Literature Review of Cash Flow in Finance
Info: 4465 words (18 pages) Example Literature Review
Published: 6th Dec 2019
2.1 What is cash flow?
Cash flow statement is about where the money came or will come from, where it went and will go. In short, cash flow statements show the predictability, timing and amount of cash-inflows and cash-outflows. Furthermore, it is also used in business planning and budgeting. Accounting personnel are interested in knowing organization’s ability to cover payroll and other immediate expenses while creditors or potential lenders would like to see the company’s able to repay or not. In addition, potential investors have to judge company’s finance and contractors or potential employees that happy to know the company is able to afford compensation.
2.1.1 Classification of Cash Flow
In cash flow statements, it has three distinct activities that are operations, investing and financing.
Cash flow from operating activities indicates the cash provided or used by a company’s normal operations. This cash flow figures show the ability of the company to be consistent in generating positive cash flow from operations activities. Operations activities are the core business of the company. It is the cash that the company produces internally.
Investing activities are disposing and acquiring of property, plant and equipment, investment, collecting the loans and lending money. Cash flows in investing include all the cash provided or used by the sale and purchase of income-producing assets. Cash flow from investing usually generates cash outflows. For example, activities like capital expenditures for plant, property and equipment, the purchase of investment securities and business acquisitions. On the other hand, inflows generated from the investment securities, businesses and sale of assets. Capital expenditure is what investor would like to look at. Investors think that it is necessary to ensure proper maintenance of assets of the company and support company’s operation efficiency and competitiveness.
Financing activities generate cash from issuing debt, repurchasing shares, repaying the amounts borrowed, paying dividend and get cash from stockholders. In financing activities, the cash flow is calculated with flow of cash between a firm and its creditors and owners. Negative numbers may illustrate the company paid dividends and repurchase stock but it also may show the company is servicing debt. Debt and equity transactions are in financing activities. The issuance of stock is much less frequent. Cash dividends paid is the most important for investors.
2.1.2 Different methods in Cash Flow
Different methods are used in different cash flow statements’ format. One of the methods is indirect method while the other is direct method. The indirect method adjusts net income for items that do not affect cash. This method is more widely used by companies because it is easier and less costly to prepare. Moreover, it differentiated between net income and net cash flow from operating activities. But operating cash receipts and payments are shown in direct method which makes direct methods to be consistent with the cash flow statement’s objective.
2.1.3 Cash Flow versus Income
It is vital to able to see and differentiate between having positive cash flow transactions and being profitable. Companies does not bringing in cash is not mean that they not making profit.
For example, a manufacturing company sells off half of its factory equipment because low product demand. Cash will be received from the buyer for the used equipment. Manufacturing company is actually losing money on the sale. Equipment is manufacture products to earn an operating profit would be preferable. Best choice is to sell off the equipment at prices much lower than the company paid for it. In the year that it sold the equipment, the company would end up with a strong positive cash flow, but its current and future earnings potential would be fairly bleak. Cash flow can be positive while profitability is negative.
2.2 Financial Stability
Financial stability is defined in terms of its ability to facilitate and enhance economic processes, manage risks, absorb shocks. Financial system enables the financial intermediation process which facilitate and the flow of funds between savers and borrowers which ensure that financial resources can efficiently towards promoting economic growth and development. Positive cash flow ensures good flow of funds. Good cash flow will show good liquidity ratio and acid test ratio.
Financial stability is important to evaluate the risks within a financial product such as in matching re-investment requirements, evaluating default risk, cash requirements and others. Financial statements are accrued based accounting which takes into account non-cash items. It hopes to reflect the financial health of company. But accrual accounting may sometimes not clear actual amount of cash generated. Operating cash flow ratio shows the ability of company to service its interest and loans payments. Even a slight change in the cash flow statement can jeopardize its loan payments, therefore company will bare more risk than a company with stronger cash flow levels.
Acid test ratio takes a closer look at the paying debt ability. It is a stringent test to determine whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. This is a test of immediate solvency. The higher the ratio, the more financially secure a company is in a short term. Quick ratio greater than 1.0 is sufficient to meet their short-term liabilities. This acid test ratio will be combined with explanation of how solvency affects the financial stability. Solvency ratios measure the stability of a company and its ability to repay debt. If is negative acid test ratio, then company should find ways to make it become positive. An acid test of 1.1 is considered satisfactory. This way to calculate acid test ratio is:
Acid test ratio= Quick Asset (current asset- stock) ÷Current Liabilities
For example, Burger Kings Holdings Inc. and Wendy’s/ Arby’s Group Inc. Burger Kings has acid test ratio of 0.60 while Wendy’s Arby’s has a ratio of 0.41. Burger Kings is better as it acid test ratio is nearer to 1. Obviously, it is vital that a company have enough cash on hand to meet account payable, interest expenses, and other bills when they become due. Thus, good cash flow is needed
2.3 Financial Performance
There are many different ways to measure financial performance, but all measures should be taken in aggregation. Line items such as revenue from operations, operating income or cash flow from operations can be used as well as total units sales. Furthermore, the analyst or investor may wish to look deeper into financial statements and seek our margin growth rates or any declining debt.
Liquidity ratio is a measure of a company’s ability to meet its short-term obligations achieved through a comparison of financial variables. The most common liquidity ratio is current ratio. It expresses a company’s ability to repay short-term creditors out of its total cash and shows the number of times short-term liabilities are covered by cash. A lot of cash or capital is tied up in high levels. Accrual accounting concepts is believed that do not represent economic realities. For example, a company’s cash flow may show profitable but actually they might generate additional operating cash by raising additional debt finance or issuing shares. Therefore, cash flow is used to evaluate income generated by accrual accounting.
As we acknowledged, business is all about cash, the trading and exchange of value between two or more parties. Hence, it is very obvious that some industries are more cash intensive as business that not generating positive cash flow per share is unable to survive in the long run. Long-term cash inflows of a company are necessary to more than its long term cash outflows to get a positive cash flow. User of cash flow statement should first look at net increase/decrease in cash and cash equivalent as since it reports the overall change in the company’s cash and its equivalents over the last period.
2.4 Financial Planning
Financial Planning is the process of estimating the capital required and determining its competition. Moreover it is also framing objectives, policies, procedures, programmes and budgets in relation to procurement, investment and administration of funds of an enterprise. Financial planning helps you manage your financial affairs so you can build wealth and achieve financial security. Financial Planning is about investment. In addition, financial planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained. For investment, enough cash flow is important to generate more cash. The investment value is easily found in the balance sheet and cash flow.
It is important to determine a project’s rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such as internal rate of return, and net present value. Business decisions might be affected by the cash flow projection as it highlight the time that will short of cash which enable time saving in thinking ways to secure the fund. Cash flow projection is a good planning tool. It show the cash inflow and outflow of business on next year or future year. This will enable user to make financial decisions to avoid full blown crisis.
In an August 1995 article in Individual Investor, Jonathan Moreland provides a very succinct assessment of the difference between earnings and cash. Many investors routinely ignore importance of the cash flow statement. They usually just look at income statement.
2.5 Capital Budgeting
Capital budgeting used to determine whether a firm’s long term investments such as new machinery, replacement machinery, new plants, new products and research development projects are worth pursuing. Capital budgeting is the process by which the financial manager decides whether to invest in specific capital projects or assets. In some situations, the process may entail in acquiring assets that are completely new. In other situations, it may replace an existing obsolete asset to maintain efficiency. Plan for raising large and long-term sums for investment in plant and machinery, over a period greater than the period considered under an operating budget. Techniques such as internal rate of return, net present value and payback period are employed in creating capital budgets. Expected future cash flows of the project may predicted, the risk of cash flow associated will be analyze, develop alternative cash flow forecasts, examine possible changes in the predicted cash flows and subject the cash flows to stimulation.
There are typically two types of investment decisions. One is selecting new facilities or expanding existing facilities like investments in long-term assets such as property, plant and equipment and resource commitments. The second type is replacing existing facilities with new facilities. For example, replace a manual bookkeeping system with a computerized system. As such, capital budgeting decisions are a key factor in the long term profitably of a firm.
2.6 Cash flow ratios
In many cases, cash flow ratios signify a more accurate measurement of a stock’s value than the price to earnings ratio, P/E. Cash flow ratios examine the flow of money into a company, it can help to identify struggling companies and in turn, struggling stocks. Price to earnings is a very important ratio because when is very high or low, it usually makes a splash on the financial pages. Price to earnings ratio is valuable metric and can help a successful investor with his or her stock technical analysis, but it is only one technical analysis tool and should be considered as such. While the same can be said for each of the cash flow ratios, these give insight into the money coming in and going out of a company. A company can demonstrate earnings, but if more money is pouring out a company than pouring in, there will fiscal problems in the future.
Profits are very vital for the survival of a company. But sometimes, companies look like very profitable may actually opposite what you seen. It might encounter financial risk if they are generating little cash from these profits. For example, a company can look profitable if they sales on credit and have not received cash for the sales that hurt their financial health since they obliged to pay. Cash flow indicator ratios use cash flow compared to other company metrics. They are used to determine amount of cash generated from their sales or free and clear, and the how much cash they have to cover obligations. The ratio that will be looked at are operating cash flow/sales ratio, free cash flow/operating cash flow ratio and cash flow coverage ratios.
Operating Cash Flow/Sales Ratio is expressed as a percentage, compares a company’s operating cash flow to its net sales or revenues. This ratio gives investors an idea of the company’s ability to turn sales into cash. It would be worrisome to see a company’s sales grow without a parallel growth in operating cash flow. This indicator will show the changes in a company’s terms of sale or the collection experience of its accounts receivable whether in positive or negative. In this ratio, we use the figure for operating cash flow that frequently named in financial reporting as cash flow from operating activities, simply cash flow, net cash provided by operating activities and cash flow provided by operations.
In the operating section of the cash flow statement, the net income figure is adjusted for non-cash charges and increases/decreases in the working capital items in a company’s current assets and liabilities. This reconciliation results in an operating cash flow figure, the foremost source of a company’s cash generation. The greater the amount of operating cash flow, the better. There is no standard guideline for the operating cash flow/sales ratio, but obviously, the ability to generate consistent or improving percentage comparisons are positive investment qualities.
The free cash flow/operating cash flow ratio measures the relationship between free cash flow and operating cash flow. Free cash flow is most often defined as operating cash flow minus capital expenditures, which, in analytical terms, are considered to be an essential outflow of funds to maintain a company’s competitiveness and efficiency. The cash flow remaining after this deduction is considered “free” cash flow, which becomes available to a company to use for expansion, acquisitions, and/or financial stability to weather difficult market conditions. The higher the percentage of free cash flow embedded in a company’s operating cash flow, the greater the financial strength of the company.
Cash flow coverage ratios measures the ability of the company’s operating cash flow to meet its obligations – including its liabilities or ongoing concern costs. The operating cash flow is simply the amount of cash generated by the company from its main operations, which are used to keep the business funded. The larger the operating cash flow coverage for these items, the greater the company’s ability to meet its obligations, along with giving the company more cash flow to expand its business, withstand hard times, and not be burdened by debt servicing and the restrictions typically included in credit agreements.
Dividend payout ratio identifies the percentage of earnings (net income) per common share allocated to paying cash dividends to shareholders. The dividend payout ratio is an indicator of how well earnings support the dividend payment. Here’s how dividends “start” and “end.” During a fiscal year quarter, a company’s board of directors declares a dividend. This event triggers the posting of a current liability for “dividends payable.” At the end of the quarter, net income is credited to a company’s retained earnings, and assuming there’s sufficient cash on hand and/or from current operating cash flow, the dividend is paid out. This reduces cash, and the dividends payable liability is eliminated. The payment of a cash dividend is recorded in the statement of cash flows under the “financing activities” section.
Other ratio is such as operating cash flow ratio is one of the most important cash flow ratios. Cash flow is an indication of how money moves into and out of the company and how you pay your bills. Operating cash flow relates to cash flows that a company accrues from operations to its current debt. It measures how liquidity a firm is in the short run since it relates to current debt and cash flows from operations.
Operating Cash Flows Ratio = Cash Flows From Operations/Current Liabilities where:
Cash flows from operations comes off the Statement of Cash Flows and Current Liabilities comes off the Balance Sheet. If the Operating Cash Flow Ratio for a company is less than 1.0, the company is not generating enough cash to pay off its short-term debt which is a serious situation. It is possible that the firm may not be able to continue to operate.
The price to cash flow ratio is often considered a better indication of a company’s value than the price to earnings ratio. It is a really useful ratio for a company to know, particularly if the company is publicly traded. It compares the company’s share price to the cash flow the company generates on a per share basis.
Price/cash flow ratio = Share price/Operating cash flow per share where:
Share price is usually the closing price of the stock on a particular day and operating cash flow is taken from the Statement of Cash Flows. Some business owners use free cash flow in the denominator instead of operating cash flow. It should be noted that most analysts still use price/earnings ratio in valuation analysis.
The Cash Flow Margin ratio is an important ratio as it expresses the relationship between cash generated from operations and sales. The company needs cash to pay dividends, suppliers, service debt, and invest in new capital assets, so cash is just as important as profit to a business firm. The Cash Flow Margin ratio measures the ability of a firm to translate sales into cash. The calculation is:
Cash flow from operating cash flows/Net sales = _____%.
The numerator of the equation comes from the firm’s Statement of Cash Flows. The denominator comes from the Income Statement. The larger the percentage, the better.
Cash flow from Operations/Average total liabilities is a similar ratio to the commonly-used total debt/total assets ratio. Both measure the solvency of a company or its ability to pay its debts and keep its head above water. The former is better, however, as it measures this ability over a period of time rather than at a point in time.
This ratio is calculated as follows:
Cash flow from Operations/Average Total Liabilities = _______% where:
Cash flow from operations is taken from the Statement of Cash Flows and average total liabilities is an average of total liabilities from several time periods of liabilities taken from balance sheets. The higher the ratio, the better the firm’s financial flexibility and its ability to pay its debts.
The current ratio is the most simple of the cash flow ratios. It tells the business owner if current assets are sufficient to meet current debt. The ratio is calculated as follows:
Current Ratio = Current Assets/Current Liabilities = ______X
both terms come from the company’s balance sheet. The answer shows how many times over a company can meet its short-term debt and is a measure of the firm’s liquidity.
The quick ratio, or acid test, is a more specific test of liquidity than the current ratio. It takes inventory out of the equation and measures the firm’s liquidity if it doesn’t have inventory to sell to meet its short-term debt obligations. If the quick ratio is less than 1.0 times, then it has to sell inventory to meet short-term debt, which is not a good position for the firm to be in.
Quick Ratio = Current Assets – Inventory/Current Liabilities where all terms are taken off the firm’s balance sheet.
2.7 Economic Growth
Economic growth means a positive change in the level of production of goods and services by a country over a certain period of time. Increase in the capital stock, advances in technology and improvement in the quality and level of literacy are considered to be the principal causes of economic growth.
According to Riebold, cash flow is the internal flow of generation and use of money over a certain period of time. Accordingly, variations of cash flow affect the firm’s production decisions. If there is an increase in cash flow, then production will most likely increase, indirectly improving economic activity.
2.8 Working Capital
Working capital is amount of liquid assets that a company has on hand. It is needed to meet the short term obligations of the business, pay for planned and unexpected expenses and to build the business. A lack of working capital makes it hard to attract investors or to get business loans or obtain credit. Thus it is something to do with liquidity of cash flow. It is important to determine problems with a business’s liquidity. A company can bankrupt because of a shortage of cash, even while profitable.
For example, operating cash flow / net sales ratio is describe as a percentage of a company’s net operating cash flow to its net sales, or revenue. It illustrated the amount of cash we able to get for every dollar of sales. The higher the percentage of this ratio, the better. Ratios for industry and company will be significantly different. Investors should take a look of this ratio that able to show the performance of a company to detect varies of the average cash flow/sales relationship along with how the company’s ratio compares to its peers. In addition, it is vital that they cash flow increases as sales increase at a similar rate over time.
Free cash flow is often defined as net operating cash flow minus capital expenditures. A steady, consistent generation of free cash flow is a highly favorable investment quality.As a practical matter, if a company has a history of dividend payments, it cannot easily suspend or eliminate them without causing shareholders some real pain. It might cause problem for shareholders for dividend payout reductions. As such, the market considers dividend payments to be in the same category as capital expenditures – as necessary cash outlays. But the important thing here is looking for stable levels. This shows not only the company’s ability to generate cash flow but it also signals that the company should be able to continue funding its operations.
Comprehensive free cash flow coverage can be calculate by dividing the comprehensive free cash flow by net operating cash flow to get a percentage ratio – the higher the percentage the better. Free cash flow is an important evaluative indicator for investors. It captures all the positive qualities of internally produced cash from a company’s operations and subjects it to a critical use of cash – capital expenditures. If a company’s cash generation passes this test in a positive way, it is in a strong position to avoid excessive borrowing, expand its business, pay dividends and to weather hard times.
Cash flow statement is about where the money came or will come from, where it went and will go. In short, cash flow statements show the predictability, timing and amount of cash-inflows and cash-outflows. Furthermore, it is also used in business planning and budgeting. Accounting personnel are interested in knowing organization’s ability to cover payroll and other immediate expenses while creditors or potential lenders would like to see the company’s able to repay or not. In addition, potential investors have to judge company’s finance and contractors or potential employees that happy to know the company is able to afford compensation. The statement of cash flows reports the cash payments, cash receipts and net change in cash during a period from financing, investing and operating activities. This information should help investors, creditors and other people that will use it. Ability to generate future cash flow can be seen through by examining relationships between items in the statement of cash flows as better predictions of the uncertainty, timing and amounts of future cash flows can be made than accrual basis data. Moreover, it also determined company’s ability to meet obligations and pay dividends. Enough cash are required to pay dividends, settle debts, or pay debts. It lets reader can better understand why assets and liabilities changed of cash investing and financing transaction during the period.
Other than cash flow statement, there are other two important parts of a company’s financial statements that are the balance sheet and the income statement. The balance sheet provides a clear preview of a company’s assets and liabilities while the income statement shows the profit of a business. The reason of cash flow statement different from other financial statements is it reconciles the income statement and balance sheet that acts like corporate checkbook. Cash flow does not necessarily indicate all the expenses as not all expenses the company accrues have to be paid right away. Expenses are not recorded as a cash outflow until they are paid. Cash flow only gives a little room for manipulation because under the Securities and Exchange Commission, every company filing reports required its quarterly and annual reports of cash flow. In the old adage, “it takes money to make money.” The statement of cash flows also shows how the spending trend of a company and where the money comes from.
By looking all the dependent variables, it is important to able to relate independent variables and dependent variables.
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