Introduction to Cash Flow Statement

Talking in terms of business, a cash flow statement is summary of the actual or expected income and expenditure i.e. incomings and outgoings of a firm or business over monthly, quarterly and annually. It also assesses the amount, timing and predictability of cash inflows and outflows and plays a pivotal role during budget formulation and business planning and mainly answers two questions such as:

  • Source of money or income i.e. where the money is coming from?
  • Investment options i.e. where the money is going to?

Normally a cash flow statement would capture both the current operating results and the accompanying changes in the balance sheet and as an analytical tool; it helps in determining the short-term viability of a company in terms of its ability to pay bills. A generic cash flow statement would include people and groups such as:

  • Shareholders of the business.
  • Potential employees or contractors, who need to know whether the company will be able to afford compensation;
  • Potential investors, to decide and evaluate if the company is financially sound or not;
  • Potential creditors or lenders, who would expect to have a clear picture if the company can repay or not and
  • Accounting personnel, who need to know if the organization will be able to cover payroll and other immediate expenses.

Structure of Cash Flow Statement (CFS)

A cash flow statement also known and referred as statement of cash flows constitutes the critical set of financial statement or information required for successful operation of a business and presents the accounting data in three main sections:

Operation-related activities such as sales of goods and services: Cash flow from operation related activities is calculated by using the following formula:

Cash flow from operations = Net income + non cash expenses + changes in working capital.

It would be no exaggeration to say that a continuous cash flow of an organization is similar to continuous supply of oxygen to the human body and by making some changes in the working capital, you can ensure a constant cash flow for your business i.e. if you prolong the time to pay the due bills you can preserve the cash in the organization. Similarly, if you collect the bills owed to you or rather shorten it, you can accelerate the receipt of cash and similarly if you delay the inventory purchase, you can preserve the cash in the company and ensures cash flow. Changes made in cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from operations and operating activities include:

a. Interest payments b. Income tax payments c. Receipts from sales of goods and services, d. Payments made to suppliers of goods and services used in production, e. Salary and wages of the employees, f. Rent payments, g. Receipts from sales of goods and services, h. Any other type of operating expenses

Investment-related activities such as sale or purchase of an asset: Cash flow from investment-related activities reflects the company’s purchases or sale of its assets and investing activities normally adds up to the cash outflow

Financing activities such as borrowings or sale of common stock: Cash flow from the financing activities as the name suggests is related to the finance-driven changes to the cash flow and reflects the company’s purchase or sale of its stock and the measures related to financing activities generally varies with the different capital structures, dividend policies and debt terms a company may have and unless you are planning to engage your business for raising finances, you will see a net cash outflow in this section. One must take following things into account for financing activities:

a. Include as outflows, reductions of long-term notes payable b. Or as inflows or issuance of new payable notes, c. Include as outflows, all dividends paid by the entity to outside parties, d. Or as inflows, dividend payments received from the outside parties; e. Include as outflows, the purchase of notes stocks and bonds, f. Or as inflows, the receipt of payments on such financing vehicles.

How a cash flow statement is utilized?

A cash flow statement is a financial statement that shows how a change in the balance sheet affects cash and its equivalents and captures both the current opening results and accompanying changes in the balance sheet and is an indispensable part of an organization. One could never the real picture by viewing the income statement because the income statement is prepared under the accrual basis of accounting, the actual revenues may not have been collected and similarly the expenses reported on the income statement might not have been paid. Investors and shareholders utilize the cash flow statement in various ways, such as:

  • Lot of financial models is designed based on cash flows.
  • It would not be wrong to say that cash is king and cash flow statement identifies the cash flowing in and out of the company and can thus be utilized in determining shares and dividends and stocks. Because based on the cash flow statement, one can take decisions such as whether to increase its dividend or not. Also whether to buy back some of its stock, reduce debt or acquire another company. If a company is having constant surplus cash or is consistently generating more cash than what is being spent, then it will be able to increase its dividend, buy some of its stock, reduce debt or acquire another company.
  • Cash flow statement allows the investors to understand how a company’s operations are running in terms of source of income and how money is being spent and it is the cash flow statement which determines if a company is on the solid financial footing or not.
  • Cash flow statement allows the investors to determine how much cash is available for conducting the operations in terms of liquid cash.
  • Cash generated from the operating activities is compared to the company’s net income and cash flow statement can be utilized to see if the net income of the company is of high quality or not i.e. in case the cash generated from the operating activities is more than the net income, then the income is considered to be of high quality and is a matter of serious concern if its other war round and raises questions such as why the reported net income is not turning into cash and investors are on a constant look-out for companies having high or improving cash flow.

How cash flow statement is calculated?

Cash flow statement can be calculated by making certain changes or adjustments to the net income either by adding or subtracting the expenses, differences in revenue, credit transactions etc and the reason why these adjustments are required is because non-cash items are also a part of the net income in the income statement whereas total assets and liabilities are a part of balance sheet and thus certain items need to be re-evaluated while calculating cash flow. There are two main ways to calculate cash flow statement i.e. direct method and indirect method.

Direct method: Under the direct method for creating a cash flow statement, major classes are reported for each class of gross cash receipts and payments such as taxed paid are directly linked to the operating activities, they will be reported under the operating activities and if the taxes paid are directly linked to the investing or financing activities, they will be reported under the applicable activity. It also adds up all the various types of cash payments and receipts including cash paid out as salaries, cash receipts from the customers and cash paid to the suppliers, if any and interest and income tax paid and in order to do so, beginning and end balances of various business accounts are examined thoroughly for net increase or decrease in the accounts.

Indirect method: Cash flow statement under the indirect method uses the net income as its basis and then progress to make any addition or deduction for non-cash revenue and expenses. Indirect method of cash flow statement is relatively a more popular method as compared to the direct one, because former one requires less information. And since indirect method uses net income as its base, it has to make certain adjustments to add back non-operating activities because net income is not an accurate representation of net cash flow from the operating activities and also revenue is recognized only when it is earned or credited, so it becomes important for an organization to adjust earnings before interest and taxes for the items affecting the net income even if actual cash has not been paid or received against those activities. So in other words, an indirect method converts accrual basis net-income or loss into cash flow by using series of additions and subtractions.

No matter how a cash flow statement is being generated or produced, cash flow statement helps a company to expand, venture into new markets and products, buy back stocks, pay dividends and reduce debts and thus it is given more importance than any other financial statements. If a cash flow statement shows low quality income, one has to borrow money in order to pay dividends, to explore new markets and to expand and in worst case shut down the business.