UNIVERSITY OF LATVIA
FACULTY OF ECONOMICS AND MANAGEMENT
KĀRLIS SUBATNIEKS
Summary of the Promotion Paper
APPLICATION OF CASH FLOW
IN CORPORATE FINANCIAL ANALYSIS
Promotion to the Degree of Doctor of Economics (Dr. oec.)
Branch: Economics
Subranch: Finance and Credit
Riga, 2007
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The Promotion Paper was developed and approved in Riga at the Institute of
Finance, Faculty of Economics and Management, University of Latvia from 2003
till 2007.
Scientific supervisor: Dr. oec., Professor Elvīra Zelgalve
Reviewers: Dr. oec., Professor Inta Brūna
Dr. oec., Asoc. Professor Gaida Kalniņa
Dr. oec. Sergejs Babuškins
The Promotion Paper will be defended at open session of the Promotion
Council for Economics of University of Latvia on May 14, 2007, at 16.00 in 5
Aspazijas boulevard, Riga, Room 322.
The Promotion Paper is available at the library of University of Latvia 4
Kalpaka boulevard, Riga, LV-1050.
All opinions should be sent to the Academic Department of University of
Latvia at:
19 Raina boulevard, Riga, LV-1586.
Chair of the Council Dr. oec., Professor Ērika Šumilo
Secretary of the Council Dr. oec., Docent Anda Batraga
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Contents
The Abstract of the Promotion Paper ...................................................... 48
General Description of the Promotion Paper ........................................... 49
Main Propositions of Promotion Paper .................................................... 56
1. Concept of Cash Flow in Economic Theory and Role
in Corporate Financial Analysis ...................................................... 56
1.1. Concept and Methods of Measuring of Corporate Cash Flow ... 56
1.2. Theoretical Aspects of Corporate Cash Flow Analysis ............... 58
1.3. Literature Review on Corporate Cash Flow Prediction ............. 59
1.4. Concept, Calculation and Usage of Free Cash Flow .................. 61
2. Application of Cash Flow Measures in Determining
Financial Position of a Company ..................................................... 62
2.1. Comparison of Corporate Earnings and Cash Flows
in the Context of Valuation of Company’s Financial Position .... 62
2.2. Assessment of Cash Flow Statement Measures ......................... 64
2.3. Cash Flow Ratios Used in Determining Financial
Position of a Company ............................................................... 65
2.4. Analysis of Indicators of Cash Flows of Samples
of Latvian and European Companies ......................................... 66
2.5. Correlations between Indicators of Corporate Cash Flow
and other Corporate Finance Measures ...................................... 69
2.6. Factors Influencing Corporate Cash Flow .................................. 71
3. Potential Improvement of Cash Flow Statement and
its Use in Corporate Cash Flow Prediction ..................................... 73
3.1. Potential Enhancement of Cash Flow Statement ....................... 73
3.2. Corporate Cash Flow Prediction ................................................ 75
3.3. Impact of Financial Statement Measures on Corporate
Cash Flow Prediction and Company Valuation .......................... 76
Main Conclusions and Proposals of Promotion Paper ............................. 80
Data on Promotion Paper and Author ...................................................... 86
Author’s publications on the subject of promotion paper: ....................... 86
Author reported content of promotion
paper at scientific conferences: ................................................................ 86
Data on author’s previous education and scientific background: ............ 86
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The Abstract of the Promotion Paper
The goal of the Promotion Paper is to provide proposals for the improvement of
the cash flow statements, cash flow analysis and management, as well as cash flow
prediction based on analysis of cash flow and factors influencing them, as well as
investigation of legislative acts introduced on the subject of cash flows.
In Chapter 1, the author analyses the concept of cash flow in economic theory
and its role in corporate financial analysis. In Chapter 2, based on the investigation
of theory and methods conducted in previous chapter, the use of cash flow measures
in determining financial position of a company is analysed. Following the investigation of the theoretical aspects and practical analysis of cash flow measures in the
forgoing chapters, in Chapter 3 the author works out recommendations for enhancement of a cash flow statement, and explores the application of cash flow data in
corporate cash flow prediction.
In the course of preparing this paper author has defined more precisely the
definitions of cash flow indicators, has developed a new definition and a new, simplified formula for the calculation of free cash flow, as a result of which it is possible
to conduct a better founded analysis of company’s ability to finance growth and
likewise limit the tendency of company management to overestimate firm’s assets.
The author has worked out a classification of cash flow ratios, thus providing new
opportunities in determining financial position of companies. The promotion paper
also emphasises specific symptoms of cash flow problems in commercial entities
that allow financial managers to react more quickly to negative signals. The author
puts forth a proposal how to avert discrepancies in definitions of cash flow measures
and how to ensure standard terminology in different legislations, as well as suggestions to accounting standard setting institutions for improvement of the cash flow
statements, thereby helping cash flow statements to reflect more precisely company operations. The author puts forward recommendations for financial analysts,
corporate financial managers un other employees, auditors, current and potential
investors, creditors, as well as other users of financial statements with regard to
application of cash flow in corporate financial analysis, prediction and planning,
proposals to management of Latvian enterprises for a more appropriate selection of
investment projects that are necessary to implement. There are suggestions on the
subject of peculiarities of cash flow statement preparation methods on a corporation’s divisional level, which are required in order to ensure stricter control and
evaluation of results of divisional activities. The author has carried out an empirical
study of the data of Latvian companies, which has resulted in verification of the
hypothesis put forward in the introduction of the paper and substantiated in the main
body of the paper, that usage of cash flows in determining company’s financial position and cash flow prediction leads to a more accurate assessment than using data
from the profit and loss statement.
The promotion paper consists of 192 pages, it includes 27 tables and 7 figures,
there are 10 appendices attached. References include 132 sources of cited literature.
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General Description of the Promotion Paper
Topicality of the Promotion Paper. Recent findings in financial economics
emphasise the growing role of cash flow measures in company valuation models
and assessment of the financial position of an enterprise. Given the measurement
problems in accrual accounting, more and more investors and other users of financial statements are beginning to focus on company’s cash flows instead of focusing
on earnings of a firm.
Nonetheless, many users of financial statements still spend more time studying
the profit or loss account and the balance sheet of a company rather than the cash
flow statement. Consequently, the user of the financial statement can not form an
objective opinion on changes in funds’ flow and financial position as a whole. Profit
or loss account is prepared by the principle of accrual accounting; it includes all
revenues regardless of the actual cash received, or lack of it. On the other hand, it
includes expenses that have not yet been paid, or have been paid previously but
written off in current period. However, the cash flow statement complies with so
called cash principle, thus including only actual cash inflows and outflows.
An additional reason for exploring cash flow is connected with the need of a
company to forecast its financial position in the nearest and farthest future, in order
to plan purchase of fixed assets and other development projects. Cash flow data are
prevalent in evaluating company investment projects, determining company cost of
capital and the value of an enterprise, too. These are the fields of economic research
where cash flow measures and ratios are indispensable.
There have been many widely publicised cases, in which a positive conclusion
was reached on the financial position of a corporation, followed shortly afterwards
by its insolvency and bankruptcy. Those who reached the wrong conclusion admit
later to their unwillingness or inability to analyse cash flow conditions of a company.
According to a survey of world leading auditing firms, their audit procedures
have not changed in ways that take advantage of the information presented in the
cash flow statement even in 21st century, in spite of the fact that this statement has
been required in the present form for nearly twenty years. Educators have not been
placing emphasis the cash flow statement either. Textbooks commonly include only
ratios based on the balance sheet and income statement with little or no discussion
of cash ratios.
Investor success is usually measured by the cash return expressed as a percentage increase of cash, but discounted at an appropriate rate of interest. Investors
and creditors are mainly interested in future cash flows and, in particular, in their
amounts, timing, and certainty. A company not generating the same amount of cash
flow as its competitors can go bankrupt when times get rough. Even a profitable
company can go under if there is not enough cash flow to pay bills.
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Information content of company earnings and operating cash flows has been
studied intensely in the last two decades. Because earnings are considered as the
primary profitability indicator, the majority of studies focus on investigating the
information content of earnings by measuring the association between earnings and
stock returns. On the other hand, cash flows are viewed as a secondary signal of
firm value (Bernard and Stober, 1989; Ali, 1994; Cheng, Liu and Schaefer, 1996).
Consequently, previous studies concentrate on evaluating the incremental information content of cash flows beyond that of earnings (Ali and Zarowin, 1992; Ali and
Pope, 1995; Clubb, 1995; McLeay, Kassab and Helan, 1997; Charitou, 2001).
Before the availability of international accounting standards, studies reported mixed
and inconclusive results for the incremental information content of cash flows in
determining company’s financial position. Recent studies (for example, Cheng and
Yang, 2003) have shown strong and consistent evidence on the incremental information content of cash flows when reported cash flows from operations are used.
Lee, Ingram and Howard (1999) report that the excess of earnings over cash
flows is substantially greater for fraud firms prior to the year of fraud discovery. It
suggests that cash flow is an important signal in that regard as well. Most authors
agree that cash flows become indispensable when earnings are transitory or extreme.
However, most studies focus on the supplementary role of cash flows. Few
studies have assessed whether cash flows play the main role and earnings the supplementary role in evaluating current and future financial position of an enterprise.
According to modern economic and finance literature, the main goal of the
owners of an enterprise and, consequently, the main goal of its managers and other
personnel is maximizing shareholder value, as measured by company share price.
Changes in cash flow, arguably, is an indicator overtaking the change in company
value. This is why many authors have turned in recent years to cash flow prediction,
which would enable potential investors and creditors to acquire the necessary data
faster. Cash flow predictions influence company value today.
The results of their research have been contradictory. Despite many accounting
standard setting organizations in different countries arguing that earnings are
superior to cash flow data as a predictor of future cash flows, Bowen, Burgstahler
and Daley (1986) did not find evidence for that. However, Greenberg, Johnson and
Ramesh in the same year arrived at opposite conclusions, and Lorek and Willinger
(1996), studying quarterly, not annual, data, concluded that earnings measures have
a greater cash flow forecasting ability. Finger (1994) inferred that cash flow has
better predictive ability in the short term but earnings and cash flow provide equally
precise results in long-term prediction.
The findings by Barth, Cram and Nelson (2001) revealed that disaggregating
earnings into cash flow and six aggregate accruals components – change in
accounts receivable, change in accounts payable, change in inventory, depreciation,
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amortization, and other accruals – significantly increases predictive ability. DeFond
and Hung (2003) have analysed cash flow forecasts by financial market analysts.
The study by Jordan and Waldron (2001) on cash flow prediction used a range of
predictor variables, rather than comparing the predictive abilities of only two
measures (accrual earnings and operating cash flow). The study by Nikkinen and
Sahlström (2004), dedicated its attention to performance of cash flow prediction
models in US, Canada, France, Germany, Japan and UK. In their paper, as well as
in the paper by Al-Attar and Hussain (2004) there are similar results that suggest
the need to split earnings measures into their cash flow and accrual components.
Mavrotas, Caloghirou and Koune (2005) also have paid attention to potential
improvement of cash flow prediction and emphasised its role in implementing
different investment projects.
There is an insufficient number of studies on the subject of cash flow absolute
and relative measures, as well as their role in corporate financial analysis in Latvia.
Latvian entrepreneurs and scientists give inadequate attention to cash flow statement data and free cash flow. Studies conducted up until now have looked at cash
flow statement mainly from accounting perspective.
By analysing the sources of literature named above, and taking into account the
aforementioned problems existing in theoretical and practical sphere, the author
concludes that the subject covered by the thesis is topical.
The goal of the promotion paper is to provide suggestions for enhancement of
cash flow statements, corporate cash flow analysis and management, as well as cash
flow prediction on the basis of analysis of cash flow and factors influencing it, cash
flow ratios and legislation on the subject of cash flow.
There are following tasks to achieve this aim:
• analysing the concept of company cash flow and its presentation methods;
• investigating the role of cash flow measures in corporate financial analysis;
• reviewing the existing literature and chronological development of company cash flow analysis and prediction;
• assessing the application of free cash flow and providing recommendations for a more precise calculation of free cash flow;
• investigating cash flow measures and ratios used for assessment of the
financial position of a company;
• evaluating cash flows of samples of Latvian and European companies and
finding correlations between measures of cash flow and other measures of
corporate financial economics;
• exploring factors influencing cash flow;
• comparing the efficiency of company earnings and cash flow in evaluating corporate financial position;
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• on the basis of analysis of financial statement providing proposals for
enhancement of cash flow statement;
• using a developed model, to give suggestions for improving cash flow
prediction.
The object of the research is corporate cash flow.
The hypothesis of the research is: the use of past and present cash flow data in
analysis of the financial position of an enterprise leads to a more accurate assessment than using data from profit and loss account; past and actual cash flows are a
better predictor of future cash flows than earnings.
Foundation for the outline of the Promotion Paper. The proposed tasks have
determined the structure of the promotion paper. Since the promotion paper is on
the subject of corporate cash flow, first of all it is necessary to analyse the concept of
cash flow in economic theory and its role in corporate financial analysis. Therefore,
in Chapter 1, author investigates the essence of company cash flow and methods
of its presentation, the role of cash flow indicators in corporate financial analysis,
the historical development of cash flow analysis and prediction, as well as variation
of cash flow widely used in financial economics – free cash flow. In this chapter
author devotes attention to calculation of measures mentioned above, as well to
possibilities of improving their estimation, which is necessary because the actual
computation and analysis follows suit.
In Chapter 2, based on theory and methods explored in the previous chapter,
author calculates and investigates indicators of cash flow of enterprises in Latvia
and other European countries. A comparison is conducted of earnings and cash flow
measures in the context of determining corporate financial position. Author analyses the most appropriate measures and ratios for evaluation of financial position
of a company, as well as the results of computations and correlations with other
variables. The chapter also includes an evaluation of factors influencing corporate
cash flow.
On the basis of investigation of theoretical aspects and analysis of actual cash
flow indicators, it is essential to work out recommendations for enhancement of
cash flow statement, as well as improvement of cash flow prediction, which is done
in the last chapter – Chapter 3. The evaluation of cash flow predicting ability has
been conducted with the help of regression models.
Methods of the research. The methodology of the research includes several
techniques of economic and statistical analysis like expert opinion, calculation of
relative values, comparing and grouping of data, calculation of mean values, content analysis, case studies, graphical analysis, correlation and regression analysis,
testing of statistical hypotheses etc.
Restrictions of the study. Promotion paper analyses application of cash flow
in corporate financial analysis. With the term „corporation” author labels the notion
of „commercial entity” as defined by Commercial Law and Annual Reports Act.
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Moreover, in promotion paper author does not analyse the role of cash flows in banks,
savings and loan associations, insurance companies, private pension funds, investment
brokerage companies and investment management entities.
Cash flow analysis and prediction is investigated in the paper also in the context of
company life cycle and on the divisional level of corporations. With the term „division”
author labels an economic unit of a company, for which it is possible to autonomously
collect accounting data. Legally it is usually registered as a subsidiary or a subsidiary
company.
The promotion paper does not give forecasts of cash flows for specific Latvian
companies or reveal the peculiarities of cash flows in different industries. The goal of the
paper does not include analysis of the impact of accruals and their components on cash
flow prediction, but is restricted by the comparison of earnings and cash flows in an
evaluation of future cash flow assessment efficiency.
Period of study. The period of the theoretical part of the research is from the
emergence of cash flow usage until today, the period of the empirical part is 1995-2006.
Description of sources. The informative base for the research is laws and regulations
of the Cabinet of Ministers of the Republic of Latvia, scientific literature and papers from
North America, Western Europe, Eastern Europe and Asia, periodicals, internet pages,
Amadeus, Science Direct, Blackwell Synergy, J Stor, EBSCO data bases, financial reports
of companies.
Scientific contribution by the author. The author has developed the following
scientific innovations within the promotion paper:
 has defined more precisely the definitions of cash flow and net cash flow;
 has critically analysed the concept of cash flow and its role in financial
analysis, as well as methods of preparing cash flow statement and legislation
on the subject of cash flow
 has explored the chronological development of corporate cash flow prediction;
 has developed definition and new, simplified formula for calculation of free cash
flow, as a result of which it is possible to conduct a better founded analysis of
company’s ability to finance growth, and the willingness of company
management to overestimate firm’s assets is limited as well;
 has worked out and streamlined a classification of cash flow ratios, thus
providing new opportunities in determining financial position of companies;
 has formulated the factors influencing corporate cash flow.
Practical contribution by the author. The promotion paper also provides the
following practical innovations:
 diligently investigates cash flow measures used in assessment of corporate
financial position, emphasises specific symptoms of problems with cash
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







flow in commercial entities that allow financial managers to react more quickly
to negative signals;
there is a proposal to avert discrepancies in definitions of cash flow measures and
to ensure standardized terminology in different legislation,
analyses cash flow measures of Latvian and European companies and correlations between them, which has allowed to put forward several conclusions
and recommendations;
there are suggestions to accounting standard setting institutions for improvement
of the cash flow statement, thereby helping cash flow statement measures to
more precisely reflect company operations;
there are recommendations for financial analysts, corporate financial managers
un other employees, auditors, current and potential investors and creditors, as
well as other users of financial statements with regard to application of cash
flow in corporate financial analysis, prediction and planning;
there are proposals to the management of Latvian enterprises for a more
appropriate selection of investment projects that are necessary to be implemented;
there are suggestions on the subject of peculiarities of the cash flow statement
preparation methods on the divisional level of a corporation, which is required in
order to ensure stricter control and evaluation of results of divisional activities;
provides recommendation to company owners how to lay down cash flow goals
in employee job responsibility descriptions, for evaluation of employee’s or
manager’s performance, and for corporate reward system;
there is an empirical study of the data of Latvian companies, which has resulted
in testing of the hypothesis put forward in the introduction and substantiated in
the main body of the paper.
Defendable propositions:
1. Free cash flow in a certain period of time is calculated by subtracting respective
period’s capital maintenance expenditure from net operating cash flow. The
calculation of capital maintenance expenditures is accomplished by multiplying
company assets at the beginning of period with the nominal growth rate of the
respective sector of industry for that period of time.
2. The classification of cash flow ratios must be conducted by their character,
thereby splitting them into three categories. One category of cash flow relative
measures must characterise corporate solvency, the second category must be
used in determining company’s ability to finance growth, the additional category
must show corporate cash-generating efficiency.
3. Taking into account the peculiarities of commercial and financial environment in
Latvia, operating cash flow, not earnings, is a better predictor
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of corporate cash flow and a measure of financial position of a company.
4. When analysing the impact of cash flow in operating cash flow prediction
using a regression model with a lag of one year, the sign of the regression
coefficient for the cash flow independent variable must be positive.
Approbation. The main propositions of promotion paper have been introduced to a
wide circle of interested parties:
• 8 international and local scientific conferences in Latvia and abroad;
• in the course of conducting the scientific study, the author has prepared and
published 6 scientific papers in Latvian and English;
• in the course of educating process, reading lectures for bachelor’s and
vocational students and conducting seminars for master’s students in Faculty
of Economics and Management of the University of Latvia;
• while participating in seminars of the project „Latvijas doktoranti Norvegija”
(LDN);
• while participating in the seminar of the project of Academic Development of
the University of Latvia;
• the author has received positive reviews of the promotion paper and practical
use of several recommendations from JSC „Rigas piena kombinats”, Risk
Management department of audit company „KPMG Baltics” Ltd., as well as
director of a subsidiary of JSC „DnB Nord Banka”.
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Main Propositions of Promotion Paper
1. Concept of Cash Flow in Economic Theory and Role in Corporate
Financial Analysis
1.1. Concept and Methods of Measuring of Corporate
Cash Flow
In 2004, Latvian Accounting Standard (LAS) 2 “Cash Flow Statement” was passed. This
standard was one of the two first national accounting standards in Latvia that are compulsory.
It determines the structure, contents and order of presentation of the cash flow statement, as
well the information on changes in cash and its equivalents during the reporting period, so that
users of financial statement, based on cash flow statement, could evaluate company’s generating
ability of cash and its equivalents, as well as to predict the timing, sources, uses and stability of
cash flows.
LAS 2, standards in other countries, as well as Needles, Powers and Crosson, Penman,
Nikonova, Grebenko, Bertoneche and Knight, provide a definition of cash flow. In author’s
opinion, company cash flow must be defined as an increase and decrease in cash and its
equivalents, net cash flow must be defined as an increase or decrease in cash and its
equivalents.
Company cash flow must be divided into three parts – operating cash flow, investing cash
flow, and financing cash flow. Division of cash flow and nature from the point of view of
company assets and liabilities is shown in Figure 1.
Figure 1. Company cash flows in the context of balance sheet components
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When founding an enterprise, owners and, possibly, creditors provide funds in
the form of statute capital and debt, which is shown by the small-dotted arrow in
Figure 1, resulting in positive cash flow from financing activities. These financing
cash inflows are then converted into investing cash outflows, since they are invested
in long-term assets (narrow black arrow).
Long-term assets along with the rest of company assets are used to generate
positive operating cash flow (to make cash inflows larger than cash outflows),
which is shown by the wide black arrow. Operating cash flow then can be divided
into two parts. First of all, a company must pay principal and interest payments to
its creditors, as well as dividends to its shareholders. It is described by the double
line arrow that manifests itself in the cash flow statement as negative cash flow from
financing activities. The rest of operating cash flow, depending on the amount, can
be invested in capital maintenance or to increase the size of company assets. This
is the way that this part of operating cash flow, which is represented by the squaredotted arrow in Figure 1, alongside with financing from owners and creditors can
be invested in new assets again.
Figure 2 shows the mutual relation between company cash flow categories.
Figure 2. Mutual relation between company cash flows
Figure 2 is drawn on the assumption that company operating and financing cash
flows are positive, for its part investing cash flow is negative. That corresponds to
the situation in a normally operating enterprise. As shown by the figure, positive
net operating cash flow that is internally generated by the company itself from its
assets, and positive financing cash flow that is acquired from external sources of
financing, can be used either for new investments, which results in negative net cash
flow from investment activities, or for increasing balance of cash and its equivalents
(generating net cash flow).
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It means that sources of cash flow (financing) are reflected in Figure 2 on the
left, while uses of cash – on the right. Usually, generating net cash flow in the reporting period is not expedient because cash and its equivalents are company assets
with the lowest level of return. Therefore a corporation must find or create investment projects with positive net present value (NPV), in which it is appropriate to
invest cash, thereby generating cash flow from investing activities.
There are two methods of presenting operating cash flow: direct and indirect.
Although both methods provide identical results, indirect method is used more often
– due to its relative simplicity. Investing and financing cash flows are presented only
with the direct method. Direct method means that cash changes are recognized
from records in accounts of cash and its equivalents, presenting gross cash inflows
and outflows in a breakdown of their main components. The essence of indirect
method is that net income is adjusted with several long-term and short-term
components of accruals to arrive at cash flow from operations.
There are differences among authors on the advantages and disadvantages of
the methods. However, one must infer that users of financial statements that do not
reveal direct method information incur additional costs by estimating and collecting
this information. There is also potential for low quality financial analysis and misallocation of resources when decisions are based on incomplete and incorrect data.
1.2. Theoretical Aspects of Corporate Cash Flow Analysis
The number and diversity of company valuation, financial analysis and decision-making models and procedures developed by investors and scientists keeps
growing all the time. In many of those, a significant role is played by cash flow
measures. A number of authors and whole institutions have explored and analysed
cash flow data in different countries.
The scope of discounted cash flow (DCF) methods in modern scientific literature is growing. They are used for calculating corporate cost of capital, investment
decision-making and valuation of securities. Extensions of the DCF concepts to investment valuation are free cash flow techniques by Copeland, Koller and Murrin,
and Damodaran, and managerial performance evaluation are economic value added
concept by Stewart. Financial performance assessment using the concept of residual
income known as economic value added, has received much attention in recent academic literature, notably Bacidore, Boquist, Milbourn and Thakor, Biddle, Bowen
and Wallace, as well as financial periodicals and publications of finance practitioners.
Historically, the use of cash flow data has been episodic, with greater emphasis
on cash flow information evident at times of major corporate scandals connected
with sudden business failures. Notorious bankruptcies early in this century again
motivated greater integration of cash flow data in models of equity valuation and
assessment of company creditworthiness.
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Bowen, Burgstahler and Daley were one of the first to study the nature of
corporate cash and its flows using correlation analysis. In addition, Shrieves and
Wachowicz, Al-Attar and Hussain, Dechow, Kothari and Watts, Kwok, Allen and
Cote, Barth, Cram and Nelson, Wild, Bernstein and Subramanyam, Penman, Hand,
Houge and Loughran, Ettredge and Fuller, Brooks and Buckmaster, Ali, Klein and
Rosenfeld, Sloan, White, Sondhi and Fried, Jones, Romano and Smyrnios, Quirin,
O’Brian, Wilcox and Berry, Bahnson and Bartley, Schilit, Cheng, Liu and Schaefer,
Catanach, Previts, Bricker, Robinson and Young, Billings and Morton, Beaver,
Ohlson, Boyd, Giacomino and Mielke, Davies, Paterson and Wilson, Kochanek and
Norgaard, as well as Hayn have given their input in development of cash flow analysis around the world.
An important factor that impacts the role of cash flow is corporate financial analysis is earnings volatility. Volatile earnings are perceived as lower quality, creating
a demand for additional information to help users of financial statements distinguish
the persistent component in earnings. For example, in the case of losses earnings are
usually transitory, therefore users of financial statements must emphasise operating
cash flow in their analysis.
Financial analysts find that cash flow assessment and forecasting is more useful
for capital intensive firms. This is consistent with the data on the number of cash
flow forecasts made by financial analysts. Creditors put emphasis on the role of
liquidity and cash flow in their analysis of company creditworthiness. Operating
cash flow measures are helpful to creditors in identifying company’s cash-generating efficiency from its operations, as well as the ability to cover principal and
interest payments of a loan. Overall, one must infer that cash flow measures are
indispensable in:
1. ascertaining the sources and uses of cash;
2. explaining the difference between earnings and cash changes;
3. evaluating company’s ability to settle debt and pay dividends;
4. predicting cash flow.
1.3. Literature Review on Corporate Cash Flow Prediction
Research on the comparative predictive abilities of accrual earnings measures
and cash flow measures exists in two primary areas. First, a considerable amount of
research examined the comparative abilities of earnings and cash flows in predicting securities prices using stock returns as a proxy for future cash flows. Second,
are those studies that compared earnings measures and cash flow measures as predictors of actual net cash flow from operations. Recently, there have been many
studies of the second type, since scholars are more aware of the need to conduct
direct research. These studies need to be examined in more detail because their essence is compatible with hypothesis of promotion paper put forward by the author.
These direct studies do not provide specific cash flow forecasts but are solely trying
to explain the variation in cash flows.
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The results of early studies were contradictory. In the eighties, Bowen,
Burgstahler and Daley concluded that none of their results were consistent with the
U.S. Financial Accounting Standard Board’s assertion of the superiority of earnings, as opposed to cash flows, as predictors of future cash flows. The results by
Greenberg, Johnson, and Ramesh indicated that in four of five cases, net income
outperformed cash flow in a significant manner. Murdoch and Krause came to the
same conclusion as the previous authors.
In the nineties, McBeth stated that the predictive ability depends on the time
period. Contrary to McBeth, Finger found that cash flow is a superior predictor for
short horizons, and that earnings and cash flow are approximately equivalent for
longer horizons. The findings by Lorek and Willinger were consistent with the
viewpoint espoused by accounting standard setting institutions of many countries
that cash flow prediction is enhanced by consideration of earnings data. The conclusions by Dechow, Kothari and Watts implied that current earnings was a better
predictor of future cash flows than current cash flows. Quirin, O’Bryan, Wilcox and
Berry found that the best predictor of cash flow from operating activities was past
cash flow from operating activities. Likewise, the results of Krishnan and Largay
suggest that past cash flow data are more useful than past earnings in predicting
future cash flows.
In this century, according to Jordan and Waldron, the best predictor of future
operating cash flows seems not to be a pure measure of either accrual earnings or
cash flows, but rather a hybrid measure containing elements of both. In a paper that
is the most cited publication in this field of research Barth, Cram and Nelson find
that accruals have substantially more predictive ability for future cash flows than
several lags of aggregate earnings. DeFond and Hung found that cash flows have
incremental power in explaining stock returns and future cash flows. Al-Attar and
Hussain came to a following conclusion: the model containing only current cash
flows had a significantly superior explanatory power than the model containing only
current earnings as an independent variable. The study by Nikkinen and Sahlström
has covered the widest population of countries in papers on the subject of cash flow
prediction known to the author. They discovered that the model created by Barth,
Cram and Nelson performs consistently across countries where the study was conducted, except in Germany.
On the whole, one must conclude that recently the proportion of studies, which
show that cash flow is a better predictor of future operating cash flow, has increased. This might be due to improvements in research methodology. Many authors
have used only univariate regression models in their studies, and have not evaluated
marginal contribution of each explanatory variable that has made it hard to provide
well-founded conclusions.
An important task is to inquire into current regularities of cash flow prediction
in Latvia. Author’s hypothesis would be that taking into account the strong role of
banks in providing financing for Latvian enterprises, which means also a direct
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access to company financial information, as well as lack of need to turn to capital
market and new investors for raising capital, and relatively fragile legislation system, the quality of earnings numbers would be quite low, leading to cash flow as
the best predictor of future cash flow. The one factor that might work against this
assumption is the separation of financial and taxation accounting in Latvia. As a
consequence, financial statement information may be more informative, since there
is no incentive to reduce earnings.
1.4. Concept, Calculation and Usage of Free Cash Flow
Although the inclusion of free cash flow category is not required in the cash
flow statement at this time, the amount of free cash flow can give an in-depth perspective on company’s ability to finance growth and financial position as a whole.
This term is commonly used in sources of science literature of corporate financial
economics and the business press, but, unlike other cash flow categories, there is no
wide spread agreement on its definition and equation for calculations.
Free cash flow is known by many names, including raiders’ cash flow, surplus
cash flow, excess cash flow, distributable cash flow, and disposable cash flow. If free
cash flow is positive, it means that after the company has met all of its operational
and capital maintenance cash commitments, it still has cash earned in the reporting
period available to reduce debt or expand and for payments to owners, usually in the
form of dividends. A negative free cash flow means that the company will have to
reduce its cash balances, sell part of its investments, borrow money, or issue stock
in the short term to continue operating.
The definitions of free cash flow were given by such authors as Hackel and
Livnat, Needles, Powers and Crosson, Penman, such institutions like one of the
world’s largest credit rating agencies “Standard & Poor’s”, “First Interstate Bank of
Nevada”, as well as periodicals like “Forbes”, “Wall Street Journal”, and “Business
Week ”.
The approach provided in this thesis will differ from conventional free cash
flow estimation methods. It takes into account International Accounting Standard
(IAS) 7, which recommends that companies should segregate cash flows that reflect
an increase in productive capacity from cash flow necessary for maintenance of productive capacity. Using this description, and subtracting only capital maintenance
(maintenance of productive capacity) cash outflows, dividends and mandatory debt
payments would not be subtracted to arrive at free cash flow.
Hence, the author implies a capital maintenance approach to calculation of free
cash flow. It means that capital expenditures should only represent those expenditures necessary to renew the company’s operational assets, so that productive capacity
is maintained. To compensate for the lack of normal capital expenditure information, many analysts use the actual amount of capital expenditures, thus generally
understating free cash flow.
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One must note that the concept of capital maintenance is not connected with
revenues, like some authors have suggested, but with capital. Every company must
maintain its competitiveness in the branch of industry it is competing in. Therefore,
there are grounds to assume that firm’s capital (assets) must grow at the same rate
as the whole sector or branch of industry it operates in. There is a case for saying
that nominal, not real, growth rates should be used for these calculations, which
would take into account the inflation. Of course, inflation also affects company’s
balance sheet numbers. In the case of a negative growth rate, a growth rate of 0 per
cent should be applied. As a basis from which to subtract capital maintenance, it is
necessary to use net cash flow from operating activities, not earnings, like some
periodicals and scientific publications have recommended.
Taking this all into account, it is possible to come up with a whole new and
simple equation for calculating free cash flow:
BNP = PDNP – nt * Asāk = PDNP – Izmku ,
(1)
where
BNP – free cash flow,
PDNP – net operating cash flow,
nt – nominal growth rate of respective industry,
Asāk – company assets at the beginning of period,
Izmku – capital maintenance costs.
The reason for company beginning-of-year assets to be used in Equation 1 is
that it is necessary to calculate the nondiscretionary capital spending during the
year. The amount of end-of-year assets from previous year will be used when determining next year’s capital maintenance expenditure.
If used for corporate evaluation, Equation 1 will also serve to minimize the willingness of company management to overestimate the value of their assets. The problem with free cash flow underestimation in companies with intensive investments
for their development is solved, as well.
2. Application of Cash Flow Measures in Determining
Financial Position of a Company
2.1. Comparison of Corporate Earnings and Cash Flows in the
Context of Valuation of Company’s Financial Position
As the sudden insolvency and bankruptcy of “Enron” in the USA at the end of
2001 and beginning of 2002 showed, corporate guesstimates can play a big part in
calculations of corporate earnings. With its accounting policy, corporate management can increase or decrease the profits or losses in the reporting period. Accrual
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principle in accounting serves this intention. According to Point 4 of Part 1 of Article
25 of Annual Reports Act of Latvia, “profit or loss account must include revenues
and costs associated with the reporting year, irrespective of date of payment and
date of receiving or writing out the bill”.
On the one hand, the accrual principle must improve assessment of current
financial position of an enterprise and prediction of operating performance in the
future. On the other, the greater opportunity to “manage earnings” or manipulate
the results of operations that is provided by the principle may reduce the quality of
earnings. Many authors believe that company management will be interested to
manipulate earnings if the level of its rewards depends on the result of corporate
performance calculated by company accountants. Results of scientific research testify that financial analysts are usually unable to identify manipulation of earnings.
Cash is the ultimate measure in business. Acquisitions, expansions, buyouts,
insolvencies and bankruptcies all revolve around and depend on flows of cash. Too
little cash can kill a business, too much can invite unwanted takeovers.
However, cash flow has some deficiencies. It does not characterise company
earnings, does not give an idea of assets, liabilities and equity, and their magnitude.
Generally speaking, the money supply and its velocity will have more variability for a smaller company and less variability for a larger one. The reason is the law
of large numbers. One consequence is that the risk of the money supply dipping to
the danger point is much greater for small enterprises. The other element of risk that
is related to size is access to capital. Because risk is greater in a small enterprise, it
is much harder to get outsiders to plug a cash deficit.
The chief executive officer of every company needs to know how much sales
growth can be handled within given cash constraints. The problem here is that more
rapid growth means higher rates of cash consumption, due to increases in accounts
receivable and inventory, for instance. The sad fact is that the majority of failing
firms are profitable as they enter insolvency.
In addition, one must note that maximising the wealth of company owners is the
main goal of a corporation in the context of finance. Wealth of owners is measured
by company share price, which in turn depends on magnitude, timing and risk of
cash flows. The two factors influencing share price are cash flow and risk. That is
why most popular, and advanced in terms of information technology, models of
company valuation today are based on future cash flow measures.
Overall, it is possible to conclude that application of accrual principle in calculation of earnings can enhance the quality of current earnings and profitability
measures, thus, possibly, lessening the role of cash flows, or can worsen the quality,
which leads to cash flow indicators being more precise in financial analysis and prediction. The opinion of the author formulated in the hypothesis of the research and
the results of assessment undertaken in this chapter are more in tune with the second
proposition. Hypothesis will be tested statistically in Chapter 3.3 of the paper.
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2.2. Assessment of Cash Flow Statement Measures
The focus of research in corporate financial economics has been on the information content of operating cash flows. In this chapter, author will accentuate
not only the part of operating, but rather also investing and financing cash flows in
evaluation of financial position of a company.
When it comes to analysing cash flow statement, author believes that it helps to
start the assessment with the total amount of cash and its equivalents. However,
on the divisional level one must not pay great attention to changes and balances of
cash and its equivalents. The amounts of separate cash flow categories are more
important.
First, as you analyse cash flow statement, it is important to look at whether or
not the operating activities have generated cash. The magnitude of net operating
cash flow should be checked in this regard. It is a good trend if the company has
generated cash from operating activities. It is not necessarily a bad sign if they have
not. Because the expansion of business often requires increased working capital investment, and company products will still not have gained a foothold in the market,
operating cash flow will reflect badly on businesses in a growing phase and favourably on those in a stagnant or declining phase.
A major working capital component is accounts receivable. Inventory is a
vital component in operating cash flow cycle, too. Operating cash sources also include accounts payable. It must be mentioned that cash flow connected with paying corporate income tax must be presented as a separate item in operating cash
flow. If net operating cash flow is sufficient for planned investment activities one
can infer that internally generated cash is being used to ensure new cash flows in
the future.
After looking at any significant measures in the operating activities, the cash
provided for or used in investing activities must be investigated. It is essential to
compare this year’s capital expenditures to last year’s capital expenditures to determine the existence of any significant increases or decreases. Next, it is necessary to
look at different types of investment activities related to cash flow. First, purchase
and sale of fixed assets must be investigated. If the management wants to analyse
the investment activities of a subsidiary, it must perform an assessment of capital
expenditures budget, at the centre of which must be the prices of fixed assets, total
capital required for implementation of investment projects, net preset value and
internal rate of return of the projects. Intangible assets and long-term financial
investments are also related to investment activities.
Cash flow from financing activities will tell how much debt or equity has been
paid (cash outflows) or borrowed (cash inflows). Author believes that the phase of
company life cycle can be characterised by net cash flow from financing activities.
Increase in debt that manifests itself as cash inflows, to author’s mind, should
always be examined on a specific issue basis whether it ensures the preservation of
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optimal financing structure, or movement towards it. Concerning analysis of equity
financing, author believes that dividends should be reviewed to determine whether
they are tied to income or whether they are relatively constant. The financial
assistance received from the government that is meant for financing of long-term
investments should also be presented as financing cash flow.
In short, when analyzing cash, it is important to look at how much cash was
generated from operating activities, how much was used in capital expenditures in
a period of time, and how much was needed in additional debt or equity, or used to
pay creditors and owners. Author believes that cash flow measures give a new
overview angle on financial statement analysis.
2.3. Cash Flow Ratios Used in Determining Financial Position of a
Company
Creditors, and later on – investors, began using cash flow ratios because those
ratios give more information about a company’s ability to meet its payment commitments than do traditional balance sheet and income statement based financial
ratios. When a loan officer evaluates the risk bank is taking by lending cash to a
particular company, the greatest concern is whether the company can pay the loan
back, with interest, on time, in other words, cash flow. Lenders, rating agencies and
financial analysts have long used cash flow ratios but auditors have been slow to
catch on.
Solvency is the most basic requirement for a company to be able to continue
operating and generate cash flow. However, financial analysts, bank and credit-rating agency officers, auditors, and other users of financial statements, need to measure a company’s ability to finance growth, as well as to meet ongoing financial
and operational commitments. Another aspect of cash flow statement analysis is the
measurement of company’s cash-generating efficiency that shows the ability of a
company to generate cash from its current or continuing operations. Therefore,
author believes that cash flow ratios should be divided into three categories:
• solvency ratios;
• ability to finance growth ratios;
• cash-generating efficiency ratios.
The names of cash flow ratio categories have been developed by the author of
promotion paper, based partly on generally accepted titles of traditional financial
ratios, as well as the terminology of Latvian Accounting Standard 2. Part of the ratios author has acquired from different sources of literature referenced in promotion
paper, the other part has been worked out by the author himself.
Figure 3 introduces the system of cash flow ratios worked out by the author of
promotion paper.
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Figure 3. Classification of cash flow ratios
As shown by Figure 3, every cash flow ratio category characterises distinctive
aspect of corporate financial position and operating performance. Creditors are
especially interested in solvency ratios, investors turn greater attention to ability to
finance growth ratios, while cash-generating efficiency ratios are irreplaceable to
corporate financial managers for well-founded decision-making on the subjects of
financing and investing.
In order to fully understand where to set the acceptable levels of cash flow ratios
and levels at which the cash flow ratios discussed in this chapter should trigger
deeper investigation, empirical studies are not enough. Auditors and other users of
financial statements need to understand the peculiarities of businesses and the
industries in which the corporations operate. As with any other ratio, it is important
to become acquainted to the management’s explanation of any unfavourable
changes in cash ratios before drawing conclusions. A successful financial analysis
is not just a matter of picking the right equations and plugging in the numbers. But
properly applied cash flow ratios can be revealing about the company, for example,
to auditors during the audit planning and preparation stages that will lead to a more
effective audit.
2.4. Analysis of Indicators of Cash Flows of Samples of Latvian and
European Companies
In order to calculate and analyse cash flow measures of Latvian companies, the
author conducted an empirical study that contains 91 observations of 38 different
firms from 1996 to 2004. Not all of the studied companies were observed for the
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same length of time. Some of them were founded after 1996, while others ended their
operations before 2004. Furthermore, it was not possible to obtain financial statements
for all years in the period of study.
Author chose for calculation those cash flow ratios, which, to author’s opinion,
provide the most comprehensive insight and enable to draw conclusions on regularities of
corporate cash flows in Latvia. The main measures and ratios of the calculated indicators
are summarised in Table 1.
Table 1
Summary of research data on Latvian companies, LVL (except for ratios; n = 91)
Variables
Net operating cash
flow
Net investing cash
flow
Net financing cash
flow
Operating cash flow
ratio
Cash flows to sales
ratio
Cash flows to assets
ratio
Return on sales
Return on assets
Free cash flow
Investing cash flow
to sales ratio
Financing cash
flow to sales ratio
Average
Standard deviation
Median
8 807 687
18 916 310
974 400
–9 807 917
21 278 698
–635 264
1 153 633
6 812 694
–70 646
0.6250
1.8278
0.5798
–0.0822
1.0918
0.1162
0.0867
0.1736
0.0921
0.0148
0.0797
2 222 507
0.9174
0.1144
14 765 768
0.0724
0.0644
–18 889
–0.0870
0.5766
–0.0768
0.1768
1.0214
–0.0154
As shown in Table 1, a typical Latvian enterprise has a positive net cash flow from
operating activities of some 974 thousand lats and negative net cash flow from investing
activities of approximately 635 thousand lats. This means that this typical Latvian firm is
financing its investments fully from its operations. This tendency is a positive one which
says a great deal about the relative stability of a company. Financial activities show a
negative net cash flow of around 71 thousand lats. This is evidence of the fact that in the
last few years most Latvian companies have started to repay funds acquired earlier – settle
debts and pay dividends to their shareholders. However, a smaller but sizeable proportion
of firms are drawing in new sources of financing.
But another important indicator of company’s financial health – free cash flow – in
the majority of Latvian firms is negative. If free cash flow of a company is
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negative, then it will be necessary to raise cash either through selling of long-term
assets or through increase in debt. The second trend is now dominant in Latvia.
A typical Latvian firm is able to cover only about 58 per cent of its liabilities,
which are payable within one year, with the cash it is generating in everyday activities, as shown by the operating cash flow ratio. The outstanding 42 per cent must be
obtained through other means. So, here again, external financing is most crucial.
The median cash flows to sales ratio is 0.1162, which means that only around
12 per cent of company sales turns into cash increase from operating activities. In its
turn, the median operating profit margin (return on sales) is 0.0724. This must lead
to the conclusion that usually net cash flow from operating activities is higher than
company’s earnings before interest and taxes. Another proof of this lies in the cash
flows to assets and return on assets ratios.
After computing investing cash flow to sales and financing cash flow to sales
ratios, one can infer that a typical Latvian company invests 7.68 % of its sales in
long-term assets. The same company pays 1.54 % of net turnover to service its
financial obligations. As shown by standard deviation, the variability of the second
ratio is bigger than the first, which indicates that some firms are drawing in new
sources of financing, while others are repaying the finances they acquired earlier.
Since Latvian accession into European Union, companies in Latvia are operating in a wider market than before. To explore the regularities of cash flows in corporate financial economics that exist in Europe author investigated financial measures of companies in the common market. The empirical data are from “Amadeus”
database, which provides information on approximately 7 million enterprises in
Europe. In 2005, it was possible to acquire data from nearly 250 000 companies of
different sizes, legal forms, countries and industries.
In Table 2, these companies are broken down by their year of founding with
relation to their net cash flow from operating activities.
Penetration index characterises the extent of prevalence of one occurrence in
another occurrence that is related to it. As might have been expected and shown by
penetration indices in Table 2, to generate adequate cash flow a company in Europe
must develop for a certain period of time. Of course, this period varies from company to company, however, one can infer that in 2004 a company can be expected to
have higher than average cash flow (over 5000 th USD) if it were founded no later
than in the sixties of the twentieth century.
From other calculations author gathers that as the company gets larger its cash
flow would also improve. Public companies in Europe have a quite high cash flow,
private limited liability companies are quite varied in their cash flow amounts with
an emphasis on the average size of cash flows. Sole proprietorships and private partnerships have a relatively small volume of cash flows. Many European companies
with a large net operating cash flow have quite small total assets. On the other hand,
companies with large assets and small cash flow are quite rare. One must remark
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69
also that the higher corporate liquidity is, the more cash company is generating from
its operations. It is possible to infer that European companies still are reporting their
earnings numbers more often than cash flows, moreover, there is even less popularity of cash flow data in Latvia.
Table 2
European companies broken down by the year of incorporation and net
operating cash flow, penetration indices, 2004 (n = 244 250)
Year of
incorporatio
nBefore 1900
1900-1909
1910-1919
1920-1929
1930-1939
1940-1949
1950-1959
1960-1969
1970-1979
1980-1989
After 1989
Total
Operating cash flow (th USD)
<300
300-1000 1000-5000
78
50
76
67
55
100
63
54
98
67
70
100
82
72
101
87
91
105
86
97
102
76
94
111
75
108
117
81
109
111
125
100
89
100
100
100
Total
>5000
210
183
193
168
147
117
117
117
97
98
86
100
100
100
100
100
100
100
100
100
100
100
100
100
2.5. Correlations between Indicators of Corporate Cash Flow
and other Corporate Finance Measures
To analyse the cash flow ratios of Latvian companies more diligently, as well
as to conduct a well-founded selection of variables for models used in Chapter 3.3.
author believes that it is necessary to compute and investigate mutual correlations
between relative measures of cash flow and closeness of correlations with other absolute and relative corporate indicators. Table 3 shows only correlation coefficients
that, to author’s mind, provide the main conclusions.
As shown in Table 3, operating cash flow (OCF) ratio’s lowest correlation
(0.229) is with return on sales or the operating profit margin (ROS). This means that
there is almost no connection between operating profit margin, which is a measure
of profitability, and operating cash flow ratio, which is a measure of solvency. This
fact reinforces the conviction that a company can be very profitable on paper from
the accounting point of view but this does not mean that it will necessarily generate
loads of cash. A very firm correlation (0.958) can be found between cash flows to
sales (CF/sales) and free cash flow to sales (FCF/sales) ratios. This indicates a
highly close relation between operating cash flow and free cash flow. That is a
conclusion one might have anticipated.
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Table 3
Correlation matrix for selected variables of Latvian companies (1996-2004; n = 91)
Interesting and significant information is at the bottom of Table 3 where financing cash flow to sales (CFF/sales) ratio is correlated with different variables.
Because the correlation with operating cash flow (CF/sales and CF/assets) and free
cash flow (FCF/sales and FCF/assets) relative measures is negative and rather
strong, it brings to the conclusion that the more positive is company’s operating or
free cash flow, the more cash outflows of financial activities it is willing to sustain.
This conclusion is connected with the pecking-order theory of capital structure,
which says that in the case of a growing cash flow, the surplus is used to repay debts
and for similar purposes.
The one correlation that is strong and negative, is the connection between profitability (ROS) and investing cash flow to sales (CFI/sales) ratio (-0.917). This
shows the link between the perception that a company is profitable and the willingness of its management to invest money (cash) in new projects. To author’s mind,
this link points out that executives of Latvian enterprises do not make adequate use
of cash flow measures in making capital budgeting decisions. As shown by the
correlation coefficient, they are more inclined to follow what the accounting
numbers are telling them about the state of company earnings, but they do not pay
enough attention to the cash flow statement. If they were to have listened to the cash
flow data, the correlation would be quite different. Then, a correlation coefficient of
close to -1 would be expected between cash flows from investing activities to sales
and cash flows to sales ratios (currently, it is approx. -0.4 to -0.5). This situation as
a whole indicates that Latvian companies do not base their capital budgeting
decisions on real possibilities available to them, which can lead to acceptance of
negative NPV projects.
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2.6. Factors Influencing Corporate Cash Flow
Taking into account the analysis undertaken above, it is possible to arrive at a
formulation of several factors influencing cash flows in a company. Author believes
that seven main factors influencing cash flow are as follows:
1) Sales growth. The primary cash driver, to author’s mind, is the sales growth
rate. Sales growth is one of the first things that corporate managers, lenders, managers and professional financial analysts look at when evaluating business performance. The reason is straightforward – sales volume tends to drive practically
everything else. Positive change in sales will give a company an additional source
of cash.
2) Gross margin. Gross margin is expressed as a percentage of sales to help
demonstrate how many centimes out of each sales lat are available to pay for other
business costs (apart from costs of goods sold). All other things being equal, an
increased gross margin will provide with a better operating cash flow.
3) Indirect costs. These costs mainly include selling and administrative costs.
They are best expressed as a percentage of sales to reveal how many centimes out
of each sales lat are taken by this kind of expenses. Indirect costs are a use of cash
and reduce net cash flow.
4) Inventory. Average days of inventory on hand ratio is of importance to cash
flow analysis, since it indicates the average number of days required to sell company’s inventory. It is found by dividing the number of days in a year by the inventory
turnover ratio. A shorter inventory period will give a company the possibility of
collecting cash earlier.
5) Accounts receivable. Author believes that this measure is also an important
corporate cash driver. The average collection period is noteworthy, since it shows,
on average, how long it takes to collect accounts receivable from customers. To find
it the number of days in a year is divided by the receivables turnover ratio. A shorter
collection period will provide company with an earlier cash flow, which certainly is
more valuable than cash flow received at a later date.
6) Accounts payable. An important factor in corporate cash flow management
is the average period of time a company takes to pay its accounts payable. To find
it, the number of days in a year is divided by the payables turnover ratio. A longer
period will ensure a delayed negative cash flow for a company, which is a positive
development in the context of maximising operating cash flow.
By combining the three items above, it is possible to arrive at an important
measure of company’s financial position, corporate activity and cash flow – cash
conversion cycle. It is found by adding average days of inventory on hand to average
collection period, and subtracting average days of accounts payable. A positive
result will indicate the number of days for which working capital needs to be invested to keep company going. A shorter cash conversion cycle is preferred.
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72
7) Capital expenditures. The capital expenditures deal with the issue of new
investment in the infrastructure of an enterprise to keep it healthy and growing. This
factor is usually measured both in absolute terms – that is, in lats – and also in relative terms relating it to sales growth. To author’s mind, the best relative measure in
this respect is capital expenditure expressed as a percentage of the growth in sales.
Each industry may have its measures that can be used as cash drivers, for example, load factor for an airline, or proportion of homes penetrated on a line for a cable
television operator. For most of the companies, though, the seven factors above are
most appropriate.
Moreover, the author believes that business language needs to be adjusted to
express fully the cash flow realities and factors. Nowadays, the cash flow motivational shift is underway. For instance, in 1998, “PepsiCo” introduced a change in
reward system of senior division-level managers whose compensation had previously been tied to profit. Under the new plan, the compensation is tied to cash flow
targets in their divisions.
On December 12th, 2005 “PepsiCo” overtook “Coca-Cola” in market capitalisation for the first time in history. The stock market value of “PepsiCo” reached $
98.4 billion, compared with $ 97.9 billion for “Coca-Cola”. Share price movements
for both corporations are depicted in Figure 4.
Figure 4. Share price of “PepsiCo” (left graph) and “Coca Cola” (right
graph), 2001-2006, USD
Price movements suggest that in the years following decision of “PepsiCo” to
switch to cash flow motivational goals its share price has substantially outperformed
its main competitor. This is consistent with the main goal of the company – shareholder wealth maximisation.
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3. Potential Improvement of Cash Flow Statement and its
Use in Corporate Cash Flow Prediction
3.1. Potential Enhancement of Cash Flow Statement
The roots of the precursor of cash flow statement – statement of changes in
financial position – can be found in the United States of America. In 1971, it was
officially made one of the three primary financial documents required in annual reports. In late 1987, the U.S. Financial Accounting Standards Board (FASB) issued
Statement No. 95, which called for a more specific statement of cash flows to replace the more general statement of changes in financial position. Additionally, the
FASB, in an effort to help investors and creditors better predict dynamics of cash
flows, specified a universal statement format that highlighted the three parts of cash
flow. This format is still used today almost around the whole world. Analysis that
has a goal of predicting cash flow needs financial information, which is sensibly
divided into uniform categories.
This chapter investigates cash flow statement standards in Latvia, United States,
Australia, New Zealand, Canada and United Kingdom, as well as International
Accounting Standards Committee (IASC), on the basis of which author offers proposals for improving the cash flow statement.
A substantial proportion of financial analysts believe that it is necessary to subtract increases in outstanding accounts payable to the extent they exceed revenue
growth by 25 percentage points or more. This is understandable, since increases in
accounts payable lead to rise in operating cash flow. If there is indeed such large
expansion in payables, this can not be evaluated as a positive development. There
are also other reasons for adjusting operating cash flow, so that it better reflects the
financial and economic nature of company operations, not just accounting standards.
Likewise, one must mention that some transactions may generate cash flows
that refer to more than one activity type. For example, in the United Kingdom it is
specified that interest paid can be classified in a separate (fourth) category. To
author’s mind, it is the wrong approach. There is no need to divide corporate cash
flows into more than three categories. This will not add to the clarity of cash flow
assessment.
The classification of interest payments and dividends in cash flow statements in
different countries is shown in Table 4.
As seen in Table 4, there is a noticeable stringency and similarity in the classification of interest and dividends in the standard documents of Canada, New Zealand
and the U.S. However, Latvia, Australia and the IASC authorize a great amount of
corporate judgment in the classifica tion of interest and dividends. In this case,
author would agree with positions of Canada, New Zealand and USA on all of these
topics, with the exception of dividends received. These payments are not connected
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74
with internal and day-to-day financing, so dividends received can not be classified
as operating activity. The recommendation is to unequivocally classify dividends
received as cash inflows of company’s investment activity.
Table 4
Classification of interest payments and dividends in cash flow
statements around the world
Country
Interest Received Interest Paid Dividends Received Dividends Paid
Latvia
Operating or
investing
Operating or
investing
Operating or
investing
Operating or
financing
Canada
Operating
Operating
Operating
Financing
New Zealand
Operating
Operating
Operating
Financing
USA
Operating
Operating
Operating
Financing
IASC and
Australia
Interest and dividends, received and paid, should be classified in a
consistent manner from period to period and each separately disclosed as
one of operating, investing or financing activities
UK
Interest and dividends (both received and paid) should be classified into a
separate category described as “Returns on investments and servicing of
finance”
Non-cash transactions have a significant impact on future cash flows of a company. The effect of these transactions is similar to a cash inflow followed immediately by a cash outflow, or vice versa. Non-cash transactions are usually not trivial,
but they do not form part of cash flow statements. As a result, valuable information
is lost.
To author’s mind, it is not necessary to provide information in cash flow statement on credit unused, since there may be potentially a lot of different, currently
unused external financing opportunities for a company. These may be connected
with debt but not exclusively. The same could apply to the possibility of issuing new
shares of stock (equity).
The Canadian and IASC standards encourage reporting entities to provide information about the aggregate amount of cash flows that represent increases in operating capacity separately from those cash flows that are required to only maintain
operating capacity. Some users of financial statements may prefer to classify certain
capital expenditure items, such as regular replacements of fixed assets, as an operating activity rather than an investing activity. Nevertheless, it is very difficult to
define precisely operating capacity. Therefore, the recommendation of the author to
Latvian Council of Accounting and other standard setting institutions is to mandate
the calculation and reporting of free cash flow in cash flow statements. Taking into
consideration author’s proposal in Equation 1, it would be possible to cut out arbitrary and subjective element in calculating free cash flow.
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75
3.2. Corporate Cash Flow Prediction
A firm’s cash flow affects the values of its equity securities, for some companies – also bonds, and thus, the value of the firm itself. For this reason, back in 1978,
U.S. FASB stated in its announcement that the primary objective of accounting
data is to provide information to help present and potential investors, creditors, and
others assess the amounts, timing, and uncertainty of prospective net cash in flows
to the related enterprise. Latvian Accounting Standards contain a similar assertion.
Moreover, standard setting bodies in many countries have also emphasized the notion that cash flow prediction represents the underlying rationale for the existence
of accrual accounting.
However, benefits of equity investments include future stock returns (paper by
Lev), or future dividends (papers by Rubinstein and Ohlson), future earnings (papers by Miller and Modigliani, Litzenberger and Rao, Ohlson), or future cash flow
(papers by Miller and Modigliani, Watts and Zimmerman, Ohlson) that must be
discounted to determine the value of a company.
Financial analysts in developed countries have been providing earnings forecasts to other users of annual reports for over three decades. More recently, U.S.
analysts are also disseminating operating cash flow forecasts for a growing and
economically significant fraction of firms. There is a large variation, though, in the
proportion of firms with cash flow forecasts across industries. DeFond and Hung
found that analysts tend to forecast cash flows for firms with:
1) large accruals,
2) more diverse accounting choices relative to their industry peers,
3) high earnings volatility,
4) high capital intensity,
5) poor financial health.
One may infer that cash flow prediction and, more specifically, the ability of
alternative measures to explain future cash flow, is important in varied contexts.
First, it provides a basis for evaluating the assertions of many financial accounting
standard setting institutions that earnings are superior to historical cash flow in predicting future cash flow. Second, it provides an opportunity to test the behaviour of
simple models of cash flow expectations in different companies and countries.
The company life cycle helps a user of financial statement to predict cash flow
for a typical company in the context of three phases of the cycle. Since most of the
Latvian enterprises are in the beginning phases of their development and growth
when the demand for cash is highest, author infers that it is topical to analyse and
predict cash flow using financial statement data of Latvian companies, as well as
to evaluate the impact of measures of financial statements on corporate cash flow
prediction.
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3.3. Impact of Financial Statement Measures on Corporate Cash
Flow Prediction and Company Valuation
This chapter analyses impact of earnings and operating cash flow on corporate
cash flow prediction and company valuation. Valuation is an important aspect because most popular company valuation models are based on cash flow forecasts.
This is the reason why explanatory power of earnings and cash flow to predict future
operating cash flow will be investigated.
The study includes only Latvian enterprises. Total number of observations that
have been acquired by collecting information from annual reports of 52 different
companies is 243. Annual reports are for the period from 1995 till 2005. When selecting companies for the research, author took into account 3 basic principles:
1) accessibility of financial report. As a result there is a relatively high representation of public limited companies listed on Riga Stock Exchange.
2) magnitude of cash flows. When selecting companies, author used the list of
TOP 500 Latvian companies by sales compiled by newspaper „Dienas Bizness”.
3) credibility of data. Author selected companies with the highest marks from
Reputation TOP 100 of Latvian companies compiled by newspaper „Diena”.
Author evaluated the marginal contribution of each explanatory variable with
regression models 2, 3 and 4, to determine whether adding a variable significantly
increases coefficient of determination and improves model’s future cash flow explanatory power. This analysis is the goal of using models 2, 3 and 4. The following
univariate models will be estimated:
OCFt+j = δ0 + δ1 * Et + ε t+j ,
(2)
where j = 1, OCF – net operating cash flow, E – earnings (the models will be
estimated using two kinds of earnings (independent variables) – earnings before interest and taxes EBIT, and net profit p).
OCFt+j = θ0 + θ1 * OCFt + εt+j ,
(3)
where j = 1.
Parameters of regression equations for specific companies – coefficients of regression – in this case, do not allow reaching the goal of the research. To evaluate
whether adding cash flow as an independent variable to Model 2, or adding earnings
as an independent variable to Model 3 provides material increase in model’s significance, a multivariate Model 4 will be applied:
OCFt+j = γ0 + γ1 * OCFt + γ2 * Et + ε t+j ,
(4)
where j = 1.
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77
To arrive at relevant conclusions, next the observed F statistic must be computed that allows for testing of the following null and alternative hypotheses drawn
up in the introduction of the promotion paper and substantiated in Chapter 1.3. on
significance of independent variables added to the cash flow prediction model:
1. H0 : γ1 = 0
H1 : γ1 ≠ 0
2. H0 : γ2 = 0
H1 : γ2 ≠ 0
With the help of models 2, 3 and 4, author will test the hypotheses above not
just on data of specific companies with the highest number of observations but also
on pooled data of all 52 enterprises in the sample. To author’s mind, it is expedient
to conduct cash flow prediction for Latvian companies only one year in advance
because of very fast changes in business environment, in comparison with more
economically developed world countries.
The highest number of annual reports and most information on corporate earnings and cash flow measures author was able to gather from „Lattelecom” Ltd.,
JSC „Latvenergo”, JSC „Latvijas Balzams”, JSC „Olainfarm” and JSC „Valmieras
Stikla Skiedra”. Financial statements of other companies incorporate period of less
than eight years in a row. The only exception is JSC „Ventspils Nafta” whose gathered financial statements were for nine consecutive years. However, due to extraordinarily high variation in sales and changes in holding structure, 2004 and 2005
data were not representative, and some outliers appeared in the data. Therefore, the
indicators of this company will not be studied separately, and indicators from most
recent years will not be included in the pooled corporate data set. In all, 12 outliers
that represented 5 companies were excluded from the pooled data set.
After excluding outliers, the initial total number of observations of pooled data
(243) was reduced by 12, and due to lags in models the number of observations was
still reduced by 54 (two more than 52, since data of two companies had a dynamic
break). Therefore, 177 observations of 50 companies were used for the most important analysis of pooled data. However, to additionally test the stability of results, the
author compared them with results that were acquired without excluding outliers
(number of observations – 189, number of companies – 52).
Number of years in the pooled data base of financial statement information possible to obtain for different companies was diverse. Hence, the indicators of these
companies can be regarded as an unbalanced data set.
The hypotheses of the research were tested employing absolute measures of
cash flow and earnings from financial statements, as well as relative measures of
earnings and cash flows. To attain relative measures, the absolute measures had to
be deflated by some measure characterising the size of a company. The absolute
measures of cash flow and earnings were deflated by company revenue.
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and taxes ROS is the primary variable significantly improves model’s ability 78
From the five thoroughly analysed companies, statistically significant results
were acquired only regarding „Lattelecom” Ltd. Adding operating cash flow variable to a univariate regression model with earnings or profitability measure as
independent variable significantly enhances explanatory power of the model, and,
therefore, null hypothesis that regression coefficient of cash flow is equal to 0 can be
rejected with probability of 95 %, which means that cash flow independent variable
must be added to the model.
With regard to joint-stock companies „Latvenergo”, „Latvijas Balzams”,
„Olainfarm” and „Valmieras Stikla Skiedra”, the author of promotion paper was not
able to obtain statistically significant results. Nevertheless, from the five diligently
analysed companies, in four coefficient of determination is higher for univariate
regression model containing operating cash flow independent variable, comparing
with model containing earnings before interest and taxes independent variable, as
well as with model containing net income independent variable.
Past cash flow explains 32.7 % of variation in future operating cash flow for
Latvian companies included in the study. Past data of earnings before interest and
taxes explain 13.9 % of variation in future cash flow, while past observations of
net income – just 11.4 %. One must infer that past data of operating cash flows are
most precise predictors of cash flow one year ahead, followed by observations of
earnings before interest and taxes, and the least predictive power have observations
of net income.
In all models regression coefficient of relative cash flow independent variable
is positive, meaning that an increase in cash flow a year ago will lead also to higher
cash flow this year if other factors remain unchanged. The significance of this regression coefficient is extremely high both in univariate, and multivariate models (pvalue 0.000), testifying on the significance even at probability of 99 %. Regression
coefficients of relative earnings independent variables are positive as well, which
means that higher earnings in previous year will ensure greater operating cash flow
a year later if other factors remain unchanged. However, regression coefficients of
earnings are not significant at probabilities of 95 and 99 %. Regression coefficient
of relative earnings before interest and taxes is significant at probability of 90 %
(p-value of 0.057).
The results of verification of hypotheses mentioned above are shown in Table 5.
To draw well-founded conclusions about the efficiency of cash flow prediction
models, the main attention in Table 5 must be turned to measures of hypotheses
testing for models with relative data. As evident in row that is devoted to the first
of relative data models, adding independent variable of relative operating cash flow
CFna to the model where independent variable of relative earnings before interest
to predict cash flow. Null hypothesis that regression coefficient of CFna equals 0
is rejected with a probability of 95 %. It means that variable of operating cash flow
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79
must be added to the cash flow prediction model where earnings before interest and
taxes is the primary variable. Although hypotheses testing in the table was
conducted using significance level of 0.05, the same conclusion can be drawn also
with a probability of 99 % where Fcr = 6.78. An inference of the same character must
be drawn about adding independent variable of relative operating cash flow CFna to
model where relative net income pNA is the primary independent variable.
Table 5
Hypotheses testing based on pooled data from 50 Latvian companies without
outliers (1995-2005; n = 177)
Data
description
primary
variable
Absolute
EBIT
Absolute
added
variable
R2
multivariate R2
OCF
0.656
0.864
266.12
3.90
rejected
OCF
EBIT
0.864
0.864
0.00
3.90
not
rejected
Absolute
p
OCF
0.588
0.868
369.09
3.90
rejected
Absolute
OCF
p
0.864
0.868
5.27
3.90
rejected
Relative
ROS
CFna
0.139
0.341
53.34
3.90
rejected
Relative
CFna
ROS
0.327
0.341
3.70
3.90
not
rejected
Relative
pNA
CFna
0.114
0.337
58.52
3.90
rejected
Relative
CFna
pNA
0.327
0.337
2.62
3.90
not
rejected
Fobs
Fcr (1; 174;
0.05)
H0
On the other hand, adding independent variable of relative earnings before interest and taxes ROS to the model where independent variable of relative operating
cash flow CFna is the primary variable does not significantly improve cash flow
predictive ability of the model. Null hypothesis that regression coefficient of ROS
equals 0 can not be rejected with probability of 95 %. It means that variable of
earnings before interest and taxes must not be added to cash flow prediction model.
Analogous inference must be drawn about adding independent variable of relative
net income pNA to model where relative operating cash flow CFna is the primary
independent variable.
One must conclude that operating cash flow has significance in corporate cash
flow prediction, and, therefore, in company valuation because the most popular
company valuation models are based on future cash flow. Earnings have no statistical significance in corporate cash flow prediction, as a result of which they are less
important in company valuation.
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80
Main Conclusions and Proposals of Promotion Paper
Based on the research conducted in the paper, author has arrived at following
main conclusions:
1. As a result of analysis of scientific literature and legislation author defines
company cash flow as an increase and decrease in cash and its equivalents, for its
part, net cash flow is an increase or decrease in cash and its equivalents. Author
believes that the magnitude of net operating cash flow is the most important ab
solute measure of cash flow statement in corporate financial analysis. Operating
activity must be the main source of company cash, it must be positive to ensure not
only maintenance of current level of operations but also corporate growth. If net
operating cash flow is adequate for planned investments, this means that internal
financing is used to generate cash flows in the future.
Investigation of the concept of company cash flow has lead the author to conclude that internal cash flow resources are generated from operating activities and
selling of assets, as well as from consuming beginning-of-period cash balances.
Investing cash flow must be negative because it means that a company is investing
money in its development. Net financing cash flow shows whether a corporation has
drawn in new external financing, or, on the contrary, repaid the cash flow resources
acquired earlier.
2. The titles of investing and financing activity cash flow categories in Annual
Reports Act and Latvian Accounting Standard 2 “Cash flow statement” are not harmonized. Such discrepancies in legislation are not acceptable. Moreover, Latvian
Accounting Standards’ definition of investment activities as “purchase and divestiture of investments that are not cash equivalents”, to author’s mind, is not accurate.
Under a strict interpretation it is possible to include changes in accounts receivable
and inventory in investment activities. These changes by their definition must be
regarded as an operating activity. Author thinks that investment activities are company operations with long-term assets.
3. After exploring the role of cash flow in corporate financial analysis, author
concludes that, in comparison with investors, creditors are conducting much more
detailed cash flow analysis. If cash flow analysis is not undertaken, creditors are
assuming greater level of risk and are increasing their alternative costs, as well cost
of capital.
To author’s opinion, cash flow measures are indispensable in determining sources and uses of cash, determining differences between earnings and changes in cash,
evaluation of company creditworthiness and ability to pay dividends, as well as
cash flow prediction.
4. After investigating theoretical aspects of cash flow, author of the paper con
cludes that one part of scientific papers on the subject of cash flow prediction as
sert that cash flow is able to better explain future cash flow than earnings. The
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81
other half has the opposite conclusion. Many authors have confined themselves to
using exclusively univariate regression models and have not assessed the marginal
contribution of each independent variable, which has hampered drawing founded
conclusions. Based on the data analysis of financial reports of Latvian companies,
author of promotion paper concludes that cash flow has higher cash flow explanatory power than earnings.
Company development is necessary; however, it must be sustainable, so that
growth does not cause negative total cash flow. Since the majority of Latvian companies are now in the phase of their initial evolution when the demand for money
is highest, it is a live issue to analyse cash flow using financial statement data, and
it is especially important to evaluate the impact of financial statement measures on
corporate cash flow prediction.
5. In science literature and in financial practice, the concept of free cash flow is
used often. It is known also by other names, and different authors define it in a
diverse way. There is no widely accepted definition and calculation formula of free
cash flow. Author believes that free cash flow characterises the amount of money
that company owners can consume themselves without reducing company value
and endangering its future prospects. The amount of free cash flow can provide a
thorough picture of corporate ability to finance growth and financial position as a
whole.
6. After analysing company performance data available in data bases, one must
conclude that European companies still are reporting their earnings measures more
often than cash flows, what is more, there is even less popularity of cash flow data
in Latvia. Author can explain this occurrence with “earnings fixation phenomenon”
dominant in financial analysis, the existence of which is substantiated in scientific
literature.
When corporate reporters are allowed discretion, they prefer not to change their
reporting practices to the one that is perceived as beneficial to users of information
but is more costly to implement. Users of financial statements that do not reveal
direct method cash flow information incur additional costs by estimating and collecting this information. There is also potential for misallocation of limited financial
resources when investment decisions are based on incomplete or incorrect data.
7. As practical operations of companies show, earnings are poorly defended
against manipulations by corporate management that are difficult for investors and
professional analysts to uncover. The ability of a corporation to manipulate its cash
flow measures is limited. However, cash flow is not immune from subjective esti
mations and assumptions. The need to adjust the amounts of cash flows in finan
cial statements arises even when the reports are compliant with generally agreed
accounting standards. Since the cash flow statement has been compulsory for a
relatively short period of time, there is no generally accepted approach to cash flow
ratio analysis.
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82
8. Based on the study of empirical data, author infers that most Latvian compa
nies have positive operating cash flow and negative investing cash flow. Moreover,
a typical Latvian firm is financing its investments fully from its operations, which
is evidence of corporate stability. Free and operating cash flow ratios indicate the
necessity to draw in external financing, which is something that Latvian companies
are actually currently doing. In addition, usually their net cash flow from operating
activities is higher than company’s earnings before interest and taxes.
As shown by correlation analysis of cash flow relative measures, executives of
Latvian enterprises choose investment projects that are necessary to implement
without adequate substantiation. It may lead to acceptance of negative net present
value projects and misallocation of cash resources that will reflect badly on the
financial position of a company.
Highly leveraged enterprises studied by the author are not operating in an efficient manner because they do not generate adequate operating cash flow. As a result,
indebted firms are forced to rely on new, external sources of funds. Today, when the
economy is expanding at a high rate, it quite probably will not cause any problems
with insolvency both for the companies and their creditors. However, in the future
when economic growth is expected to slow down the number of financially problematic enterprises in Latvia may rise.
9. Analysis conducted in the paper testifies that after a firm implements change
in salary system of corporate managers that replaces compensation linkage to ear
nings with linking rewards to cash flow indicators, company share price performs
noticeably better than stock prices of its main competitors.
10. From the companies investigated in depth, statistically significant results
were attained only with regard to “Lattelecom” Ltd. The results testify that the ope
rating cash flow independent variable must be added to cash flow prediction model
of “Lattelecom” Ltd. Moreover, in the majority of companies cash flow predictive
ability is higher for a univariate regression model that includes operating cash flow
independent variable than for a model that includes earnings before interest and
taxes independent variable and also than for a model that includes net income in
dependent variable.
Using a pooled data set of financial statements of Latvian companies one can
conclude that, with a probability of 99 %, the addition of operating cash flow independent variable to a cash flow prediction model in Latvian corporations is required.
On the other hand, the addition of both earnings independent variables is not required because the undertaken analysis has not confirmed the independent influence of
these factors. The conclusion confirms the hypothesis put forward and substantiated
in the paper that, bearing in mind the peculiarities of Latvian commercial, financial
and accounting environment, operating cash flow may have a higher cash flow predicting ability than earnings.
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83
Based on the analysis undertaken in the paper and its conclusions, author puts
forward the following proposals:
In order to improve the cash flow statement, Council of Accounting of Latvia
must work out and pass, as well as the Cabinet of Ministers must accept amendments in Latvian Accounting Standard 2 “Cash Flow Statement” (Proposal 1, 2, 3,
4, 5 and 6) where it must be stipulated that:
1. The titles of „investing activity” and „financing activity” in Latvian must
be named more accurately, thereby harmonizing Latvian Accounting Standard 2
„Cash Flow Statement” with Annual Reports Act, which includes more precise titles of cash flow categories.
2. Cash flow statement must be prepared also with direct method if the indirect is used. This will improve the quality of financial analysis undertaken by
users of financial statements, and will reduce the costs of gathering information for
external users of statements.
3. Cash flow statement must separate the increase in outstanding accounts
payable to the extent they exceed revenue growth by 25 percentage points or more
from the rest of operating cash flow. This amount must be included in financing cash
flow, thus ensuring a more precise reflection of corporate financial position by net
operating cash flow and net financing cash flow.
4. Dividends received must be unequivocally classified as investing cash inflows. Interest paid must be classified only as operating cash flow. In this way, it is
possible to achieve classification of cash flows according to their character, as well
as greater comparability of financial statements of different enterprises.
5. To ensure not losing significant information that facilitates cash flow prediction all significant non-cash transactions must be reflected in notes to financial
statement. Moreover, the cash flows of foreign subsidiaries should be translated into
lats using exclusively the average annual currency exchange rate. This is needed to
guarantee greater comparability of annual reports and reduction of labour-intensity
in preparing cash flow statements.
6. To enhance cash flow analysis free cash flow must be calculated and publicised in company cash flow statement in accordance to equation drafted by the
author (Proposal 8) alongside financing, investing and operating cash flow.
Financial analysts, corporate financial managers and other personnel, auditors, current and potential investors and creditors, as well as other users of financial statements must (Proposals 7, 8, 9, 10, 11, 12 and 13):
7. Classify cash flow ratios according to their character in three parts as solvency ratios, ability to finance growth ratios, and cash-generating efficiency ratios.
To author’s mind, each cash flow ratio category characterises distinctive aspect of
corporate financial position and operating performance. Creditors are especially
interested in solvency ratios, investors turn greater attention to ability to finance
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84
growth ratios, while cash-generating efficiency ratios are indispensable to corporate
financial managers for well-founded financing and investing decision-making.
7. Calculate free cash flow according to a formula drawn up by the author:
BNP = PDNP – nt * Asāk = PDNP – Izmku ,
where
BNP – free cash flow,
PDNP – operating cash flow,
nt – nominal growth rate of respective industry,
Asāk – company assets at the beginning of period,
Izmku – capital maintenance costs.
In the case of a negative growth rate, a growth rate of 0 per cent should be
applied. The equation has been developed in conformity to capital maintenance
approach in calculating free cash flow. Moreover, it cuts out the arbitrary element
in the calculation, as well as limits the willingness of company management to overestimate the value of assets.
9. While determining the role of profits in financing corporate growth, compare net operating cash flow with earnings. If earnings are high but operating cash
flow does not cover the necessary amount of investment activity cash outflows,
profits do not increase company value.
10. Take into account the features of operations of the company and respective
industry in order to fully understand the acceptable levels of cash flow ratios, and
when they indicate the necessity for a deeper analysis. Auditors must acquire the
explanation of company management why cash flow ratios have deteriorated, and
only after that draw conclusions. However, auditors can use cash flow ratios to discover problems more quickly when planning and preparing for an audit.
11. While evaluating ability of a company to settle short-term liabilities, not
rely just on static balance sheet liquidity ratios but must use more frequently the
dynamic cash flow solvency ratios.
12. Because of specific character of cash flow measure dynamics, perform diligent analysis of the magnitude of operating cash flow in the growth phase of company development. Furthermore, large and medium-sized companies must explain
the amount of cash flows of separate categories in the context of company’s life
cycle in the annual report.
13. Based on the results of empirical study, carry out corporate cash flow prediction by using operating cash flow data.
Management of Latvian companies must (Proposals 14, 15 and 16):
14. While making decisions on potential investment projects, place more emp
hasis on cash flow measures that point out the real ability to implement investments
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85
and repay funds that were necessary for project’s realisation, rather than earnings
measures.
15. Take into account the extra value that is inherent in the option to delay the
implementation of investment project. The higher the uncertainty of project’s cash
flows, the higher the value of this option. Usually, an investment project is successful if it has been implemented the right time dictated by economic conjuncture.
Therefore, an option to choose the time for execution of the project has a positive
impact on company share price and value.
16. Introduce a system, according to which all company divisions must report
changes in cash and its equivalents in a certain period of time that must be determined depending on the needs of the enterprise. It will ensure improvement of corporate cash flow analysis and management. Operating cash flow on the divisional level
must be presented only with one of the two possible methods.
17. Company owners in shareholder meetings must pass decisions that will
oblige corporate management to set cash flow based goals in personnel rewards system. Employee job responsibility descriptions and performance evaluation must be
linked to factors influencing cash flow, which will ensure maximisation of company
owners’ wealth.
18. Management of parent companies must prescribe to subsidiaries to report
cash inflows from parent company and cash outflows to parent company in
financing activities of cash flow statement separately from cash inflows and outflows from external investors and creditors. Moreover, in order to enhance financial
analysis, holding or parent company management must compare gross operating
cash flow of the division with financing provided by the holding company or parent
company.
19. Based on correlation analysis of cash flow ratios of Latvian companies,
author believes that to avert financial risk today and possible insolvency problems
in the future, creditors of Latvian companies must reduce the amount of loans to
highly leveraged corporations.
20. To cut down on costs and possible losses of commercial banks, bank loan
officers must pay greater attention to cash flow information. Extremely important
indicator for determining corporate creditworthiness is the ratio of planned operating cash flow to planned loan payments.
21. Economic educators and commercial bank personnel training centres
must develop improved instructional materials that will contain diligent analysis of
data from cash flow statement and cash flow ratios, as well as explanation of the
importance of this analysis.
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Data on Promotion Paper and Author
Author’s publications on the subject of promotion paper:
1. Subatnieks K. Naudas plūsmas un tās rādītāju analīze Latvijas uzņēmumos// Latvijas
Universitātes raksti, 696.sēj.: Ekonomika un vadības zinātne. ISBN 9984-783-90-1.
Rīga, 2006. 240.-249. lpp.
2. Subatnieks K. Free Cash Flow and Analysis of Corporate Cash Flow Indicators in
Latvia// 5th Global Conference on Business & Economics Proceedings. ISBN 09742114-3-5. Cambridge, UK, 2006. Published in a CD.
3. Subatnieks K. Potential Improvement of Cash Flow Statement// Opportunities and
problems of economic development. ISBN 9984-779-26-2. Rēzekne, 2006. pp. 200209.
4. Subatnieks K. Concept of Cash Flow and Assessment of Cash Flow Ratios of Latvian
Companies// Organizaciju vadyba: sisteminiai tyrimai 36. ISSN 1392-1142. Kaunas,
2005. pp. 163-176.
5. Subatnieks K. The Use of Cash Flow in Determining Financial Position of an Enterprise
and the Concept of Free Cash Flow// Latvijas Universitātes raksti, 677.sēj.: Ekonomika
un vadības zinātne. ISBN 9984-770-13-3. Rīga, 2004. 394.-402. lpp.
6. Subatnieks K. An Assessment of the Financial Position of Enterprises in Latvia//
Finance in EU Accession Countries: Experiences and Solutions, Vol. 1. ISBN 998556-824-9. Tartu, 2003. pp. 200-209.
Author reported content of promotion paper at scientific conferences:
1. 65th Conference of the University of Latvia. Riga, Latvia. February 5, 2007.
2. International Scientific Conference „5th Global Conference on Business & Economics”.
Cambridge, UK. July 6-8, 2006.
3. International Scientific Conference „Opportunities and Problems of Economic
Development”. Rezekne, Latvia. March 24, 2006.
4. 64th Conference of the University of Latvia. Riga, Latvia. February 6, 2006.
5. International Scientific Conference „Knowledge-based Economy: Management of
Creation and Development”. Kaunas, Lithuania. September 22-23, 2005.
6. 63rd Conference of the University of Latvia. Riga, Latvia. February 4, 2005.
7. International Scientific Conference „2004 Hawaii International Conference on
Business”. Honolulu, USA. June 21-24, 2004.
8. International Scientific Conference „Finance in EU Accession Countries: Experiences
and Solutions”. Tartu, Estonia. October 17-18, 2003.
Data on author’s previous education and scientific background:
Author of this Promotion Paper has acquired social sciences master’s degree in
economics at the University of Latvia in 2002, and has acquired education sciences
master’s degree in pedagogy at the Latvia University of Agriculture in 2005. Author
is a lecturer at the Institute of Finance of Faculty of Economics and Management
of the University of Latvia since 2003. In 2004, has been elected to the position of
an assistant.
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