Show Me the Money: Tracing a Firm's Cash Flow

Step 1: Can I See How a Company Raises Money and What It Is Used For?

Show Me The Money: Tracing A Firm's Cash Flow Splash image

Earnings, dividends, and asset values are important factors, but it is ultimately a company's ability to generate cash that fuels the growth in these factors. Strong cash flow allows a company to increase dividends, develop new products, enter new markets, pay off liabilities, buy back shares, and even become an acquisition target. It is important to understand the statement of cash flows and the elements that impact upon cash flow trends.

Earnings and earnings multiples dominate standard measures of company performance and stock price valuation. However, slight accounting differences can make it difficult to track earnings over time or between firms. Net income reports on a company's performance under principles of accrual accounting, which attempts to match expenses to revenues when the revenues are recognized.

Classroom Steps

Accrual accounting introduces many interpretations and estimates by management into the financial statements. Decisions regarding the capitalization of expenses, the recognition of revenue, the creation of reserves against losses, and write-off of assets are examples of just a few of the factors that may vary from firm to firm. Many of these issues are factors that relate to the "quality" of a firm's earnings.

For example, cash used to build up inventory will not be reflected as an expense on the income statement until the inventory is sold. But even the recognition of this inventory cost may vary from firm to firm if one company uses a last in, first out (LIFO) method to measure the cost of inventory sold while another firm uses a first in, first out (FIFO) method. Higher sales may not translate into higher cash flow if accounts receivable is allowed to grow. Prepaid expenses such as income taxes and software development costs may not flow through the income statement when the payments are actually made. On the other hand, much like a personal checkbook, cash accounting tracks cash inflows and outflows directly when they actually occur.

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