UNDERSTANDING FINANCIAL STATEMENTS
Chapter 4
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Required by SFAS #95
• Replaced the Statement of Changes in
Financial Position in 1988
• One of the required MAJOR statements
• Can be developed from Balance Sheet and Income Statement data
• Provides very RELEVANT information!
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

“A positive net income on the income statement is ultimately insignificant unless a company can translate its earnings into cash, and the only source in financial statement data for learning about the generation of cash from operations is the statement of cash flows”
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• From OPERATING ACTIVITIES
• From INVESTING ACTIVITIES
• From FINANCING ACTIVITIES
• Which do you think is most important in assessing the firm’s prospects? Why?
• Defining these activities may help answer the question...
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Delivering or producing goods for sale and providing services
• The cash effects of transactions and other events that enter into the determination of income
• Examples: cash flows resulting from sales of goods, purchase of inventories, payment of operating expenses
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Acquiring/disposing of securities that are not cash equivalents
• Acquiring/disposing of productive assets
• Lending money/collecting on loans
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Borrowing from creditors/repaying the principal
• Obtaining resources from owners
• Providing owners with a return on investment
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• All sources and uses of cash represent important information
• But, only cash flows from operating activities represent cash generated internally
• In order to SURVIVE, a firm needs to generate positive cash flows internally, i.e. from “what it does for a living”...
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Look at changes in balance sheet accounts from beginning to end of accounting period
• Classify changes in all accounts except cash as resulting from (1) operating, (2) investing or (3) financing activity(ies)
• The summary of all these changes
EXPLAINS the change in cash!
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Some folks like the DIRECT approach
• Others like the INDIRECT approach
• Both methods provide the information necessary for financial analysis
• Either method is acceptable but FASB prefers DIRECT approach
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Shows cash collections from customers, interest and dividends collected, other operating cash receipts, cash paid to suppliers and employees, interest paid, taxes paid and other operating cash payments
• Translates each item on the accrualbased income statement to a cash revenue or expense item
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Starts with net income (accrual-based) and adjusts for deferrals, accruals, noncash items such as depreciation and amortization and nonoperating items such as gains and losses on asset sales
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Keep in mind -- either method will get you to the same place, i.e. operating cash flows will not look “better” using one method as opposed to the other -it’s a matter of format
• Regardless of the method chosen to present operating cash flows, the rest of the Statement of Cash Flows looks the same…
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Investing and Financing sections are pretty straight-forward -- the method chosen (direct or indirect) to present the
Operations section does not affect the presentation of this information
• Focus primarily on changes in noncurrent assets and liabilities
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Firm’s ability to generate cash flows in the future
• Firm’s capacity to meet cash obligations
• Firm’s future external financing needs
• Firm’s success in productively managing investing activities
• Firm’s effectiveness in implementing financing and investing strategies
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• BIG DIFFERENCE between overall increase or decrease in cash and increase or decrease in cash from operating activities
• Overall decrease in cash may be a positive sign
• Net cash outflow from operating activities is NOT desired...
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

A COMPANY CAN BE HIGHLY
PROFITABLE AND BE IN TROUBLE
HOW CAN THIS BE???
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• A firm is defined as “profitable if it has a positive net income
• A positive net income results from accrual-based revenues exceeding accrual-based expenses
• A firm may have a positive net income, but this does not guarantee that the firm has the CASH to meet its obligations!
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• How long would you sell to a company that didn’t pay your bills (in CASH)?
• How long would you sit still if you had loaned money to a firm (bought their bonds) and didn’t get your interest (in
CASH)?
• Would you loan more money to a firm who didn’t pay your last loan (in CASH)?
Et cetera, et cetera
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Is the firm generating sufficient cash from operations?
• What are underlying causes of positive or negative operating cash flow?
• How large is the positive or negative operating cash flow?
• Have operating cash flows fluctuated over time or are they stable?
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• Examination of the cash flow statement will help assess a firm’s financial health
• Major focus is on operating cash flows but there is important information in the other categories as well
• The information provided on the cash flow statement is REALLY necessary!
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business

• NEXT ON THE AGENDA:
• THE ANALYSIS OF FINANCIAL
STATEMENTS
Fraser/Ormiston: Understanding
Financial Statements, 6th ed. (C)
2001 Prentice Hall Business