Definition
A Cash Flow Statement is a financial statement showing the movements of cash and cash equivalents during the period. This financial statement demonstrates the effects of changes in the accounts of Balance sheet on cash and cash equivalents. This is an important part of Financial Statements and also called Statement of Cash Flows as per International accounting standards.
A cash flow statement bears very useful information for both investors and creditors. The gross as well net cash movements remained during the period has always been a point of concern for investors and creditors. The investors usually want to know that how much the business is financially stable and sound. The creditors on the other hand want to know that how much the business is liquid enough to pay out its debts and liabilities.
- This statement serves both these purposes for investors and creditors
- This reconciles opening and ending cash and cash equivalents
- This tells the financial statements users that how much the business is good at maintaining effective level of cash and cash equivalents.
Cash & Cash Equivalents
Cash & Cash equivalents is a term which is more often used in the context of cash flow statement. Therefore, before understanding the format and other areas of cash flows, students are advised to get clear their concept regarding this term.
What is Cash
Cash would mean and comprise of cash on hand and demand deposits.
What is Cash Equivalents
Cash Equivalents include short-term highly liquid investments that are readily convertible to known amount of cash and which are subject to an insignificant risk of changes in value. Cash equivalents are held in the business for purposes of meeting short term cash commitments. These are not primarily held for investments and other purposes. This is very important point to make that for any investment to qualify as cash equivalent this is mandatory that the same should be readily convertible to known amount of cash and must be subject to an insignificant risk of changes in value.
Format
In financial accounting cash flow statement refers to the statement which shows the effects caused by the changes occurred in the accounts which are reflected in balance sheet and profit and loss account. In other words, this element of financial statements shows that how changes in balance sheet and profit and loss accounts have affected the movement of cash during the period.
According to IAS-7 the cash flow statement format it is divided in three sections.
- Operating activities
- Investing activities
- Financing activities
Operating Activities
These activities include revenue producing activities of a business or any operating activities generally results from the business transactions and other events that enter into the determination of net profit and net loss. These activities are receipts from sales of goods and rendering or services, receipts from royalties, fees or commission, payment to suppliers for goods or payment on behalf of employees.
Investing Activities
Cash flows from investing activities are the acquisition and disposal of long term assets and other investment not included in cash and cash equivalents. These activities include sales and purchasing long term assets like property, plant and equipment etc. Cash payment to acquire equity or debt instrument (shares or debentures) of other organization for long term investment.
Financing Activities
Cash flow from Financing Activities that result in changes in the size and composition of the equity / capital and borrowing of the company. These activities include cash receipts from issuing shares and debentures, loans, bonds, mortgage and cash payments for redemption of shares and loans instruments
The basic formula of cash flow is Net Cash Flow = CFF + CFI + CFO.
Example
The following example shows the the sample cash flow statement.
Analysis
- This statement Can be used as a tool providing valuable information regarding liquidity, solvency and financial soundness of an enterprise.
- Provides detailed and comprehensive summary of cash inflows and outflows which is not readily available from the data of Balance Sheet and Income Statement.
- Also serves as an indicator of amount, timing and even the extent of future cash flows (both inflow and outflows).
- Recognizes profits when it is realized and not when it accrued.
- Evaluates the enterprise’s ability to generate cash from its normal trading activities.
- Does not focus on accruals and other management’s estimates.
- Provides meaningful data for the computation of Internal Rate of Return.
- Enables the readers of financial statements to assess that how the business generated cash and from which activities (operating, investing and financing).
Preparation
Statement of cash flow can be prepared by using two methods direct and indirect method. According to IAS-7 a company should report cash flow from operation activities using either
Direct Method whereby major classes of gross receipts and payment of cash disclosed.
Indirect Method whereby net profit or loss is adjusted for the effects of transaction of a noncash nature, any deferrals or accruals of past or future operating cash receipts or payments and items of income or expense associated with investing or financing cash flows.
Importance
The importance of cash flow statement in accounting cannot be ignored. It serves various purposes and provides the users of financial statements with useful data for evaluating business progress.
Cash flow analysis is a very handy tool for determining the effectiveness and efficiency of an entity with which it has managed its working capital. In case where the cash generated from operating activities is appeared to be greater than or substantially equal to the profit reported for the period, it is considered very good signal. It is an indication that working capital has been managed quite effectively and efficiently. On the other hand, if the scenario is quite opposite i.e. cash generated from operating activities is substantially lower than the period’s profit, it denotes that working capital management needs improvements.
Generally, both cash inflows and outflows under ‘investing activities’ are deemed as good sign for an entity. Inflows from these activities would indicate that entity is generating from its investments made. On the other hand, excessive outflows under these activities would indicate that entity is in a good practice of investing its idle funds in more profitable businesses.
Cash outflows reported under financing activities would signify the business ‘strength and financial standing as this shows that business is paying back borrowed funds as well as paying dividends to the shareholders.