How the Indirect Method of Cash Flow Presentation Affects Financial Ratios

Introduction

Cash flow presentation is an integral part of financial analysis, and the indirect method is the most commonly used for the purpose. In this method, the cash flows from operating activities are calculated starting with net income from the income statement and making necessary additions and subtractions. Cash flows from investing and financing activities are also reported under this method.

Financial ratios demonstrate the relationship between various financial metrics and are essential for financial analysis and management decision-making. Some of the most common financial ratios include the debt-to-equity ratio, the debt-to-assets ratio, profitability ratios and the price-to-earnings ratio.

In this blog post, we will explore how the indirect method of cash flow presentation affects financial ratios.

Describing the Impact of the Indirect Method

The indirect method of cash flow presentation is a common approach for disclosing cash flows in financial reports. It mandates that the cash inflows and outflows be grouped into operating, investing, and financing activities. As a result, this method affects various financial ratios. In particular, it has a notable impact on investment ratios, liquidity ratios, and cash flows used in decision-making.

Mandatory Disclosure of Cash Outflows

The indirect method of cash flow presentation is the standard accepted practice for presenting cash flows. Presenting cash flows this way permits investors to assess a company’s performance in terms of the amount of cash generated or consumed by its operations. This presentation also mandates that companies provide information regarding cash outflows, which can give investors a better understanding of how much of the company’s resources are being used to support its operations. The disclosure of cash outflows also allows them to determine how much of these resources are being invested in long-term projects or allocated to expansion.

Influence on Investment Ratios

The indirect method of cash flow presentation comes with a variety of benefits for investors. For instance, it gives them a better understanding of the impact of the company’s investment activities on its financial health. The disclosed cash outflows provide investors with insight into the company’s investment decisions and allow them to assess the effectiveness of these investments. The information provided also allows them to compare the company against its peers in terms of return on investment (ROI) and other relevant investment ratios.

Influence on Liquidity Ratios

The indirect method of cash flow presentation also influences a company’s liquidity ratios. This method allows investors to assess the company’s short-term financial health. The disclosure of cash outflows permits them to evaluate how much of a company’s resources is being invested and whether these investments are generating sufficient returns. In addition, the information provides insight into the company’s ability to pay its short-term liabilities and operating expenses.

Cash Flows Used in Decision-Making

The indirect method of cash flow presentation provides a wealth of information that can be used to make more informed decisions. The disclosure of cash outflows from operations and investing activities can give investors a better understanding of the company’s investment decisions and the potential returns from these investments. In addition, the information provided allows them to determine the company’s ability to meet its short-term financial obligations and to assess the efficiency of its operations.

Examples of Ratios Altered by Indirect Method of Cash Flow Presentation

The indirect method of cash flow presentation can alter certain financial ratios. These include the quick ratio and interest coverage ratio. To illustrate the effects, this chapter describes and compares the ratios before and after applying the indirect method.

Quick Ratio

The quick ratio, also known as the acid-test ratio, measures a company's liquidity by comparing current assets to current liabilities. It disregards investments, inventory, and other non-liquid assets. When applying the indirect method of cash flow presentation, the quick ratio goes up or down as operating cash flow is changed.

Under the indirect method, if non-cash operating costs are added or deducted, such as depreciation, then this affects the operating cash flow. Adding or subtracting from the operating cash flow in turn alters the quick ratio since the total current assets, included in the quick ratio, are unchanged. Therefore, the operating cash flow increases or decreases the quick ratio.

Interest Coverage Ratio

The interest coverage ratio measures the company’s ability to pay interest expense with its operating income. It is calculated by dividing the operating income by the total interest expense. When the indirect method of cash flow presentation is used, the calculation of the operating income is affected.

Under the indirect method, some non-cash operating costs like depreciation are excluded from the income statement. This boosts the operating income since it reduces the expenses. The higher operating income will also boost the interest coverage ratio since the commitment to interest expense is still the same.

Accrual-Based Accounting and the Indirect Method

Accrual-Based Accounting (ABA) is an accounting practice that records and reports financial transactions at the time they are incurred, regardless of when cash is received for services or when expenses are paid. This method provides a more accurate and comprehensive representation of changes in a company's financial position over time. When combined with the “indirect method” of cash flow presentation, ABA offers an especially detailed understanding of a company's financial performance.

Definition of Accrual-Based Accounting

Accrual-Based Accounting can best be explained as an accounting practice whereby the financial results of a business—primarily the profit and loss, balance sheet and cash flow statements—reveal transactions when they occur rather than when payment is made or received. It provides a snapshot of a company’s performance as a whole, providing both a current and long-term perspective to management and investors.

Accrual-Based Accounting and the Indirect Method

The cash flow statements of businesses that use Accrual-Based Accounting are usually presented using the “indirect method”. This method involves adjusting the net income to show the actual cash balance reported on the statement of cash flows. It is based on the concept of generating a statement of cash flows by starting with the net income from the income statement and adjusting it to reflect the differences between the income reported on the income statement and the actual changes that took place during that period.

This approach is preferred because it eliminates the need for detailed analysis of individual transactions and better portrays a realistic picture of a company’s cash flows for the period. Moreover, the indirect method adjusts reported net income to cash flow from operations, which can provide a useful insight into trends in the industry and area of operations. In addition, this increased level of accuracy in cash flow reporting can influence the results of certain financial ratios, such as the profitability and efficiency ratios, which can provide further insight into the financial health of a business.

Accrual Basis Versus Cash Basis

The indirect method of cash flow presentation through the use of accrual-basis accounting is preferred over cash-basis accounting by many financial professionals. Although cash-basis accounting offers a simpler approach to the cash flow presentation, accrual-based accounting increases the credibility of reported financial information. This is because accrual-basis accounting enables the full disclosure of all transactions, regardless of the timing of cash receipt or disbursement.

Differences between Accrual-Based Accounting and Cash-Basis Accounting

Accrual-based accounting recognizes revenues and expenses when they are earned or incurred, regardless of when cash is actually received or paid. This financially sound method of accounting measures the liquidity, profitability, and solvency of a company at a different point in time than cash-basis accounting. The differences stem from how they each include cash receipts and disbursement:

• Accrual-based accounting measures liquidity by how well the company's liabilities are current, regardless of its cash position.
• Cash-basis accounting measures liquidity by how much cash the company has when bills are due or payments must be made.
• Accrual-based accounting measures profitability by the company's total revenues and costs over a given period of time, regardless of when cash enters or leaves the business.
• Cash-basis accounting measures profitability by the difference between cash receipts and cash disbursements over a given period of time.

Other Benefits of Accrual-Based Accounting

In addition to the differences in cash flow presentation, accrual-based accounting offers several other benefits. This method of accounting presents a true and fair view of the entity's financial position and allows for comparison of financial performance to prior periods. The ability to match revenue with related expenses aids in determining profitability. Accrual-based accounting also provides a more realistic representation of an entity’s financial health than cash-basis accounting.

Discussion

The Indirect Method of Cash Flow Presentation affects financial ratios in several ways. Both the cash-based and accrual-based presentations of cash flows can impact a company's net income and operating performance. By understanding the differences between these two ways of presenting cash flows and their impacts on financial ratios, companies can improve their financial performance.

Impact of Changes in Cash Flow Presentation

The impact of changes in cash flow presentation on financial ratios will depend on the types of cash flows included in the presentation. A cash-based presentation of cash flows includes only cash inflows and outflows; an accrual-based presentation includes both cash inflows and outflows, as well as changes in accounts receivable and accounts payable.

The cash-based method of cash flow presentation provides greater visibility into the company’s liquidity position, allowing investors and lenders to better assess a company’s ability to generate cash. However, the accrual-based approach provides more information about a company’s performance and its net income because it incorporates changes in accounts receivable and accounts payable.

In addition to the impact of the cash-based and accrual-based presentations of cash flows on financial ratios, the change in the company’s operating performance may also be affected by the adoption of the Indirect Method of Cash Flow Presentation. The reduction in the company’s net income resulting from the adoption of the Indirect Method of Cash Flow Presentation may result in a decrease in its leverage ratio or a decrease in its ability to generate cash from operations.

Disclosure of Cash Basis

When presenting its cash flows, a company must ensure that it discloses the cash basis of the presentation. In particular, it should specify the cash flows that are included in the presentation, as well as the differences between cash-based and accrual-based presentations. This helps investors and lenders better understand the company’s financial health and makes it easier to compare the company’s performance to that of its competitors.

It is important to note that the Indirect Method of Cash Flow Presentation is subject to the rules and regulations of the Financial Accounting Standards Board (FASB). Companies must ensure that they are in compliance with these rules and regulations to avoid penalties or fines. In addition, companies should be aware of any changes to the FASB’s rules and regulations that may affect their financial performance.

Conclusion

The Indirect Method of cash flow presentation can have a significant impact on financial ratios that are used when assessing a business. As previously discussed, the nature of the Indirect Method affects the operating cash flow, by removing the gains and losses due to extraordinary or non-cash transactions, and the capital structure, by eliminating the effects of long-term debt and the effect of gaining or losing assets in the financial year. By managing the cash flows more accurately, the Indirect Method of cash flow presentation provides more useful data to assess the financial health of a business.

Summary of the Impacts of the Indirect Method

The Indirect Method of cash flow presentation has a significant effect on operating cash flow, capital structure, and the earnings per share calculations of a business. The removal of the extraordinary items, and the non-cash items give investors a more accurate picture of the operating performance of a business. Furthermore, the removal of the long-term debt impacts the capital structure of the business, by looking at the leverage and liquidity of the business on a more consistent basis. Lastly, by eliminating the effects of the unusual gains or losses from the year, the Indirect Method allows for a more accurate calculation of the earnings per share.

Advantages of Accrual-Based Accounting

Unlike the Direct Method, the Indirect Method provides a more accurate understanding of the business's performance and financial health. The removal of non-cash and extraordinary items in the Indirect Method allows investors to more accurately assess the performance of a business. The removal of the long-term debt from the Indirect Method of cash flow helps investors to more accurately measure the capital structure and liquidity of the business. Lastly, the removal of the unusual gains or losses allows the Indirect Method to provide a more accurate calculation of the earnings per share for the company.

By using the Indirect Method of cash flow presentation, businesses are better equipped to provide meaningful information about their financial performance to investors, that allows for a more accurate and comprehensive analysis of the business. As such, the Indirect Method of cash flow presentation is an invaluable tool for businesses to better manage their financial ratios.