Most people do not recognize that it wasn’t until the beginning of the Depression Era, the early 1930s, when the New York Stock Exchange mandated basically what we call today the matching principle: the accounting matching of revenues and expenses, as undertaken in the typical income statement, that a separate form of income determination apart from the balance sheet grew to general use. And so it was not until the Depression Era that the income statement, the matching principle, and the separate determination of net income gained ascendancy as the predominant form of financial analysis. Further, we can see why this would be the case at that time. During the Great Depression income was so scarce and hard to come by that its separate determination was called for. In the early 1930s, interest rates were extremely low, in some cases negative. Banks closed their doors in record numbers, and the power of bankers to influence the course of events was on the decline. Income analysis became more and more important, and net income analysis and the income statement predominated as a form of financial analysis. This persisted until relatively recently.

In the 1970s, with great inflation, income computations according to the traditional methods, with the use of historical costs, became a bit silly and meaningless due to the misapplication of valuation with respect to the balance sheet. The significant level of inflation made these historical costs less meaningful, and what was found on the balance sheet (basically historical cost determined assets that represented unexpired costs) went into the income statement as these costs expired. In that these costs were no longer a reflection of current valuation in a highly inflationary era, the balance sheet (which was already in considerable disrepute) went into even further decline as an analytical tool, and an understanding developed that the income statement was not very meaningful, either, without some adjustments. Accordingly, price level adjustments that had been developed for some time resurfaced as a means of enhancing the analytical use of both the balance sheet and the income statement.

Basically, the conditions of the time led to an understanding that neither the income statement nor the balance sheet was of much analytical value in dealing with the prevalent business environment. Different product costing techniques, such as LIFO, FIFO, and average, led to very different accounting results. Similarly, different depreciation techniques – straight- line, double declining balance, etc. – led to very different income statement and balance sheet results. And while new financial analytical methods were called for, it was really old techniques that were found to deal with the requirements of the times.

Cash flow analysis became more and more in vogue because of its ability to deal with the economic exigencies of the time and its lessened degree (as compared to the balance sheet and the income statement) of being subject to accounting manipulation by the preparers of financial statements in order to portray the desired results. Today, cash flow analysis truly is by far the most important kind of financial analysis, and most finance professors now deal with their students in terms of free cash flow (cash flow from continuing operations less capital expenditures and dividends) in that it leads to an enhanced ability to effectively analyze the firm, regardless of the level of inflation or the accounting techniques that are used. That is, free cash flow provides a far better handle on the solvency and productive operations of a firm than the income statement or the balance sheet. This is especially true in difficult and volatile economic times.

With the return of the ascendancy of cash flow analysis after many centuries have also come many alternative ways of understanding cash flow. Free cash flow is just one of them; there are others. It has been an interesting metamorphosis through the years. We’re back where we started at the dawn of the Industrial Revolution, with cash flow predominating as a financial analytical tool.

The high-profile bankruptcies of the 1990s and early 2000s have certainly helped bring about this change. Moreover, the financial bubble at that time, which in many ways reflects other such bubbles of other centuries, also reflects this – a need to get away from allowing businesses to tell us what they want to tell us and what they want us to believe they are worth. We have to look beyond some of the inherent misstatements in the balance sheet and the income statement and the amenability of these forms of financial analysis to manipulation by some unscrupulous financial managers who sometimes find it desirable to tell lies to cover misdeeds or poor financial performance. It is important that financial analysts employ techniques that will effectively determine the value of businesses they are studying.

There are many types of financial analysis. You can almost call anything having to do with dollars financial analysis; as long as you’re dealing with a dollar sign, you’re engaging in some form of financial analysis.

A bit of history with respect to the relative emphasis of various forms of financial analysis or accounting statement types through the years might be useful at this at this point. There has been a very interesting change through the centuries in the focus of financial analysis and the relative importance of the various financial statements. Cash flow analysis was the predominant focus of financial analysis at the dawn of the Industrial Revolution. Businesses at that time, when they opened their doors, had to be sure they could last the day, and so they had to have cash to make change and sufficient liquidity to secure their other transactions. Basically, what was needed was sufficient cash to satisfy what economists like to call transaction demand and some security beyond this for purposes of what economics refer to as a precautionary demand for cash. So cash flow analysis is what was focused on at that time.

Businesses were simple; there was no complex manufacturing, where the determination of product costs and the requisite financial statements are very significant. Enterprises were predominantly simple, service-type businesses: trading and very rudimentary manufacturing, and such.

Then, in the early 1800s, what was then Britain (United Kingdom now) passed what were known as the Company Acts. The British Company Acts mandated the compilation of something pretty close to what we now know as the balance sheet, and that changed the focus from a cash flow analysis to a balance sheet analysis. This change was prompted by banks, which understood borrowing customer solvency in terms of a relationship between assets and liabilities; hence an emphasis upon the balance sheet.

Bankers are now far more intelligent and sophisticated in financial affairs, understanding that it is really income and basically cash flow that will repay their loans. But bankers at that time wanted to look at balance sheets. They believed that in the event of the insolvency of their borrowers, they could proceed against the physical assets of these borrowers and wished to know the book values of these assets, as well as the amount of claims standing in line with them for satisfaction. This knowledge required balance sheets prepared on the basis of historical costs. So income, while of some importance as a measure of business stability and success at the time, was of secondary consequence and was computed indirectly.

You would determine net income in those days according to what is now referred to as the net worth method. The net worth method of net income determination is basically as follows: you compute net worth at the beginning and at the end of the year (Assets – Liabilities = Net Worth), as found on the balance sheet, compare these two net worth figures, add back a capital consumption allowance (depreciation), and you have your net income for the year. Accordingly, net income was not computed directly at the time as is done today, but was ascertained as a derivative from the balance sheet. This was because, as noted, at the time net income was of secondary importance, and cash flow was of even less consequence.

As time went on and there were financial upheavals and monetary panics aplenty on both sides of the Atlantic, investors and bankers began to realize the limited nature of the net worth method, not only for an accurate determination of net income, but also as a gauge in determining expected business solvency. Change in the focus of financial analysis and the relative importance of the various financial statements and income determination methods was on its way. However, it is interesting to note how long it took before a fundamental alteration took hold in the emphasis placed upon the various types of financial analysis.