Understanding How to Common Size Cash Flow
Cash flow statements find use to analyze the cash income and expenditures during the designated period. They reveal how the company spends the money it earns. A standard cash flow statement divides the cash inflows and outflows into three major sections: business operations, investing and financing.
Method
If you’re seeking how to common size cash flow, remember these pointers:
Normal cash flow statements depict dollar values for each line item. Common size cash flows either replace such dollar values for percentage values, or include percentage values alongside dollar values.
Common sizing the cash flow statement is easy. Simply add up all the cash inflows and calculate the percentage value of each line item of the total cash inflow. For instance, for one line item, interest is $3,400 and the total cash inflow is $10,000; the common value line value for interest is = $3,400/$10,000*100 = 34 percent. Thus 34 percent of the net income for the period comes from interest.
Do a similar calculation for the cash outflows.
One important point to note is that the base value for calculating the percentage figure remains the same regardless whether the calculation is for the cash inflow column or cash outflow column. If net cash inflow exceeds net cash outflow, the excess cash finds entry as a line item “cash on hand” in the cash outflow section.
Application
Conversion of the value of line items in the cash flow statement into percentages allows for vertical analysis, which is comparison of the value of one line item in the cash flow with another. This provides a better understanding of the relationship among two or more items, such as the relationship between overhead expenses and sales, or between a particular cash flow and the net change in cash.
Another major application of common size cash flows is to determine the quantum of allocation of cash. For instance, converting the sub-totals for net outflows in operations, investing, and financing as a percentage of the total cash allows determining the proportion of cash used for these purposes. Company A with total revenue of $1,000 may reinvest $100, whereas company B with total revenue of $5,000 may reinvest $200. Though apparently company B reinvests more, Company B actually reinvests only 4 percent of revenue, whereas Company A reinvests 10 percent of revenue.
Common size statements also cater to horizontal analysis or comparison of the two different companies for the same period. Common size cash flow statements help in removing bias when comparing operational, investing or financial cash flows of two different companies of different size. It is unit free and ignores the size differentials. Absolute dollar values remain inadequate to gauge the effect of changes in values over time.
Finally, understanding how to common size cash flow statements may help highlight inconsistencies resulting from data entry errors!
The use of common size financial statements extends far beyond providing a standard scale for comparison and analysis. It provides insights regarding the economic characteristics of the business.
References
- Curtiss, Rand. “Common-Size the Cash Flow Statement.” https://www.go-iba.org/news/index.php/2009/07/31/common-size-the-cash-flow-statement/. Retrieved 09 March 2011.
- Thomas, Friedlob, G. Thomas. “New ways to analyze cash flows.” https://www.allbusiness.com/finance/130440-1.html. Retrieved 09 March 2011.
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