Explanation of the Topic...
Introduction to Financial Ratios, General Discussion of Balance Sheet, |
Common-Size Balance Sheet
|Part 2||Financial Ratios Based on the Balance Sheet|
General Discussion of Income Statement, Common-Size Income Statement, |
Financial Ratios Based on the Income Statement
|Part 4||Statement of Cash Flows|
The income statement has some limitations since it reflects accounting principles. For example, a company's depreciation expense is based on the cost of the assets it has acquired and is using in its business. The resulting depreciation expense may not be a good indicator of the economic value of the asset being used up. To illustrate this point let's assume that a company's buildings and equipment have been fully depreciated and therefore there will be no depreciation expense for those buildings and equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings and equipment? Compare that situation to a company with new buildings and equipment where there will be large amounts of depreciation expense.
The statement of cash flows is a relatively new financial statement in comparison to the income statement or the balance sheet. This may explain why there are not as many well-established financial ratios associated with the statement of cash flows.
We will use the following cash flow statement for Example Corporation to illustrate a limited financial statement analysis:
|Free Cash Flow||
Cash Flow Provided by Operating Activities – Capital Expenditures
$25,000 – $28,000
|This statistic tells you how much cash is left over from operations after a company pays for its capital expenditures (additions to property, plant and equipment). There can be variations of this calculation. For example, some would only deduct capital expenditures to keep the present level of capacity. Others would also deduct dividends that are paid to stockholders, since they are assumed to be a requirement.|
The cash flow from operating activities section of the statement of cash flows is also used by some analysts to assess the quality of a company's earnings. For a company's earnings to be of "quality" the amount of cash flow from operating activities must be consistently greater than the company's net income. The reason is that under accrual accounting, various estimates and assumptions are made regarding both revenues and expenses. When it comes to cash, however, the money is either in the bank or it isn't.
To learn more about the statement of cash flows, go to:
Whether you are a business person or student of business, our Master Set of 87 Business Forms will assist you in preparing financial ratios, financial statements, break-even calculations, depreciation, standard cost variances, and much, much more.
Because the material covered here is considered an introduction to this topic, many complexities have been omitted. You should always consult with an accounting professional for assistance with your own specific circumstances.
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