TOWARD EFFECTIVE USE OF THE STATEMENT OF CASH FLOWS

This paper promotes the use of the statement of cash flows in financial analysis by exploring analytical techniques using elements of the statement. The Financial Accounting Standards Board made the statement of cash flows a required part financial reporting in 1987 and, since 1988, companies have included the statement of cash flows in their quarterly and annual reports. Our review of collegiate finance textbooks shows that financial analysis, as presented in most of these textbooks, is predominantly based on the income statement and the balance sheet. The statement of cash flows is typically discussed as an after-thought, if at all. Practically all the financial ratios are based on numbers drawn from either the income statement or balance sheet. The paper develops a common-size analysis framework as the starting point for the financial analysis using the statement of cash flows. We propose four different common-size models for financial analysis using the statement of cash flows and discuss the relative merits and disadvantage of these. As diagnostic tools, common-size statement of cash flows can be used to examine the quality of a firm's earnings as well its life cycle phase (growth, mature, declining, etc.) We review eight ratios based on components of the statement of cash flows as alternatives to traditional financial ratios.