Which is an appropriate method of preparing a common-size cash flow statement?
A. Show each item of revenue and expense as a percentage of net revenue.
B. Show each line item on the cash flow statement as a percentage of net revenue.
C. Show each line item on the cash flow statement as a percentage of total cash outflows.
The correct answer and explanation is:
The correct answer is:
B. Show each line item on the cash flow statement as a percentage of net revenue.
Explanation
A common-size cash flow statement expresses each line item as a percentage of a common financial base, making it easier to analyze cash flow trends and compare companies of different sizes. The most appropriate base for a cash flow statement is net revenue (total sales minus returns, discounts, and allowances) because it represents the company’s primary source of cash generation.
Why Net Revenue?
- Comparability: Expressing cash flow components as a percentage of net revenue allows comparisons across companies, regardless of size. It helps investors and analysts assess efficiency in cash generation relative to sales.
- Performance Evaluation: This method helps in evaluating how much of the revenue is translated into operating cash flow, investment activities, and financing activities.
- Standardization: Financial analysts commonly use net revenue as a base for ratio analysis, ensuring consistency in financial statement analysis.
Why Not Other Methods?
- Option A (Percentage of Revenue and Expenses): This approach is typically used for income statements rather than cash flow statements, where expenses are broken down relative to revenues.
- Option C (Percentage of Total Cash Outflows): While cash outflows are important, they do not represent the total cash position of a company. Using total cash outflows as a base could distort the interpretation, as some businesses have different capital structures or financing methods.
Using net revenue as the denominator in a common-size cash flow statement provides a clearer picture of cash flow efficiency and financial health.
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