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Cash Flow Statement

A cash flow statement is one of three financial statements prepared by a business organization periodically. It analyses the flow of cash in and out of the business.

1. What is a Cash Flow Statement?

A cash flow statement is one of three mandatory financial reports generated by every business organization monthly, quarterly, or yearly. It measures the rate at which a business generates its cash so as to operate and pay its debts. The statement of cash flow complements the other two financial statements of the business, i.e. the income statement and the balance sheet.

The cash flow statement summarizes the inflow and outflow of cash and cash equivalents pertaining to a business.
If the operating cash is more than the net income, then the business earnings are considered of “high quality”. However, if the operating cash is less than the net income, the business will have to figure out why the net income is not being converted to cash.

When the inflow of cash is greater than the outflow of cash, the business is said to have a “positive cash flow”. In such a situation, the business will have enough money for its operations and expenses. When the inflow of cash is lesser than the outflow of cash, the business is said to have a “negative cash flow”. In such a situation, the business will be in danger of being overdrawn and will require extra money for covering its overdrafts. Therefore, businesses require proper working capital, as a line of credit or loan, for covering cash shortages.

2. Objectives of the Cash Flow Statement

The main objective of a cash flow statement is to help a business keep track of its cash inflow and outflow.
However, it also helps investors understand the working of a business and its operations. It provides them with details about the business’ cash flow, from where is it coming and where it is going. It allows them to determine if a business is worth investing in or not based on the strength of its financial footing.

Certain investors and stockholders are of the view that more cash inflow generation implies ability for the business to increase its dividend, reduce debt, buy some of its stocks back, or acquire another business. This will increase the stockholder value.

Cash flow statement also helps creditors to derive the liquidity for the business. This helps them understand the available cash that the business has for running its operations and paying its debts.

3. Calculating Cash Flow

To calculate cash flow, certain adjustments are to be made to the net income. This can be done by addition or subtraction of differences in the expenses, revenue, and credit transactions which are a result of the transactions occurring between two periods. The reason for making such adjustments is that non-cash transactions are calculated in the income statement and balance sheet. Since all transactions do not involve actual cash transactions, any others have to be evaluated again while calculating operating cash flow. This leaves two methods for calculation of cash flow:

    • Direct Method: It takes all gross receipts of operating inflows such as sales, trade receivables, etc. and subtracts them from gross payments of expenses such as purchases, credits, etc. excluding non-cash items such as provision and depreciation. Direct method gives a clearer picture of cash inflow and outflow sources which makes it easier to estimate the future inflow and outflow of cash. therefore, this method is preferred over the indirect method.
    • Indirect Method: It starts from the figure of net profit or loss, by eliminating the effects of investing, financing, and non-cash items from this profit figure. This means that it adds all expenses such as depreciation, interest paid, provisions, loss on asset sale, etc., and subtracts expenses such as received interest. Changes in working capital items are adjusted while excluding cash and its equivalents so as to reach the net cash flow figure.

4. Activities on the Cash Flow Statement

A cash flow statement has the following main components:

  • Cash from Operating Activities
  • Cash from Investing activities
  • Cash From Financing activities

a. Operating Activities

Operating activities are inclusive of any use or source of cash generated from a business’ activities. They convert the reported items on the income statement from accounting on accrual basis to cash. Changes in cash, accounts receivable, inventory, and accounts payable are generally reflected in operational cash. The operating activities may include:

  • Cash receipt from sale of products and services
  • Income tax payments
  • Payments to suppliers of goods and services required for production
  • Rent payment
  • Salary payment
  • Other operating expenses

Purchase or sale of long-term assets does not come under operating activities in the cash flow statement.

b. Investing Activities

Investing activities are inclusive of any use or source of cash generated from a business’ investments. They report purchase and sale of long-term investments including plant, property, and equipment. Sale or purchase of assets, paid loan, received loans, or any merger or acquisition related payments are part of investing activities. Changes in assets, equipment, or investments are reflected in invested cash.

c. Financing Activities

Financing activities are inclusive of any use of cash paid to a business’ shareholders or any source of cash generated from a business’ investors or banks. They report issue and repurchase of the bonds and stocks owned by the business and its dividends payment. Payment made on dividends, stock repurchases, and loans are part of financing activities. Example of changes in financing cash are reflected in financed cash as “cash in” when capital is raised and “cash out” when dividends are paid.

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