What is Cash Flow Statement? Uses, Objectives, Preparation, Limitations

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What is Cash Flow Statement?

A cash flow statement is a financial statement that shows the inflows and outflows of cash and cash equivalents for a business during a particular period of time. It provides information on how cash is generated and used by a business and helps in assessing the company’s liquidity, solvency, and overall financial health.

The Cash Flow Statement is a mandatory record of an organisation’s financial reports. It records the amount of cash and cash equivalents entering and leaving an organisation in a given time period. Thus it is a statement which shows the change in cash balances during a specified period. The Cash Flow Statement enables investors to comprehend how an organisation is performing in terms of its operations, the source of its money resources and how the available cash is utilised.

A Cash Flow Statement combined with other financial statements provides information allowing investors to evaluate the changes in net assets of an organisation, its financial structure, its liquidity and solvency conditions and the organisation’s ability to affect the amounts and timing of cash flows. Cash flow details help in assessing the ability of the organisation to generate cash and cash equivalents to enable users in comparing the present value of the future cash flows of different organisations.

Terminologies of Cash Flow Statement

Let us discuss the different terminologies associated with a Cash Flow Statement:

  • Cash: This includes an organisation’s cash in hand and deposits with banks.

  • Cash equivalents: These include the short-term highly liquid investments that can be easily converted into cash. Cash equivalents have short maturity periods (about three months or less) from the date of acquisition.

    For example, treasury bills, liquid mutual funds.

  • Operating activities: Cash flows from operating activities include the changes in cash due to major revenue producing activities such as sale of goods as well as major operating expenses for purchase of goods and services, operating expenses. Therefore, cash flows from operating activities accrue from the transactions and events that determine the net profit or loss incurred by the organisation.

    For example, cash receipts from sale of goods, cash receipts from royalties, fees, commission, etc.

  • Investing activities: Cash flows from investing activities include the changes in cash due to purchase or sale of long-term assets (also known as non-current assets) not included in cash equivalents. The disclosure is made separately to highlight the expenditures made on resources intended to generate future income and cash flows.

    For example, cash payments to purchase fixed assets, cash receipts from sale of fixed assets, cash payments to acquire shares, warrants, debt instruments, loans or advances made to other organisations, etc.

  • Financing activities: Cash flows from financing activities include the changes in the size and composition of the share/owner’s capital and debt of the organisation. Financing activities of an organisation depict how a firm raises capital and pays back to investors through the capital markets.

    For example, cash proceeds from issue of shares and other market instruments, cash proceeds from issue of loans, debentures, bonds etc., dividend/interest paid by the organisation to its shareholders, etc. Hence this section of the cash flow deals with the capital structure and major changes in the composition of the capital structure i.e. both equity and debt.

Uses of Cash Flow Analysis

  1. Discloses the movement of cash
  2. Discloses success or failure of cash planning
  3. help in evaluating financial policies and cash position
  4. Providing information about funds available from operations
  5. Other uses of cash flow statement

Discloses the movement of cash

Cash flow statement discloses the picture of cash movement. The reason for the increase in and decrease for cash can be indicated by the cash flow statement. Cash flow analysis discloses the various reasons for low cash balance in spite of heavy operation profits or for heavy cash balance inspite of low profits.

Discloses success or failure of cash planning

With the help of comparing the projected cash flow analysis, the extent of success or failure of cash planning can be determined. The projected cash flow statement is compared with the actual cash flow statement and necessary remedial measures can be taken by the organisation.

Help in evaluating financial policies and cash position

Cash is the basis for all operations and hence a projected cash flow statement will enable the management to plan and co-ordinate the financial operations properly. The management can know how much cash is needed, from which source it will be derived, how much can be generated internally and how much could be obtained from outside.

Providing information about funds available from operations

Cash flow analysis provides information about funds that will be available from operations. This will help the management in determining policies regarding internal financial management, e.g. the possibility of repayment of long-term debt, dividend policies, planning replacement of plant and machinery, etc. In this way, cash flow analysis helps in managing internal financial sources.

Other uses of cash flow statement

Cash flow statement is a useful supplementary instrument. It discloses the volume as well as the speed at which the cash flows in the different segments of the business. This helps the management in knowing the amount of capital tied up in a particular segment of the business. The technique of cash flow analysis, when used in conjunction with ratio analysis, serves as a barometer in measuring the profitability and financial position of the business.

Objectives of a Cash Flow Statement

The main objectives of a Cash Flow Statement are as follows:

  • Cash Flow Statements provides the knowledge of the cash position. It indicates the changes in the cash position as well as the reasons for the changes.

  • Cash Flow Statements are useful for providing a business with a general idea of how it will make ends meet in the short term and thereby maintain the short term and long term solvency. This aspect is also useful for external investors to analyse the liquidity and solvency of an organisation.

  • Cash Flow Statements are useful to the management for prepar- ing dividend and profit retention policies.

  • Cash Flow Statements guide the management to evaluate the changes in cash position.

  • Cash Flow Statements provide the management with details about the performance of operational, financial and investment activities for effective decision making.

  • Cash Flow Statements provide information about the factors causing the cash flows.

  • Cash Flow Statements guide the management to take a decision about short-term obligations.

  • Cash Flow Statements provide details about the sources of cash and applications of cash during a given period.

  • Cash Flow Statements provide a base for the preparation of cash budgets.

Preparation of Cash Flow Statement

A Cash Flow Statement is prepared to show the movements of cash between the closing dates of two Balance Sheets. It starts from the opening cash and ends with the closing balance of cash showing different sources from where cash was received and the manner in which it was utilized during the period for which the Cash Flow Statement is prepared.

Transactions affecting on Cash Inflows and Cash Outflows

The useful transactions resulting in cash inflows are :

  • Issue of shares
  • Issue of debentures
  • Sale of investments
  • Sale of assets
  • Cash from business operations

Cash outflows due to its application for various purpose such as :

  • Redemption of preference shares
  • Redemption of debentures
  • Purchase of investments
  • Purchase of assets
  • Cash Issues in business operations

Construction of Cash Flow Statement

While constructing the cash flow statement, following points are important :

  1. An increase of share capital, debentures and loans clearly mean that cash inflow took place due to additional issue of shares and debentures and obtaining further loans during the year.
  2. A decrease in current year figures of the liabilities will mean liquidation of liabilities and hence an application of cash.
  3. A comparison of non-current assets like land and buildings, plant and machinery, furniture, trade-investment, etc. will tell whether there had been increasing or decrease in cash or an item resulted in cash inflow or cash outflow.
  4. To calculate, how variations in noncurrent assets and liabilities generate oruse funds (cash) the following general rules are to be kept in mind.
  • Increase in Non-current liability = Cash Inflow
  • Decrease in Non-current liability = Cash Outflow
  • Increase in Non-current asset = Cash Outflow
  • Decrease in Non-current asset = Cash Inflow

Cash from Business Operations

The traditional Profit and Loss Account is based on certain accounting concepts and conventions such as accrual and matching principles according to which non-operating and non-cash items are also brought into it. Therefore, the net profit as shown by a traditional Profit and Loss Account cannot be equivalent to cash and as such, it needs certain adjustments to arrive at net cash inflow or cash losses due to business operations. The adjustments are required in respect of the non-operating and non-operating and non-cash items which do not affect the cash flows.

Limitations of Cash Flow Analysis

Following are the limitations of cash flow analysis :

  1. The cash balance as disclosed by the cash flow statement may not represent the real liquid position of the business since it can be easily influenced by postponing purchases and other payments.
  2. Cash flow statements cannot replace the Income Statement or the FundsFlow Statement Each of them has a separate function to perform.
  3. Cash flow statement cannot be equated with the Income Statement. an income Statement takes into account both cash as well as non-cash items and, therefore, net cash flow does not necessarily mean net income of the business.
  4. In the cash flow statement, the comparison of the original forecast with actual results highlights the trends of movement of cash which may otherwise go undetected.

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