The statement of cash flows, commonly known as the cash flow statement, displays the cash inflows and outflows during a specified accounting period. Companies compile the cash flow statement using information from the income statement, which shows sales and profits, and the balance sheet, which summarizes the company's assets, liabilities and shareholders' equity. Investors, lenders and other external stakeholders use the cash flow statement to evaluate a company's financial health.
In an October 1998 article in "Journal of Accountancy" article, authors John R. Mills and Jeanne H. Yamamura suggest that cash flow ratios are more reliable indicators of liquidity than other ratios because the cash flow statement does not contain noncash items or other bookkeeping tricks. It shows the cash available at the end of the period for operations, financing and investing activities. A common cash flow ratio is the operating cash flow ratio, which is the ratio of the net operating cash flow to current liabilities. This ratio indicates a company's ability to meet its short-term debt obligations. Operating cash flow is the net income plus adjustments for noncash items and changes in working capital, which is equal to current assets minus current liabilities.
External users can use a company's cash flow statements from several accounting periods to determine trends. A positive trend of steady or increasing cash flow indicates financial health. A declining trend line could indicate a fundamental weakness, although low cash flows are not necessarily bad. For example, a biotech company may have a negative operating cash flow because it needs to invest in research and clinical trials before it can take its products to market. Some investors regard free cash flow as more important than any other number on the statement of cash flows. Free cash flow is equal to operating cash flow minus capital expenditures.
Mills and Yamamura suggest that lenders, rating agencies and credit analysts have used cash flow ratios to assess risk. Auditors can also use these cash flow ratios to identify discrepancies between the cash flow statement and other financial statements, and plan their audits around these differences. Investors may use the cash flow statement to assess the reliability of dividend payments and the company's ability to survive any sharp economic downturns.
Considerations for Internal Use
Companies may use cash flow statements for internal planning purposes. Management can estimate future cash flows based on current and historical cash flow trends. Management often uses net present value analysis to compare alternative investments. This analysis methodology relies on reasonable cash flow projections, which management may also use to identify and avoid potential funding shortfalls.