Chapter 11: Interpreting Cash Flows from Operating Activities Flashcards
Importance of Operating Activities in Cash Flows
Importance: Operating activities section in the statement of cash flows focuses on the firm’s capability to generate cash internally through operations, emphasizing the management of operating assets and liabilities (operating working capital).
Significance: Operations serve as the primary sustainable source of cash in the long run. Investors gauge a company’s ability to pay dividends and expand.
Creditors assess if cash generated from operations can cover loan repayment.
Example: Internet-based companies faced crises when investors doubted their ability to translate ideas into operational cash, leading to financial instability.
Analyzing Quality of Earnings Ratio
Concept: Quality of earnings ratio assesses the ability to generate cash through operations.
Rule: Analysts avoid firms with rising net earnings but falling cash flow from operations.
Rapidly rising inventories and accounts receivable, indicating delayed cash collection, can predict falling revenues and increased need for external financing.
Importance: A detailed analysis of the difference between net earnings and cash flow from operations is essential to understand its causes.
Factors Impacting Net Earnings vs. Cash Flow from Operations
Factors:
Depreciation and Amortization: Reduce net earnings but don’t require cash outflows, leading to a discrepancy between net earnings and cash flow from operations.
Management of Assets and Liabilities: Careful management minimizes changes in assets and liabilities, influencing cash flow from operations.
Example: National Beverage’s higher cash flow from operations compared to net earnings in fiscal year 2021 was due to reduced cash outflows from depreciation and effective management of assets and liabilities.
Analysis: Analysts often compute the quality of earnings ratio to assess a company’s ability to generate cash through operational activities.
Quality of Earnings Ratio
Formula: Quality of earnings ratio = Cash flows from operating activities / Net earnings
Purpose: Measures the portion of earnings generated in cash. A higher ratio indicates a greater ability to finance operating and cash needs from operating cash inflows.
Interpretation:
Ratio > 1.0: Each dollar of earnings supported by more than one dollar of cash flows from operations.
Ratio < 1.0: Analysts investigate the source of the difference (possible causes listed below) to determine significance.
Possible Causes of Ratio Differences:
Corporate Life Cycle: Sales growth or decline impacts receivables, inventory, and accounts payable, affecting cash flows from operations.
Seasonality: Quarterly variations in sales and inventory purchases can cause fluctuations in the ratio.
Changes in Revenue and Expense Recognition: Aggressive revenue recognition or lack of proper expense accruals inflate net earnings, affecting the ratio.
Management of Operating Assets and Liabilities: Inefficient management increases assets and decreases liabilities, reducing cash flows from operations and the ratio.
Cash Flows and Fraud Detection
Importance: The statement of cash flows can be the first indicator of errors or irregularities in financial statements.
Indicator Significance: A significant difference between reported net earnings and cash flow from operations can suggest potential manipulations of accruals and deferrals to inflate earnings without affecting cash flows.
Example: In the case of Versailles, operating profits were $25 million, but the cash outflow from operating activities was $24 million, signaling a warning.
Manipulations were suspected, as reported accounting profits were not translating into actual cash inflows.
Fraud Indicators
Manipulation Technique: Unethical managers may manipulate accruals and deferrals of revenues and expenses to inflate net earnings without impacting the cash account.
Detection Method: A growing difference between net earnings and cash flow from operations can be a sign of such manipulations.
Historical Example: W. T. Grant’s bankruptcy in 1975 was preceded by a significant gap between reported net earnings and cash flow from operations. Manipulations, such as insufficient accruals for uncollectible accounts receivable and obsolete inventory, were later identified as the cause.
Analyst Response: Astute analysts recognized the growing difference and recommended selling the stock long before the bankruptcy, showcasing the importance of analyzing cash flows for fraud detection.
