in operating cash flow instead of subtracting it.
• Reporting the book value of an asset sold in investing instead of the cash received.
• Putting dividends paid in operating or interest paid in financing under U.S. GAAP.
• Forgetting to subtract preferred dividends when computing EPS or common ROE.
• Dividing by the current-year figure instead of the base year in horizontal analysis.

Before the test, make sure you can

• Classify any cash flow as operating, investing, financing or noncash.
• Prepare cash from operations using the indirect method.
• Compute cash collected from customers and paid to suppliers using the direct method.
• Compute net investing and financing cash flows and reconcile beginning to ending cash.
• Calculate free cash flow and explain what it shows.
• Calculate and interpret liquidity, solvency and profitability ratios, including EPS and P/E.
• Perform horizontal and vertical analysis and use DuPont to break down ROE.
• Spot warning signs about quality of earnings.

Words to know

Statement of cash flows

A statement that reports cash receipts and payments in operating, investing and financing activities.

Operating activities

Cash effects of transactions that create revenues and expenses and enter net income.

Investing activities

Cash flows from buying and selling long-term assets and investments and from loans made to others.

Financing activities

Cash flows from issuing and repurchasing stock, borrowing and repaying debt, and paying dividends.

Indirect method

Computes operating cash flow by adjusting net income for noncash items and changes in working capital.

Direct method

Reports operating cash flow as major classes of cash receipts and cash payments.

Noncash investing and financing activities

Significant transactions such as buying assets with debt or stock, disclosed separately.

Free cash flow

Cash from operations minus capital expenditures and dividends.

Current ratio

Current assets ÷ current liabilities.

Quick (acid-test) ratio

Cash, short-term investments and receivables ÷ current liabilities.

Debt to assets ratio

Total liabilities ÷ total assets; the share of assets financed by creditors.

Times interest earned

Earnings before interest and taxes ÷ interest expense.

Profit margin

Net income ÷ net sales.

Return on common stockholders' equity

(Net income − preferred dividends) ÷ average common stockholders' equity.

Earnings per share

(Net income − preferred dividends) ÷ weighted-average common shares outstanding.

Price-earnings ratio

Market price per share ÷ earnings per share.

Horizontal analysis

Comparing financial statement items across periods, usually as a percentage change from a base year.

Vertical analysis

Expressing each statement item as a percentage of a base amount, such as net sales or total assets.

Quality of earnings

How well reported income reflects sustainable, cash-backed performance.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.