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Principles of Accounting, Volume 1: Financial Accounting

16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency

Principles of Accounting, Volume 1: Financial Accounting16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
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  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

Cash flow ratio analysis allows financial statement users to see the company’s liquidity position from a clearer perspective. The ratios presented in this section focus on free cash flow, calculated as operating cash, reduced by expected capital expenditures and by cash dividends payments. The free cash flow value is thus an adaptation of cash flow from operating activities. The result obtained in the initial free cash flow calculation is then used to calculate the free cash flow to sales ratio, which is the ratio of free cash flow to sales revenue, and the free cash flow to assets ratio, which is the ratio of free cash flow to total assets. These three tools give indicators about the company’s flexibility and agility, which equates to their ability to seize opportunities in the future, as they arise.

Ethical Considerations

Cash Flow Analysis

Cash is required to pay the bills. All businesses need to have a clear picture of available cash so they can plan and pay their bills. The statement of cash flows allows investors direct insight into the actual activity on the company’s cash balances. Mark A. Siegel wrote in The CPA Journal that “as Wall Street analysts have lost faith in earnings-based metrics in the wake of Enron, WorldCom, and others, many have gravitated toward the cash flow statement. Companies are regularly evaluated on the basis of free cash flow yield and other measures of cash generation.”3 The operating cash flow ratio, and the cash flow margin ratio, and the other cash flow–related metrics discussed allow an investor and other users of the financial statements to analyze financial statement data to see a company’s ability to pay for current debt and assess its operational cash flow to function as a going concern.4 This helps investors and other users of the financial statements ensure the veracity of a company’s financial statements and its ability to pay its bills.

Free Cash Flow

Free cash flow calculations start with cash flows from operating activities, reduced by planned capital expenditures and planned cash dividend payments. In the example case demonstrated, free cash flow would be as follows:

Free cash flow calculation:

Cash flow from operating $13,840 minus cash planned for capital expenditures of (40,000) minus cash dividends of (440) equals free cash flow of (26,600).

The absence of free cash flow is an indicator of severe liquidity concern for Propensity Company and could be an early indicator that the company may not be able to continue operations. This could also be a one-time occurrence, in a year where a large capital investment was planned, to be financed with resources from the company’s capital reserves from previous years’ profits. In such a case, the negative free cash flow would not be an issue of concern.

Cash Flows to Sales

The cash flows to sales ratio is computed by dividing free cash flow by sales revenue. In the Propensity Company case, free cash flow had a negative outcome, so the calculation would not be useful in this case.

Cash Flows to Assets

The cash flows to assets ratio is computed by dividing free cash flow by total assets. Again, when the free cash flow had a negative outcome, as it did in the Propensity Company example scenario, the calculation would not be useful

Concepts In Practice

Lehman Brothers: Would You Have Invested?

Between 2005 and 2007, Lehman Brothers (an investment bank) increased its net income from $3.1 billion to $4.1 billion. It received nearly $42 billion interest and dividends on its investments, a primary part of its business model, in 2007 alone. It also had $7.2 billion available in cash at the end of 2007. Would you be interested in investing in Lehman Brothers? However, Lehman Brothers went bankrupt in September 2008; it was the biggest corporate bankruptcy in history. Could investors have known?

A clue would be its free cash ratio. Assuming that you would expect Lehman Brothers’ actual capital expenditures and dividend payments from 2007 be expected in 2008, Lehman’s free cash ratio would be calculated as, in millions:

Cash flows from operating activities of ($45,595) minus cash planned for capital expenditures of (1,931) minus cash dividends of (418) equals free cash flow of (47,944).

Lehman Brothers invested heavily in securities created from subprime mortgages. When the subprime mortgage market collapsed in 2008, Lehman Brothers was not able to generate enough cash to stay in business. The large negative free cash flow gave warning that Lehman Brothers was a risky investment.

IFRS Connection

Statement of Cash Flows

In every type of business across the globe, it is important to understand the business’s cash position. Analyzing cash inflows and outflows, current cash flow, and cash flow trends, and predicting future cash flows all importantly inform decision-making. The US Securities and Exchange Commission (SEC) requires the statement of cash flows as the mechanism that allows users to better assess a company’s cash position. US generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) set forth rules regarding the composition and presentation of the statement of cash flows.

  • Method: Both GAAP and IFRS recommend and encourage the direct method of preparing the statement of cash flows but allow the indirect method. Under US GAAP, if the direct method is used, a reconciliation between net income and operating income must also be presented. This reconciliation is not required under IFRS.
  • Presentation: The three categories—Cash Flows from Operating Activities, Cash Flows from Investing Activities, and Cash Flows from Financing Activities—are required under both US GAAP and IFRS. US GAAP requires the presentation of only one year of information, while IFRS requires two years of data.
  • Categorizing Transactions: IFRS is more flexible in where to present certain cash flow transactions than is US GAAP. This flexibility occurs around interest, dividends, and taxes. As shown in Table 16.1, US GAAP is more rigid in reporting.
Comparing GAAP and IFRS
  US GAAP IFRS
Interest paid Operating Operating or financing
Interest received Operating Operating or investing
Dividends paid Financing Operating or financing
Dividends received Operating Operating or investing
Taxes Operating Usually operating but option to dissect tax into operating and financing components
Table 16.1

Understanding the impact of these potential differences is important. The statement of cash flows is used not only to evaluate from where a company receives and spends its cash, but also to predict future cash flows. The flexibility of these reporting items in the statement of cash flows can result in decreased comparability between similar companies using different reporting methods. For example, Free Cash Flow (Operating Cash Flows less Capital Expenditures), will have different results if interest and dividends are classified in sections other than operating activities.

Let’s consider an example: World-Wide Co. is headquartered in London and currently reports under US GAAP because it is traded on the New York Stock Exchange (NYSE). World-Wide is considering switching to reporting under IFRS to make the company more comparable to its competitors, since most of them use IFRS. World-Wide has the following information in the operating activities section of its most recent statement of cash flows.

Cash flows from operating activities $2,500,000, including cash interest payments of 200,000, cash interest received of 90,000, taxes paid of 125,000, and cash dividends received of 50,000.

World-Wide had $1,000,000 in capital expenditures during the year, and they paid dividends of $80,000 to shareholders.

Based on this information, World-Wide’s Free Cash Flow would be as follows:

Free cash flow equals cash from operating activities minus capital expenditures.

or

$2,500,000 − $1,000,000 = $1,500,000

If World-Wide switches to IFRS reporting, it has determined that its cash interest payments would be classified as financing activities because the payments are related to long-term debt. The interest received is from a short-term receivable and thus will remain classified as an operating activity, but the dividends received are from a long-term investment and will be reclassified to an investing activity. And, $60,000 of the taxes have been identified as being associated with tax consequences of an investing opportunity and therefore will be reclassified as an investing activity. With these reclassifications, the free cash flow of World-Wide would be as follows:

FCF = ($2,500,000 + $200,000 − $50,000 + $60,000) − 1,000,000 = $1,710,000

The take-away from this example is that the flexibility afforded by IFRS can have an impact on comparability between companies.

These, and other differences, between US GAAP and IFRS arise because of the more rules-based nature of the standards put forth by FASB versus the more principles-based rules set forth by IASB. The IASB, in creating IFRS standards, follows a substance-over-form viewpoint that allows firms more flexibility in assessing the intent of transactions. Anytime more judgement is allowed and/or utilized, there must be adequate disclosure to explain the chosen reporting methodology.

Footnotes

  • 3 Marc A. Siegel. “Accounting Shenanigans on the Cash Flow Statement.” CPA Journal. March 2006. http://archives.cpajournal.com/2006/306/essentials/p38.htm
  • 4 Steven D. Jones. “Why Cash Flow Matters in Evaluating a Company.” The Wall Street Journal. August 11, 2016. https://www.wsj.com/articles/SB997466275287616386. Miriam Gottfried. “Spoiler Alert for Netflix: Debt and Cash Flow Matter.” The Wall Street Journal. April 17, 2017. https://www.wsj.com/articles/spoiler-alert-for-netflix-debt-and-cash-flow-matter-1492468397
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