Financial Statement Analysis: Inflation, Cash Flow, and Valuation
Effects of Inflation
Influence on Costs
Traditional accounting methods record asset additions to the income statement based on historical costs. Inventory values, diverse in nature and acquired at different times, are expressed in current monetary terms through the company’s ongoing operations.
Effects on Depreciation Costs
Setting depreciation based on the original purchase price during inflationary periods becomes problematic during asset replacement. The accumulated depreciation may be insufficient to replace a retired asset with an identical new one.
Impact on Stocks
Charging stocks to inventory at historical prices, which are lower than replacement costs, creates fictitious profits and reduces real asset value. This can lead to increased capital or debt. Implementing appropriate valuation methods like LIFO (Last-In, First-Out) or FIFO (First-In, First-Out) can address this issue.
Impact on Profits
While some argue that companies benefit from anticipated inflation by raising prices on existing stock, this only holds true if there’s excessive stock accumulation. Otherwise, restocking at higher prices offsets the gains.
Impact on Heritage
Valuing client assets and receivables at nominal amounts leads to a loss of purchasing power for the company, effectively decreasing the real value of recoverable amounts. The increasing price level necessitates greater cash reserves to maintain payment ability. Fixed assets, especially non-depreciable ones, lose informational value. Depreciable assets face a resource shortfall for renewal, as depreciation based on the historical purchase price won’t cover the replacement cost.
Balance Sheet as a Measure of Activity
Financial and cost accounting serve as sources for balance sheet analysis. The analysis should encompass the current status, trends, and variances. Balance sheet information on long-term assets can represent the available capacity for production during a given period. Assets and liabilities should be analyzed both at a specific point in time (balance sheet) and as average volumes used throughout the period (permanent current assets and liabilities). When these permanent current assets and liabilities align with the resources needed for a specific activity level, they can be considered truly “permanent,” as they are essential for maintaining that activity level.
Companies with fluctuating activity levels should perform separate calculations for different periods.
Role of Financial Repayment of Funds
Depreciation funds can be temporarily used for new investments. This is possible because reinvested funds aren’t always immediately needed, and maintaining the same efficiency of fixed assets in their early stages, despite depreciation, doesn’t necessarily increase wealth but creates temporary excess availability.
Functional Classification of the Balance Sheet
This classification identifies the object of analysis, objectives, and limitations of accounting information. It provides a framework for management accounting analysis and allows for integration with other economic areas, which is crucial for decision-making. The goal is to provide useful information for decision-making, including cash flow data.
Basic Rate Financing (BRF)
Long-term assets should be financed with long-term liabilities. This is the BRF. The Net Fixed Assets plus the Required Fund of Rotation equals the required permanent capital. A BRF of 1 indicates a proper funding structure. A BRF greater than 1 signifies excess permanent capital, while a BRF less than 1 indicates a funding shortfall, meaning some long-term assets are financed with short-term resources.
Cash Flow Generated as Resources
Cash flow is calculated as Benefits plus Amortization. It represents the resources generated by the company economically and financially. It reflects the company’s ability to generate profits and improve its financial position. There are ratios related to production, depreciation, paid-in capital, and fixed costs.
Explicit Cost of External Financing
Paid Financing Sources
These include loans, debentures, and bonds, which carry an explicit financial cost. This cost often differs for long-term and short-term debt. It’s the discount rate that equates the present value of funds received (net of expenses) with the present value of expected cash outflows.
Unpaid External Financing
Sources like supplier credit and hire purchase have no explicit cost but limit flexibility for other financing options.
Cost of equity is calculated as (Dividends / Paid-in Capital) * 100.
Implied or Opportunity Cost
This is the cost of forgoing other investment opportunities, including the cost of reserves, depreciation, and amortization. Internal efficiency criteria evaluate the possibility of keeping resources invested within the company, assigning the implicit cost of debt. External performance criteria consider investing these resources outside the company, assigning a cost equal to the potential return from external investments.
Business Valuation
Business valuation principles (objectivity, timing, prudence, unit of assessment, and future anticipation) are applied through various methods:
- Historical Value: Used when the past price doesn’t reflect the current value; adjustments are needed to update balances.
- Substantial Value: The value of alternative assets that would provide the same services as the current ones. This is an economic concept applicable to the entire company or individual elements.