Financial Accounting: In an Economic Context

CASH FLOW ANALYSIS

Analyzing ratios can indicate a great deal about a company's performance and financial position. However, it says little about the company's cash management performance. Companies, especially highly leveraged ones that rely heavily on debt financing, need to manage their cash flows prudently to ensure that cash is available when debt payments come due.

The investment community has become increasingly concerned with the assessment of solvency, concluding that it is not sufficient simply to analyze ratios. In large part this concern has stemmed from company failures, leading to huge investor, creditor, and auditor losses that may have been averted if better information about solvency had been available. For example, famous bankruptcies involving such companies as W.T. Grant, Sambo's Restaurants, Penn Central, AM International, and Wickes Lumber encouraged the FASB in 1981 to require the statement of changes in financial position, a predecessor to the statement of cash flows. Furthermore, economic recession in the late 1980s and late 1990s brought down such corporate giants as Campeau Corporation (including Bloomingdales, Abraham & Straus, and Circle K convenience stores), R.H. Macy, several major airlines, and a host of dot-com companies. As stated in Rick Wayman's article entitled “How to Evaluate the ‘Quality’ of EPS” (September 19, 2003), “Without question, cash is King on Wall Street, and companies that generate a growing stream of operating cash flow are better ...