In 2011, forensic accountant based in Pune, announced a J-score. This was a score which measured the probability of the creative accounting in the financial statements. J-score is an important tool in financial statement analysis using the forensic rating approach. This score is heavily focussed on the cash flows. It is believed that most of the elements in the financial statements can be manipulated but not the cash flows. Hence, most of the companies whose J-score is above one on the scale of zero-to-one are treated as indulging into creative accounting practices. This J-Score is the basis of forensic rating model designed to identify the creative accounting.
In the wake of this J-score, it has become essential to understand the cash-flow statements in detail.
What Is Cash Flow Statement?
The cash flow statement records a company’s cash receipts and payments during a year. It makes an entry only when some cash is received, unlike the income account, which records revenue as and when it is earned rather than when the cash is actually collected. Similarly, cash payment is reflected only when it is actually paid.
How does it work?
To get the net cash figure of a company, one needs to add the net cash at the beginning of the year with the cash generated during the year. To evaluate the cash earned during a year, one needs to understand the three sections of a company’s cash statement—operating, investing and financing activities.
Companies should pay dividends out of the cash from their operations. Dividends from borrowed money can’t be sustained in the long run
Operating activity is a company’s main line of business as it helps generate revenue. The cash generated from operations minus all the cash expenditures incurred is called the net cash flow from operations (CFO). The first thing you will notice in this section is net profit (as given in the income account). But, this is not the actual CFO. To reach the real figure, you need to consider three major factors—non-cash income, non-cash expenditure and inventory.
Non-cash income basically constitutes the receivables, which is the amount still to be received by the company on sales made on credit. Since the companies sell goods and services on credit, the revenue figure is not necessarily the cash realized. So, this amount needs to be subtracted from the net profit.
Non-cash expenditure has two components—payable and depreciation. Payable are the amount that is still to be paid by the company for goods and services bought on credit. This amount needs to be added to the net profit. Depreciation is deducted in the income account to reach the net profit. To determine the cash flow, this amount needs to be added back as this is not an actual expense.
The expenditure/income from the inventory too needs to be adjusted. While the expenditure on piled up inventory needs to be deducted from the net profit, the expenditure shown this year on leftover inventory from last year has to be added to it.
The investing activity of a company is when it uses cash to buy assets, such as property or machinery, and bonds and equities of other companies. The company may also receive cash by selling its assets.
Companies may bolster their operating cash as it gets maximum attention. Look at the report’s footnotes to get a clearer picture
The financing activity lists cash coming from the issue of shares, bonds and long- and short-term borrowings. Similarly, cash gets used in repaying debt, paying interests, buybacks and giving dividends.
The difference between the inflow and outflow from the financing and investing activities along with the net CFO is the cash income during a year.
Don’t go by face value
While significantly low cash levels point to a liquidity problem, high cash levels may indicate its inefficient utilization by the company. The forensic rating model designed to identify the creative accounting considers both the scenarios. Also, if a company generates excess cash through loans or by selling assets, it may not be good for its health. Similarly, outflows like capital expenditure and paying off liabilities are not bad.
If cash growth does not keep pace with sales growth, It means that the company Could face a liquidity crunch in the future.
How to check a Company’s Earnings Quality
The simplest way you can figure out a company’s earning quality is by looking at the difference between the CFO and the net income.
If a mature company has high income but poor CFO, it is a sign of its poor earning quality. For example, real estate companies Parsvnath and Unitech reported high net profit during FY05-08, but had a negative Cash Flow from Operations for all the years. This was a sign of the poor quality of their earnings.
A growing company might sell goods and services on credit to gain competitive advantage even at the cost of a negative CFO, but only in the short term. It will need a higher CFO in the long term to maintain its credit profile.
Cash statements are often overlooked, but is the most significant aspect of the forensic rating model designed to identify the creative accounting. You should not base your assessment of a company only on its cash flow statement, It should be compared with the industry average. But, you can always use it to your advantage.