Analysis of Financial Statements, 3rd Edition

CHAPTER 6

Cash Flow Analysis

An objective of financial analysis is to assess a company's operating performance and financial condition. The information that an analyst has available includes economic, market, and financial information. But some of the most important financial data are provided by the company in its annual and quarterly financial statements. However, the choices available in the accrual accounting system make it difficult to compare companies' performance. These choices also provide the opportunity for the management of financial numbers through judicious choice of accounting methods. For example, $1 of net income for one company may not be equivalent to $1 of net income of another company.

Cash flows provide the analyst with a way of transforming net income based on an accrual system to a more comparable medium. Additionally, cash flows are essential ingredients in valuation: The value of a company today is the present value of its expected future cash flows. Therefore, understanding past and current cash flows may help the analyst in forecasting future cash flows and determining the value of the company.

MEASURES OF CASH FLOW

The primary difficulty with measuring a cash flow is that it is a flow: Cash flows into the company (cash inflows) and cash flows out of the company (cash outflows). At any point in time there is a stock of cash on hand, but the stock of cash on hand varies among companies because of the size of the company, the cash demands of the business, ...