Understanding the Meaning and Importance of a Cash Flow Statement

Introduction 

Cash plays a very important role in the economic life of a business. A firm needs cash to make payment to its suppliers, to incur day-to-day expenses and to pay salaries, wages, interest and dividends etc. In fact, what blood is to a human body, cash is to a business enterprise. Thus, it is very essential for a business to maintain an adequate balance of cash.

The Cash Flow Statement provides information beyond that available from the income statement, which is based on accrual rather than cash accounting. Cash flow statement records actual movement of cash and not any credit sales or purchases and is therefore, reflective of genuine cash generated by a company. The Cash Flow Statement provides information about a company’s cash receipts and cash payments during an accounting period. As such, it does not follow the accrual accounting principle.

Meaning of Cash Flow statement

Cash Flow Statement deals with flow of cash which includes cash equivalents as well as cash. This statement is an additional information to the users of Financial Statements. The statement shows the incoming and outgoing of cash on a business. 

1. Cash means, cash in hand and demand deposits with the bank. 
2. Cash flow are inflow and outflow of cash and cash equivalent
3. Cash equivalent consists of bank overdraft, cash credit, short term deposits and marketable securities (liquidity will be high which are easily converted into cash).
4. Cash balance: Cash on hand and demand deposits (cash balance on the balance sheet).

The cash flow statement reports the cash generated and spent during a specific period of time (e.g., a month, quarter, or year). The statement of cash flows acts as a bridge between the income statement and balance sheet by showing how cash moved in and out of the business. It shall be noted that a cash flow statement is fundamentally distinct from a Balance Sheet or an Income Statement.

An Income Statement represents the net income of an organisation within a specific period, including all sorts of expenditures (accrual accounting approach). On the other hand, a cash flow statement represents the net cash income of an organisation. It includes only those revenues and expenditures that have been realized in an accounting period (cash accounting approach). Therefore, a cash flow statement indicates an organization’s ability to meet liquidity needs.

CASH INFLOW	CASH OUTFLOW
Cash sales	Cash Purchase
Cash Received against trade receivables	Cash Paid against trade payables
Cash Received for commission and royalty	Operating Expense paid (e.g., Administration Expense, Selling Expense)
Cash Received from sale of investment (Non-current & current other than marketable securities)	Cash Purchase of investment (Non-current & current other than marketable securities)
Cash Received from sale of fixed assets	Cash Purchase of Fixed assets
Cash Received from sale of securities	Loan and Advance Given
Loan and Advance Received	Loan and Advance Repaid
Proceeds from issue of equity shares	Buyback of equity shares for cash
Proceeds from issue of preference shares	Redemption of preference shares
Proceeds from issue of debenture	Redemption of debenture

Key Points of cash flow statement

1. Though cash flow statement, an attempt is being made to focus on cash and cash equivalents.
2. Inflows (sources) may be due to issue of share capital, sale of fixed assets, sale of investments, etc.
3. Outflow (usage) may be due to purchase of fixed assets, redemption of preference shares or debentures, etc.
4. Difference between Inflows and outflows of cash and cash equivalents is termed as net increase or decrease in cash and cash equivalents as the case may be.

Objective of cash flow statement

1. Cash flow statement aims at highlighting the cash generated from operating activities.
2. Cash flow statement helps in planning the schedule for repayment of loan schedule and replacement of fixed assets, etc.
3. Cash is the centre of all financial decisions. It is used as the basis for the projection of future investing and financing plans of the enterprise.
4. Cash flow statement helps to ascertain the liquid position of the firm in a better manner. Banks and financial institutions mostly prefer cash flow statement to analyse liquidity of the borrowing firm.
5. Cash flow Statement helps in efficient and effective management of cash.
6. The management generally looks into cash flow statements to understand the internally generated cash which is best utilized for payment of dividends.
7. Cash Flow Statement based on AS-3 (revised) presents separately cash generated and used in operating, investing and financing activities.
8. It is very useful in the evaluation of cash position of a firm.

Importance of cash flow statement

“Cash is king” is an old saying about business. In order to run a business efficiently, it is necessary that it has an ample amount of cash. This is important as it enables it to invest, pay bank loans, purchase commodities, etc. For instance, while your business may appear profitable, slow invoice collections may create a bottleneck that stops you from meeting your financial obligations. To get an accurate picture of your cash flow, you’ll need to produce a cash flow statement.

Purpose of cash flow statement

When it comes to looking at the financial health of your business, a cash flow statement is one of the first reports that’s considered. For publicly traded companies, it is a requirement. But even if your business is not publicly traded, a cash flow statement is incredibly important for tracking cash inflow and outflow.

1. From a strategic perspective, a cash flow statement gives you clarity on how to plan for risk, and the level of risk you’ll be facing.
2. By understanding how much cash is coming in versus how much is going out, you can identify opportunities for improvement and plan business growth accordingly.

How to use a cash flow statement

A cash flow statement serves as a crucial tool for investors, analysts, and third parties alongside the organisation itself. Use of cash flow statement is mentioned below –

1. To assess the financial footing of an organisation.
2. To determine its capability to tide over short- and long-term liabilities.
3. To gauge a company’s profitability.
4. Recognizing the sources of capital of an organisation.
5. Identifying ways in which a company is spending its capital and earnings.

Therefore, before making any investment decisions, investors can take a look at a company’s cash flow statement to see whether it suits its profile and investment objectives.

Previous

Next