What to Look for When Analyzing Cash Flows Using the Indirect Method

Introduction

A cash flow statement is a financial statement that tracks all cash incoming and outgoing funds within a specified period of time. The statement helps business owners and investors understand the liquidity, solvency, and balance of their organization. The purpose of a cash flow statement is to understand what sources of cash are coming and going in an organization, and to predict possible financial issues in the future.

When analyzing cash flows, the indirect method is commonly used. This method looks at cash from operations, investing and financing to determine net cash flows. There are several important points to look for when analyzing cash flows using the indirect method.

Overview of the Indirect Method

Cash flow statements are a key component of financial reporting that allow investors to get a better understanding of how a business is performing. There are two main types of cash flow statements used by companies: the Direct Method, and the Indirect Method. The Direct Method outlines the inflows and outflows of cash for a given period and provides a complete picture of how a business is generating and using its cash. The Indirect Method looks at the net changes in a company’s financial position and uses the accrual basis of accounting.

An In-depth Look at the Indirect Method

The Indirect Method looks at a company’s net financial position to generate a cash flow statement. This means that the income statement and balance sheet of a company is used to analyze its cash flows. One of the most beneficial elements of using the Indirect Method is that investors are able to assess a company’s performance while eliminating the impact of non-cash items.

When analyzing cash flows using the Indirect Method, investors should be looking for certain key indicators. First, investors should take note of the operating cash flows. These cash flows provide insight into a company’s ability to generate cash from its core operations and are a key indicator of performance. Investors should also look for changes in the company’s balance sheet. An increase in cash on hand, or an increase in receivables, can be a sign of a company’s success in generating cash from operations. Additionally, investors should also look for changes in debt levels, as these can be a sign of the company’s ability to pay back any outstanding debt.

Finally, investors should look for signs of financial health and stability in the cash flow statement. Are the cash flows generated from operations strong? Are the cash flows generated from investments sufficient? Are the cash flows sufficient to cover all expenses? All of these questions are important when analyzing a cash flow statement using the Indirect Method.

Cash Flows from Operating Activities – Definition and Analysis

When examining cash flows using the indirect method, one of the key sections to analyze is cash flows from operating activities. This section of a company’s statement of cash flows captures sources of cash from normal activities to generate revenue—including sales, related expenses and costs, and taxes. Cash generated from operating activities goes to showing the viability of the organization. To illustrate this section better, the following looks at the definition of operating activities, as well as tips for analyzing the cash flows.

Definition of Operating Activities

Well defined, operating activities involve items that define the company’s primary source of funds on a daily basis. It includes sorting through the inflows and outflows of funds, typically from the time period’s sale of goods and services, the collection from customers, the payment to customers and suppliers, and related subsidiary transactions.

Tips for Analyzing the Cash Flows

When examining the cash flows from operating activities, we must also understand the differences between these activities and other categories. Often, it is about understanding the difference between current and non-current assets and liabilities. The following are tips on analyzing these cash flows:

• Sort out and understand the relationship between current and non-current assets and liabilities
• Investigate the changes in a company's working capital
• Look into any changes in useful lives of long-term assets, and the methods used for depreciation
• Analyze capital expenditures that were made during the accounting period
• Examine all major income and expense lines, including including taxes and interest

By utilizing these tips and taking the time to understand the relationships between current and non-current assets, liabilities, capital expenditures, and income and expense lines, you can get a thorough understanding of the reported cash flows from operating activities.

Cash Flows from Investing Activities

Investing activities refer to the buying or selling of investments or industrial items, such as machinery and equipment, that generally last beyond one year. Examples of cash flow from investing include the purchase or sale of fixed assets, long-term loans, and venture capital investments made by the company.

Tips for Analyzing the Cash Flows

When preparing cash flow statements, it is important to understand the impact of investing activities on the overall financial health of the business. Here are some tips to consider when analyzing cash flows from investing activities.

• Check the cash flow reconciliation presentation to ensure completeness and accuracy of the amounts.
• Compare the cash flows from investing activities with those of the previous year.
• Note if there are any changes in the total invested during the period.
• Pay close attention to long-term investments, such as shares or bonds, made by the company.
• Examine any material changes in the value of investments and other assets.
• Analyze the management’s rationale for any changes in the investments.

Cash Flows from Financing Activities

Cash flows from financing activities refer to the cash used to support activities related to raising capital and paying dividends or other distributions to shareholders. This portion of the statement of cash flows often shows the amount of money used for borrowing and repaying debt, as well as how much shareholders have received from the company during the reported period.

Tips for Analyzing the Cash Flows

It is important to keep in mind the different types of financing activities when you are analyzing cash flows. Here are some key tips to remember:

• Identify any cash flows related to issuing/repaying debt and any cash flows related to issuing/repurchasing equity.
• Look for any dividend or other distribution payments to shareholders and any changes in retained earnings.
• Look for any transactions involving acquisition of interests in other businesses to understand their impact on the company's cash position.
• Pay attention to changes in the company's balance sheet for any clues about potential financing activities.
• Make sure to note any non-cash financing activities, such as stock splits or stock dividends.

By understanding and analyzing cash flows from financing activities, you can gain valuable insight into the company's financial health and its ability to raise capital. This information can be used to assess the company's risk profile and will help you make informed decisions when investing.

Common Mistakes to Avoid

When analyzing cash flows using the indirect method, there are some common mistakes to look out for and avoid. With careful examination and analysis of the statement, missteps can be avoided and potential issues can be brought to light.

Common Mistakes in Cash Flow Statement Analysis

Poor analysis of a company’s cash flow statement can lead to incorrect decisions and faulty assumptions. Here are some of the most common mistakes to beware of:

• Not analyzing a company’s cash flow statement holistically and instead emphasizing certain, isolated items
• Forgetting to account for the effects of inflation when analyzing cash flows
• Not keeping in mind the effects of non-cash items such as depreciation and amortization, or excluding them entirely

Common Red Flags in the Cash Flow Statement

Another important factor in cash flow statement analysis is identifying potential red flags. Once identified, these red flags can be investigated more thoroughly to identify potential sources of trouble. These are some of the most common red flags to look for:

• Sudden declines or surges in cash flow
• Significant increases in borrowing or financing
• Continued investments in unsuccessful projects or products
• Declines in short-term cash balances

Conclusion

Cash flow analysis can be a powerful tool for understanding a business's financial health, but it is important to analyze cash flow closely to ensure accuracy of the results.

To ensure the most effective cash flow analysis, the following should be taken into account:

• The difference between cash flow using the direct and indirect methods
• The skills needed to understand the analysis process and cash flow
• Industry standard benchmarks for comparison
• The impact of external factors on the business's cash flow

By applying these tips to analyze cash flows using the indirect method, businesses will be able to more accurately assess their financial situation. This will allow owners to make sound decisions that are in the best interests of the company.