Cash Flows: Impact on the Marketplace

In this tight credit environment, the availability of and access to cash is critical. The present plight of both GM and Ford highlights the importance of cash flows.

December 18, 2008
Sponsored by Becker CPE

by Sheldon Langsam, PhD/CPA and Jerry Kreuze, PhD/CPA

* Written exclusively for Becker CPE      

In this tight credit environment, the availability of and access to cash is critical. General Motors is in financial stress, not because of poor earnings levels, but because it is burning through cash at an alarming rate. Ford Motor Company is also spending cash at a fast pace, but is in a stronger financial position because of their negotiated credit line. The present plight of these two companies highlights the importance of cash flows. Companies that generate positive cash flows from operations on a consistent basis have lower credit risk and enhanced long-term economic viability.

Companies that do not consistently generate cash have a harder time assessing credit markets, or pay a premium for that financing. Lenders monitor a firm’s operating cash flows because they provide a source for periodic interest payments and the eventual repayment of principal. Analysis of cash flows also adds comparability to information, as it reduces the accounting inconsistencies between companies.

Basics of Cash-Flow Reporting

The reporting requirements for cash flows are mandated by SFAS No. 95, “Statement of Cash Flows,” which summarizes cash inflows and outflows into three principal activities: Operating, Investing, Financing. Operating activities present the effects of transactions and events that affect net income and indicate the amount of cash a company can generate from its ongoing core business activities. Investing activities include cash flows related to making and collecting loans, investing in stocks and bonds and purchasing and disposing of tangible assets. Financing activities arise from new issuances of stocks and bonds, paying dividends or buying back a company’s own shares and paying amounts borrowed. The purpose of cash flow reporting is to assist users in determining the liquidity, financial flexibility, and solvency of an entity. 

Cash Flows and Stock Valuation

The Financial Accounting Standards Board, in SFAC No. 1, recognized the importance of cash flows by stating that “Financial reporting should provide information to help investors, creditors, and others assess the amount, timing and uncertainty of prospective net cash flows to the related enterprise.” The head of credit strategy at Morgan Stanley stated that it all hinges on cash flow, how stable it is and could it be negative tomorrow.

Without downgrading the importance of consistent earnings, companies become even more attractive if their cash flows are improving. Positive cash flows allow companies to improve its stock price, through a restructuring, a stock buy back, reduction of debt, a special dividend or a takeover.

Research has revealed that cash flows from operations do explain security returns, supporting the contention that a firm is ultimately worth the sum of its expected cash flows. Moreover, in a study of financially distressed firms, it was observed that more bankruptcies occurred after negative shocks to expected cash flows than when expected earnings targets were not met.

Signals of Cash Flow Problems

Periodic assessment and analysis of the adequacy of cash flows is critical. The cash flow coverage ratio provides a measure of the ability of a company to make interest payments and is computed as: (Cash Flows from Operating Activities + Interest Expense + Tax Payments)/Interest Expense. The ratio of cash flows from operating activities to total liabilities, a long-term solvency ratio, shows the ability of a company to generate cash flows from operations to service both short-term and long-term obligations as it highlights the portion of total liabilities that can be serviced by annual cash flows from operating activities.

An assessment of a company’s free cash flows is important in assessing its ability to finance possible expansion in operating capacity, to reduce its debt, to pay dividends, or to repurchase stock. Typically, free cash flows are computed as: Cash flows from operating activities less (a) cash payments for the replacement of existing fixed asset operating capability, (b) scheduled debt payments, and (c) normal dividend payments. Sufficient free cash flows provide an internal source of funds.

Analysis of Reported Cash Flows

An analysis of the relationship between and trends within the three sections of the cash flow statement can also identify problem areas. For example, companies with negative cash flows from operating activities must find ways to finance their operating cash shortfall. Cash reserves must be tapped, additional borrowings obtained, additional equity issued, or investments liquidated. Net income and cash flows from operating activities will not equal, but should be correlated. Generally the closer the association of these two numbers, the higher-quality the earnings. An adverse association between these two numbers over time (cash flows begin to lag net income) can provide an early warning sign of a deteriorating cash position. Ideally, a company should have positive cash flows from operating activities, while it’s investing and financing activities should require cash outflows. This relationship suggests that the company is generating sufficient cash flows from operating activities to acquire property, plant and equipment and to provide for debt and equity commitments. 

Cash flows from investing activities should be reviewed to determine if capital expenditures and asset sales are consistent with the company’s business strategy and growth opportunities. Substantial expenditures for property, plant and equipment are expected for emerging companies and established growth companies, but mature companies should have more limited investing activities expenditures. Changes in a company’s capital expenditures or asset sales over time should be carefully reviewed.  Unexplained increases in fixed asset sales may indicate that management needs to raise cash quickly or that it is eliminating excess operating capacity. Generally consistent positive cash flows from investing activities may forecast a company in trouble. 


In an environment where credit is extremely difficult to obtain, companies that can not generate sufficient cash flows from operations impair their ability to continue as a viable company. The automobile industry is precisely in this position. The long-term viability of these companies depends on their renewed generation of positive cash flows from operations. Clearly, now more than ever, positive cash flows are king.   

About Becker CPE

Becker CPE provides world-class Web-based and live in-house continuing professional education for accounting and finance professionals. In addition to Cash Flows, Becker CPE also offers courses on a number of other timely and relevant topics to help professionals stay a step ahead in today’s fast-changing business world. Visit us at www.beckerCPE.com.

Sheldon Langsam PhD, CPA is a professor at Western Michigan University. He has published several articles in various journals. He teaches intermediate financial accounting, governmental and nonprofit accounting, and a graduate course in auditing. Jerry Kreuze PhD, CPA is a professor at Western Michigan University. He has published numerous articles in various accounting and professional journals. He teaches intermediate financial accounting and graduate financial statement reporting.