Operating Activities – Using Cash Flow Information

Many financial statement users find the operating activities section to be quite informative. Creditors, for example, recognize that loans can only be repaid with cash and that a firm’s operations are a likely source of cash for debt repayment.

Because the ability to generate cash determines dividends and share price, shareholders and their advisors are interested in cash provided by operating activities.

Moreover, some analysts believe that because reported net income can be manipulated by accounting ploys, cash flow from operating activities is a more reliable performance measure than net income.We will subsequently discuss how managers can also manipulate cash flow figures.

Keep in mind, however, that not all healthy firms have a large positive cash flow from operations.Firms that experience growth in sales invariably need to expand their accounts receivable and inventory.These asset acquisitions must be financed,and cash generated by operations is a frequently used source. For example, Digital Power Corp., which designs, develops, and manufactures component parts for computers and other electronic equipment, increased its sales from $13,835,008 in 1996 to $18,884,259 in 1997. Digital’s 36% increase in sales was accompanied by a $1,673,340 increase in accounts receivable and inventory. So even though net income increased 21% to $1,400,790, the increased investment in receivables and inventory resulted in a net cash outflow from operating activities of $80,252 in 1997. In Digital’s case, the cash outflow does not indicate poor operating performance. Instead, it reflects growth. In general, however, a negative cash flow from operating activities should prompt further investigation.

To illustrate the insights that can be drawn from cash flow numbers, which contains Altron Incorporated’s statement of cash flows. Recall that gate’s income statement appears in Figure 3.1 in the section “An Illustrated Income Statement”. Additional information that will be helpful in interpreting the cash flow statement.

First, note that Altron chose the indirect format for the operating section of the cash flow statement. Because of this, the specific sources and uses of cash are not detailed.

We will soon show how to estimate some of these numbers.The bottom of the operating section shows that a positive cash flow of $14,428,000 was generated by operating activities.Keep in mind, however, that this figure does not reflect the cash spent to replace worn-out equipment.



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