M. Ü. iktisadi ve idari Bilimler Fakültesi Dergisi Yıl:2000, Cilt: XVI, Sayı: 1, Sayfa: 121-128
IMPORTANCE OF CASH FLOW STATEMENT
iN FINANCIAL REPORTING:
AN INVESTIGATION ON BANKRUPTCY PREDICTION
USING CASH FLOW DATA
Tuba DUMLU*
INTRODUCTION
The accrual hasis accounting properly measures operating performance each period, its use does not result in reporting the critical variahle for the remaining in husiness: cash flows.1
The statement of cash flows reports the relation hetween income flows and cash flows from operations.
The primary purpose of the statement of cash flows is to provide information ahout an entity's cash receipts cash payments during a period.2 A secondary ohjec-tive is to provide information on a cash hasis ahout its operating, investing, and financing activities.
The information provided in a statement of cash flows, if used with related dis-closures and the other financial statements, should help investors, creditors, and oth-ers to:
1. Assess the enterprise's ahility to generate positive future net cash flows. 2. Assess the enterprise's ahility to meet its ohligations, its ahility to pay divi-dends, and its needs for extemal financing.
3. Assess the reasons for differences hetween net income and associated cash receipts and payments.
4. Assess the effects on an enterprise's financial position of hoth its cash and noncash investing and financing transactions during a period.
The statement of cash flows reports cash receipts, cash payments, and net change in cash resulting from operating, investing, and financing activities of an enterprise during a period, in a format that reconciles the heginning and ending cash halances.
* Öğr. Grv. Dr., Marmara Üniversitesi, İ.İ.B.F., İngilizce İşletme Bölümü.
Stickney, Clyde P., "Financial Reporting and Statement Analysis, A Strategic Perspective", The Dryden
Press, 3rd Edition, 1996, p.44.
2 Kieso, Donald E., Weygandt, Jerry J., "Intcrmcdiate Accounting", John Wilcy & Sons, ine.", 9th
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The statement of cash flows provides information not available from other fınancial statements. For example, it helps to indicate how it is possible for a com-pany to report a net loss and still make large capital expenditures or pay dividends. 3
On the other hand, an understanding of the relation between net income and cash flows is an important ingredient in analyzing both the profıtability and fınancial health ofa business.
Because investors usually look to net income as a key indicator ofa compa-ny's health and future prospects.
"The company showed a pattem of consistent profıtability and even some peri-ods of income growth. Does the company look like a good investment? Would you expect its profıtability to continue? The company had consistently paid dividends and interest. Would you expect it to continue do so? Investors answered "yes" to all three of these questions, by buying the company's stock.
Eighteen months later, this company fıled for bankruptcy. Closer examination of the company's fınancial statements revealed that the company had experienced severals years of negative cash flow from its operations, even though it reported prof-its. Analysis of cash flows would have provided an early waming signal of the com-pany's operating problems. "4
NET INCOME AND CASH FLOWS
When periodic fınancial statements are prepared, estimates of the r~venues eamed and expenses incurred during the reporting interval are required. These esti-mates require management judgement and are subject to modifıcation as more infor-mation about the operating cycle becomes available. Accrual accounting can there-fore be affected by management's choice of accounting policies and estimates. Furthermore, accrual accounting by itself fails to provide adequate information about the liquidity ofthe fırın and long-term solvency. Some of these problems can be alle-viated by the use of cash flow statement in conjunction with the income statement.5 Interpreting the statement of cash flows requires an understanding of two rela-ti ons:
1. The relation between net income and cash flow from operations.
2. The relation among the net cash flows from operating, investing, and fınancing activities.6
The statement of cash flows reconciles net income with cash flow from opera-tions. This reconciliation involves two types of adjustments.
Ibid., p.1275.
4 Ibid., p.1273.
5 White, Gerald I., Sondhi, Ashwinpaul C., Fricd, Dov, "The Analysis and Use ofFinancial Statements", John Wilcy & Sons, ine., 2nd Edition, 1998, p. l 05.
6 Stickney, Clyde P., "Financial Reporting and Statement Analysis, A Strategic Perspective", The Dryden Press, 3rd Edition, l 996, p.44.
Prof Dr. ismail Özaslan 'a Armağan
First, certain revenues and expenses relate to changes in noncurrent asset or noncurrent liahility accounts and have cash flow effects that differ from their income effect. For example, the addhack of depreciation expense to net income offsets the effect of depreciation since it does not use cash flow for operations. Another exam-ple, hecause the net income includes the gain or loss on the sale of fıxed assets, the operating section of the statement of cash flows shows an addhack for a loss and a suhtraction fora gain to offset their inclusion to net income.Other examples ofreve-nues and expenses that relate to changes in noncurrent asset or noncurrent liahility accounts include amortization of intangihle assets, minority interest in the eamings of consolidated suhsidiaries, and some restructuring charges and adjustments for changes in accounting principles.
The second type of adjustment to reconcile net income to cash flow from oper-ations involves changes in operating current asset and current liahility accounts. For example, an increase in accounts receivahle indicates that the fırın did not collect as much cash from customers as the amount of sales revenue for the period. A suhtrac-tion from net income for the increase in accounts receivahle converts accrual hasis revenues to cash receipts from customers. Similar adjustments for changes in inven-tories, prepayments, accounts payahle, and other operating current liahilities convert accrual hasis income amounts to their associated cash flow amounts.7
THE PREDICTION OF BANKRUPTCY
An important ohjective of the analysis of fınancial statements in general and that of ratios in particular is an assessment of the risk inherent in a fırın's operations. Although liquidity, solvency, and profıtahility analysis implicitly address the proha-hility that a fırın's cash will fall helow some level, commonly used ratios do not directly measure this uncertainity. A large hody of research has examined the utility of accounting-hased measures in risk evaluation and prediction. s
The ahility to predict which firms will fac~ insolvency in the near terın is important to hoth potantial creditors and investors. When a fırın files for hankruptcy, creditors often lose a portion of principal and interest payments due; common stock investors may suffer suhtantial dilution or loss of their equity interest. in addition, hankruptcy imposes signifıcant legal costs and risks on its investors and creditors as well as the fırın, even if it survives.9
For these reasons, there has heen considerahle research into the use of ratios and cash flow data to predict hankruptcy.
in their study Casey and Bartczak (1985), ıo conducted a study to assess whether operating cash flow data and related measures lead to more accurate
predic-7 lbid., p.45.
8 White, Gerald I., Sondhi, Ashwinpaul C., Fried, Dov, "Thc Analysis and Usc ofFinancial Statements",
John Wiley & Sons, Inc., 2nd Edition, 1998, p.984.
9 lbid., p.992.
1 O Casey, Comclius, and Bartczak, Norman, "Using Opertaing Cash Flow Data to Predict Financial
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ti ons of bankrupt and nonbankrupt firms. Casey and Bartczak ( 1 984 ), ı ı in their
for-m er study they reported that accrual-based ınultivariate discriminant models
fore-casted corporate bankruptcy ınore accurately than a single operating cash flow ratio.
The focus of their la ter study is on the marginal predictive content of the
oper-ating cash flow ratios, in contrast to their previous study which exaınined their
uni-variate predictive value.
Their results suggest that 11operating cash flow data do not provide
incremen-tal predictive power over accrual-based ratios. 1112
Then, in 1987 Gombola, Haskins, Ketz, and Williams (1987)13 conducted a
study and the central question in their study was whether cash flow from operations
(CFFO) is iınportant in predicting corporate failure after the mid-1970s.
Their conclusion was 11consistent with Casey and Bartczak, the evidence in
this paper is against CFFO ( calculated as working capital from operations plus/minus
changes in current liabilities and cuITent assets other than cash). In late years,
CFFO/ Assets is insignificant in predicting bankruptcy three years out of four as
measured by the significance of the coefficient. The marginal predictive ability of
CFFO is insignifıcant in all four years. It therefore appears that CFFO is not an
important predictor of corporate failure. 1114
In their conclusions section, there is an important point that we have to pay
attention is that the cash flow measure employed in their study is an estimate. Since
it's calculated with error, the results were limited by the effectiveness of the
estima-tion procedure. They said that their study might be replicated at a later time when
fırms report cash flow from operations.
On the other hand, Aziz, Emanuel, and Lawson (1988)15 conducted a study in
order to develop a model for generating a multivariate bankruptcy model. In their
study they used a cash flow for fırın valuation. According to them since the
corpo-rate bankruptcy is closely related to firm valuation, cash flow is likely to provide
bet-ter predictors.
What they found is that 11the cash flow based (CFB) models compares
favor-ably with the ZETA and Z models. First, overall accuracy is approximately equal.
Second, compared with the Z model the CFB model is sustantially more likely to
pre-dict a bankruptcy up to fıve years prior to the event. When compared with ZETA
model, the CFB model is more likely to provide early warning three or more years
before the event. 11
I6
11 Cascy, Comelius, and Bartczak, Norman, "Cash Flow - lt's Not thc Bottom Linc.", Harvard Busincss Rcview, July/ August 1984, p.60-66.
12 Cascy, Comclius, and Bartczak, Norman, "Using Opcrating Cash Flow Data to Prcdict Financial Distrcss: Somc Extcnsion", Joumal of Accounting Rcscarch, Spring 1985, Vol.23, No.1, p.395. 13 Gombola, Michael J., Haskins, Mark E., Kctz, J. Edward, and Williams, David O., "Cash Flow in
Bankruptcy Prcdiction", Financial Managcmcnt, 1987, Vol. 16, Iss.4, p.58. 14 Ibid., p.64.
15 Aziz, Abdul, Emanucl, David C., Lawson, Gcrald H., "Bankruptcy Prcdiction - An lnvcstigation of Cash Flow Based Modcls", Joumal of Managcmcnt Studics, 1988, Vol.25, lss.5, 419-437.
Prof Dr. ismail Özaslan 'a Armağan The study done by Foster and Ward (1997) l 7 suggested cash flow trends and interactions can help identify business that will eventually become bankrupt.
Their result was showing that bankrupt businesses lose cash flow equilibrium befare bankruptcy. Negative cash flow from operations drains cash and makes
financing more difficult to obtain. Not only cash flow from operations but also the cash flow from financing and investing is negative far bankrupt firms before bank
-ruptcy.
Obviously companies cannot continue in business long with all three cash flows negative. Some troubled businesses sell off long-term assets to fund their
fınancing obligations. However, cash flows and trends in the flows will continue to
differ far business that regain cash equilibrium and businessess that fail to regain
cgulibrium and become bankrupt. 18
ln 1998, Mossman and Bell (1998)19 conducted a study that compared faur
types of bankruptcy prediction models based on financial statement ratios , cash flows, stock retums, and retum standard deviations.
According to them, during the last fiscal year preceding bankruptcy, none of the individual models may be excluded without a loss in explanatory power. If con-sidered in isolation, the cash flow model discriminates most consistently two or three years befare bankruptcy. 20
According to their conclusion, "tests of bankruptcy models show that no sin-gle model proposed in the existing literature is entirely satisfactory at differentiating between bankrupt and non-bankrupt firms. The discriminatory ability of the cash flow model remains relatively consistent over the last two to three fiscal years befare bankruptcy, while the ratio model offers the best discriminatory ability in the year immediately prior to bankruptcy. Stakeholders might be particularly interested in cash flow variables as an 'early waming' of potential difficulties. "21
IAS 7
The clear consensus of national and intemational accounting standard setters is that the statement of cash flows is a necessary component of complete financial reporting.22
The percieved benefits of presenting the statement of cash flows in conjunc-tion with the balance sheet and income statement have been highlighted by IAS 7 to be as follows:
17 Foster, Benjamin P., Ward, Terry J.,
"Using Cash Flow Trends to Idcntify Risks of Bankruptcy", CPA Journal, Scpt.1997, Vol.67, Iss.9, p.60.
18 Ibid., p.61.
J 9 Mossman, Charles E., Bell, Geoffrey G., "An Empirical Comparison of Bankruptcy
Models", Financial Review, May 1998, Vol.33, Iss.2, p.35.
20 Ibid., p.35. 21 Ibid., p.39.
22 Epstein, Barry J., Mirza, Abbas Ali, "Interpretation and Application of Intcrnational Accounting Standards 1998", John Wiley Sons, ine., 1998, p.94.
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1. it provides an insight into the financial structure of the entreprise (including liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities.
2. it provides additional information to the users of financial statements for
evaluating changes in assets, liabilities, and equity of an enterprise.
3. it enhances the comparability of reporting of operating performance by
dif-ferent enterpr_ises because it eliminates the effects of using different accounting
treat-ments for the same transactions and events.
4. it serves as an indicator of the amount, timing, and certainity of future cash
flows. Furthermore, ifan enterprise has a system in place to project its future cash flows, the statement of cash flows could be used as a touchstone to evaluate the accu-racy of past projections of those future cash flows. This benefit is stated by the stan-dard as follows:
a. The statement of cash flows is useful in comparing past assessments of
future cash flows against current year's cash flow information, and
b. it is of value in appraising the relationship between profitability and net
cash flows, and in assessing the impact of changing prices.23
The statement of cash flows includes only inflows and outflows of cash and
cash equivalents. On the other hand, it excludes all transactions that do not directly affect cash receipts and payments. However, IAS 7 does require that the effects of transactions not resulting in receipts or payments of cash be disclosed elsewhere in the financial statements. The reason for not including noncash transactions in the
statement of cash flows and placing them elsewhere in the financial statements (e.g.,
the footnotes) is that it preserves the statement's primary focus on cash flows from
operating, investing, and fınancing activities.24
CONCLUSION
During last fıfteen years, researchers tried to find a model which will be used
in predicting bankruptcy. When we look at these researches, -some mentioned above-, we see that in every study cash flow <lata was taken into consideration.
in some studies it was concluded that the cash flow data has no additional
power to predict bankruptcy. On the other hand, according to some other studies, cash flow based models are more consistent in predicting bankruptcy. And according to other studies, in order to predict bankruptcy precisely, several methods should be taken into consideration together, including cash flow data.
Since there is no strict conclusion about the ability of cash flow <lata in pre-dicting bankruptcy, researchers still continue to make analysis to check the ability of
cash flow <lata in predicting a company's fınancial health. This means that the
impor-tance of cash flow <lata cannot be omitted. 23 Ibid., p.95.
Prof Dr. İsmail Özaslan 'a Armağan
Turkish Accounting and Auditing Standards Board published a standard (No.3) about cash flows statement. Board advices the use and application ofthe stan-dard by the companies. According to Board, application ofthe stanstan-dard will help the financial statements prepared correctly and transparently.25
According to General Announcement on Application of Accounting System No:826, in Turkey there is no necessity for companies to submit the cash flows state
-ment toghether with their income or corporation tax declaration.
On the other hand when we look at the laws of Capital Market Board27, the companies do not have to announce the cash flows statement together with balance shcet and income statement to the public.
So, as a result we can say that, especially from investors point of view, the
arınouncement of the cash flows statement by the companies which shares are
trad-ed in stock exchange market, will be beneficiary while making investment decisions.
The preparation and announcement of cash flows statement to public may be adviced or enforced by the Ministry of Finance or the Capital Market Board.
For further studies, we can say that the ability of cash flows statement in pre-dicting bankruptcy can be tested in Turkey, -a hyperinflationary environment.
REFERENCES
Aziz, Abdul, Emanuel, David C., Lawson, Gerald H., "Bankruptey Predietion - An lnvestigation of Cash Flow Based Models", Joumal of Management Studies, 1988, Vol.25, lss.5, 419-437
Casey, Comelius, and Bartczak, Norman, "Cash Flow - lt's Not the Bottom Line.", Harvard Business Review, July/August 1984, p.60-66
Casey, Comelius, and Bartezak, Norman, "Using Opertaing Cash Flow Data to Prediet Financial Distress: Some Extension", Joumal of Accounting Researeh, Vol.23 No. l Spring 1985, p.384-385
Epstein, Barry J., Mirza, Abbas Ali, "lnterpretation and Application of Intemational
Aceounting Standards 1998", John Wiley Sons, ine., 1998, p.94
Foster, Benjamin P., Ward, Terry J., "Using Cash Flow Trends to ldentify Risks of
Bankruptey", CPA Joumal, Sept.1997, Vol.67, lss.9, p.60
Gombola, Miehael J., Haskins, Mark E., Ketz, J. Edward, and Williams, David D., "Cash Flow
in Bankruptey Prediction", Finaneial Management, 1987, Vol.16, lss.4, p.58
Kieso, Donald E., Weygandt, Jerry J., "lntermediate Aeeounting", John Wiley & Sons, ine.",
9th Edition, 1998, p. 127 4
Mossman, Charles E., Bell, Geoffrey G., "An Empirieal Comparison ofBankruptey Models", Fimfncial Review, May 1998, Vol.33, lss.2, p.35
25 Türkiye Muhasebe Standartları 1997, TÜRMOB YAYIN N0:32, TMUDESK SERİ NO:l, p.vi 26 Muhasebe Sistemi Uygulama Genel Tebliği, No:8, "28.04.1998 tarih ve 23326 sayılı Resmi Gazete". 27 www.spk.gov.tr/mevzuat/muhasebe standartları, Mali Tablolara İlişkin Şekil ve Esaslar, Seri XI, No. l,
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Muhasebe Sistemi Uygulama Genel Tebliği, No:8, "28.04. 1998 tarih ve 23326 sayılı Resmi Gazete".
Stickney, Clyde P., "Financial Reporting and Statement Analysis, A Strategic Perspective", The Dryden Press, 3rd Edition, 1996, p.44
Türkiye Muhasebe Standartları 1997, TÜRMOB YAYIN N0:32, TMUDESK SERİ NO:l, p.vi
White, Gerald 1., Sondhi, Ashwinpaul C., Fried, Dov, ''The Analysis and Use of Financial Statements", John Wiley & Sons, Inc., 2nd Edition, 1998, p.105
www.spk.gov.tr/mevzuat/muhasebe standartları, Mali Tablolara İlişkin Şekil ve Esaslar, Seri XI, No.1, Madde:49.
