Company's Financial Accounting
Cash flow analysis: direct and indirect methods
Key figures of cash flow statement
Cash flow analysis. Direct method (in Finnish, kassavirtalaskelma)
The company's financial statements are prepared on an accrual basis, which means that income and expenses in the income statement are based on deliveries, payables and receivables rather than cash flows. With cash flow analysis we can determine the cash-based income and expenses, i.e. when they are already paid. The cash flow analysis works as a good assistant tool for traditional financial analysis.
Let's consider the difference between received income statement data and cash flow report data using our hypothetical company X. In order to make calculation we need the data from Income Statements and Balance Sheets.
In a case if we would like to find out how much the company has earned during the financial year from sales and how much has spent on purchases, we have to analyze the changes in trade receivables and payables during the financial year.
If trade receivables have increased between the current and previous financial year, it means that the turnover did not consist entirely of cash, but part of it was committed to the account receivables. Similarly, if the payables related to purchases have decreased during the period, this means that in addition to the purchases made during the financial year obviously were spent more money on acquisitions (this change has been matched by additional money).
The cash-based turnover can be calculated as following:
Cash-based Turnover = Turnover + Accounts receivable 1.1 - Accounts receivable 31.12
Cash-based Turnover = 200 + 18 – 20 = 198
The cash-based purchases can be calculated as following:
Cash-based purchases = Purchases + Accounts payable 1.1 – Accounts payable 31.12
Cash-based purchases = 50 + 15 – 7 = 58
According to our calculations we have got the following results:
- the difference between sales and purchases based on an accrual basis is equal to
- the difference between sales and purchases based on a cash basis is equal to
Accrual based sales – Accrual based purchases = 200 - 50 = 150
Cash-based sales – Cash-based purchases = 198 - 58 = 140
Cash flow analysis. Indirect method (in Finnish, rahavirtalaskelma)
Cash flow analysis structure looks as follows:
| Cash flow statement | |
| Net profit | 28 |
| Adjustments | |
| planned depreciation | 10 |
| +/- other income and expenses without cash flow impact | |
| +/- corrections booked vs. paid financial income and expenses, taxes, etc. | |
| CHANGE IN NET WORKING CAPITAL | |
| inventory increase (-) / inventory decrease (+) | 10 |
| accounts receivable increase (-) / accounts receivable decrease (+) | -2 |
| interest-free debts increase (+) / interest-free debts decrease (-) | -11 |
| A = cash flow from OPERATING ACTIVITIES | 35 |
| -INVESTMENTS | -7 |
| + proceeds from the disposal of fixed assets | |
| B = cash flow from INVESTMENTS | -7 |
| + shares issue | |
| + withdrawals of new loans | |
| - loan repayments (reduction of loan) | -10 |
| - dividends paid out | -28 |
| C = cash flow from FINANCING | -38 |
| change in cash and cash equivalents | -10 |
Our calculations for cash flow statement (indirect method) are the following:
- Net profit (data from profit and loss statement) = 28
- Depreciation (from income statement 2019) = 10
- Inventory increase (-) / decrease (+) = stock (balance 2019) -stock (balance 2018) = 40-50 = -10 (decrease)
- Accounts receivable increase (-) / decrease (+) = Accounts receivable (balance 2019) - Accounts receivable (balance 2018) = 20 – 18 = 2 (increase)
- Interest-free debts increase (+) / decrease (-) = Short-term creditors (balance 2019) - Short-term creditors (balance 2018) = (7 + 7 + 5) – (10 + 15 + 5) = 17 – 30 = - 11
- A = OPERATING ACTIVITIES = 28 + 10 + 10 - 2 – 11 = 35
- B = INVESTMENTS = Non-current assets 2019 + Depreciation 2019 - Non-current assets 2018 = 47 + 10 -50 = 7
- Loan repayments (reduction of loan) = Long-term creditors (balance 2019) - Long-term creditors (balance 2018) = 20 – 30 = -10
- Dividends paid out = Retained earnings or loss (previous financial years) (balance 2018) + Profit (loss) of the financial year (balance 2018) - Retained earnings or loss (previous financial years) (balance 2019) = 20 + 18 -10 = 28
- C = FINANCING = -28 - 10 = - 38
- change in cash and cash equivalents = A + B + C = 35 – 7 - 38 = -10
This result we can check from the balance sheet through changes in cash and cash equivalents (CCE):
change in liquid assets = Cash in hand and at banks (balance 2018) - Cash in hand and at banks (balance 2019) = 20 – 10 = 10
We have got the same result: our liquid assets have decreased at 10 K € (K = thousands)
According to our calculations we can make the following conclusions:
- cash flow from OPERATING ACTIVITIES is positive, that is a good result
- income financing (35 K €) has almost been sufficient for investments, repayments and dividend coverage
- cash flow from INVESTMENTS is equal to 7, this is quite small number, but this result interpretation varies by industry. If we suppose that our hypothetical company X is a service company, then this result will be a good one.
Key figures of cash flow statement: loan debt solvency coefficient (in Finnish, lainojen hoitokate) and self-financing ratio of investments (in Finnish, investointien omarahoitusaste)
These indicators can help to measure, for example, the sufficiency of income financing available for investments and the paying of loan instalments.
The loan debt solvency coefficient or loan servicing margin describes the company's ability to pay off debt repayments and interest at its current level of income financing.
The company is able to cover the loan servicing costs approximately three (2,8 ≈ 3) times with income financing.
The indicative values according to the Yritystutkimusneuvottelukunta (YTN) for debt solvency coefficient result interpretation are:
| more than 2 | Good |
| 1 - 2 | Satisfactory |
| less than 1 | Weak |
In our calculations we have got the debt solvency coefficient equal to 2,8, that is a good result.
The self-financing ratio of investments is the ability of a company to finance its investments from its own income financing (own resources).
The recommended indicative values for self-financing ratio result interpretation are:
| 30% - 50% | Good |
In our calculations we have got the self-financing ratio equal to 500% and this is an excellent result! All necessary investments can be made.