Alternative Cash Flow Method

The following Alternative Cash Flow Method is a slight variation of the FASB Indirect Statement of Cash Flows. It actually predates the issuance of FASB 95 and is an effective tool in understanding a company's cash flow. Unlike the method under FASB 95, Investing Activities are called Discretionary Activities. As with the other cash flow methods, activities are divided into three sections. 

 

 

Cash
Accounts Receivable
Inventory


Gross Fixed Assets
Accumulated Depreciation
Net Fixed Assets

Total Assets

Accounts Payable
N/P - Bank 
Total Liabilities 

Equity

Gross Sales
Depreciation
Net Income

Year 1

$  20,000
    30,000
    10,000
$  60,000

$ 100,000
    60,000
$  40,000

$100,000

$ 25,000
   30,000
$ 55,000

$ 45,000

$100,000
   20,000
$ 15,000

   Year 2

$  25,000
    50,000
     8,000
$  83,000

$117,000
    80,000
$  37,000

$120,000

$ 43,000
   35,000
$ 78,000

$ 42,000

$115,000
   20,000
$   5,000

   
Operating Activities

Net IncomeDepreciation(+)

Interest Expense (+)

Dividends Tax (-)

Accounts Receivable

Inventory

Accounts Payable

CF from Operations

 

Financing Activities

Interest Expense(-) Dividends, excess (-)

Princ Payments (PP-CMLTD) Scheduled Debt Service

 

New Borrowings - Bank (+)

 

CF from Financing Act

 

 

Discretionary Activities

 

Purchases

CF from Investing Act

 

Change in Cash

 

Items in blue differ from the FASB indirect method

 

 

$    5,000
    20,000
    10,000
   ( 1,000)
   (20,000)
      2,000
    18,000
$  34,000
 

 

($10,000)
   (7,000)
   (6,000)
($23,000)

$ 11,000

($12,000)


($ 17,000)
($ 17,000)

$  5,000
 

The design of this model focuses first on cash flow from operations. Interest expense is added back to operating activities to derive a true cash flow from operations. It then focuses on financing activities, dividing financing activities into existing debt service and new borrowings. Was cash flow from operations sufficient to support the outstanding debt service payments?  A debt service coverage ratio can easily be determined:  CFO/Scheduled DS = DSC Ratio.  If cash flow after scheduled debt service is positive, how was the excess cash flow used?  If it was negative, was it supplemented by new borrowings, the sale of assets or a reduction in cash?  This analysis format was developed before S-Corps became popular. Dividends tended to be a financing activity to attract investors. With the pass-through nature of S-Corps, a percentage of net income (30% - 50%) may be required to meet the tax burden caused by the entity. That portion should be deducted from operating activities as taxes are. Any excess tax distributions should be included in financing activities. Are new funds being borrowed? If so, how are they being used?  The general theory is that cash flow from operations should be able to support current debt service requirements and new borrowings, excess cash flow from operations and cash reserves should be the primary funding source for discretionary activities. Discretionary activities consist of the purchase and the proceeds from the sale of property, plant and equipment and long-term investments. Is the company selling vital equipment to keep the doors open? Or is the liquidation of older equipment justified by changes in the process or market. 

Unfortunately, all these models provide an inadequate portrait of the business. For example, if excess cash is used to take advantage of trade discounts by paying early, cash flow from operations will appear weaker than it actually is. So, it is important to understand the primary components of cash flow and if possible, use cash flow analysis in conjunction with ratio analysis and some common sense. See Using Ratio Analysis to Understand Cash Flow.  

General Cash Flow Analysis:
Is cash flow from operations high enough to cover interest and installment payments?
Is cash flow high enough to support current debt service requirements and the reasonable amortization of the existing (or proposed) line(s) of credit over 3 to 5 years?
How is residual cash flow from operations being used?
Is net income the major source of cash flow from operations?
Is a contraction of working capital the primary source of cash flow from operations?

Cash flow should not be primarily derived from other income, debt rotation or the sale of fixed assets.
  

 

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