Lenders rely on cash flow statements because cash flows help measure default frequencies and represent a core ingredient of debt service. Cash flow is literally the obligor s lifeblood. The weaker, more volatile cash flows, the higher default probabilities. Looking at this from the banker s perspective, cash flow statements should be completed in sufficient detail to make it easier to measure the impact that cash and noncash investments have on financial position, external financing requirements, reasons for variances between payments and income, and the ability to fund dividends and meet obligations. Earlier accounting standards (specifically, Accounting Principles Board [APB] Opinion 19) allowed businesses to disclose information on either a working capital or cash basis. However, there are significant problems with accepting working capital as a proxy for cash. For example, working capital reports fail to take into account the composition of working capital. While absolute working capital may increase, liquidity could actually be compromised due to buildups of stale inventory.

The section on operating activities may be disclosed using either direct or indirect methods. Under either method, a reconciliation of net cash flow from operations to net income is required, and either method should result in the same cash flow from operations. The direct method focuses on cash and the impact of cash inflows/outflows on the borrower s financial condition. By checking numbers carefully and comparing cash-based numbers to accrual results, bankers walk away with a better understanding of their client s cash flow. The indirect basis starts off with net income...