Introduction

Cash is another form of fund although in a narrow sense, it refers to a supply that can be drawn upon, according, to the need. Here the term cash includes both cash and cash equivalents. Cash equivalents are highly liquid short-term investments which could be easily converted into cash without much delay. It may however be appreciated that the obligations and liabilities of a business arising on a day-to-day basis are met through “Cash” or “Cheque”. But, in reality it never happens. Further, we must also be able to distinguish between “Profit” and “Cash”. One cannot pay the creditors, electricity bills, tax or even dividend with the “Net Profit”. For such and many other purposes, a business needs either cash balance or credit limits with banks. Not to be able to meet the business commitments through cash  as and when these arise can spell disaster for a business even if it has a strong working capital base and has earned a handsome profit.

So far we have seen that the balance sheet and profit and loss account provide information on the financial position and the results of operations in a financial period. The funds flow statement explained earlier traces the flow of funds through the organization. But neither of these financial statements can provide information about the cash flows relating to operating, financing and investing activities. To ensure that the right quantity of cash is available in accordance with the needs of a business it is necessary to make a “cash planning” by determining the amount of cash entering the business (cash inflow) and the cash leaving the business (cash outflow). The statement which explains the changes that take place in cash position between two periods is called the cash flow statement.

Cash flow statement is an important tool in the hands of the management for short term planning and coordinating of various operations and projecting the cash flows for the future. It presents a complete view on the movement of cash and identifies the sources from which cash can be acquired when needed. The comparison of the actual cash flow statement with the projected cash flow statement helps in understanding the trends of the movement of cash and also the reasons for the success or failure of cash planning.

Cash flow and fund flow statements

Cash flow and fund flow statements are similar to each other in many respects. The main difference however, lies in the fact that the terms “fund” and “cash” import different meaning. The term “fund” in fund flow statement has a wide meaning and it means current assets – current liability. A fund flow statement examines the impact of changes in fund’s position during the period under review on the working capital of the concern (working capital refers to current assets - current liabilities).

Cash in the cash flow statement refers only to cash and or balance with bank, i.e., a small part of the total fund, although very important. The cash flow statement starts with the opening cash balance, shows the sources from where additional cash was received and also the uses to which cash was put and ends up showing the closing balance as at the end of the year or period under review.

Whereas, there are no opening and closing balances in Funds Flow statement. Increase in current assets or decrease in current liabilities increases the working capital, whereas the decrease in current assets or increase in current liabilities increases the cash flow

Defining Cash Flow Statement

The statement of cash flows, or the cash flow statement, is a financial statement that summarizes the amount of cash and cash equivalents entering and leaving a company. The cash flow statement (CFS) measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses. The cash flow statement complements the balance sheet and income statement and is a mandatory part of a company's financial reports since 1987.

The CFS allows investors to understand how a company's operations are running, where its money is coming from, and how money is being spent. The CFS is important since it helps investors determine whether a company is on a solid financial footing. Creditors, on the other hand, can use the CFS to determine how much cash is available (referred to as liquidity) for the company to fund its operating expenses and pay its debts.

NOTE

• A cash flow statement is a financial statement that summarizes the amount of cash and cash equivalents entering and leaving accompany.
• The cash flow statement measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses.
• The cash flow statement complements the balance sheet and income statement and is a mandatory part of a company's financial reports since 1987.

Structure of cash flow statement

The main components of the cash flow statement are:

• Cash from operating activities
• Cash from investing activities
• Cash from financing activities

Disclosure of noncash activities is sometimes included when prepared under the generally accepted accounting principles, or GAAP

It's important to note that the CFS is distinct from the income statement and balance sheet because it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the same as net income, which on the income statement and balance sheet, includes cash sales and sales made on credit.

Operating Activities

The operating activities on the CFS include any sources and uses of cash from business activities. In other words, it reflects how much cash is generated from a company's products or services. Generally, changes made in cash, accounts receivable, depreciation, inventory, and accounts payable are reflected in cash from operations. These operating activities might include:

• Receipts from sales of goods and services Interest payments
• Income tax payments
• Payments made to suppliers of goods and services used in production Salary and wage payments to employees
• Rent payments
• Any other type of operating expenses

In the case of a trading portfolio or an investment company, receipts from the sale of loans, debt, or equity instruments are also included. When preparing a cash flow statement under the indirect method, depreciation, amortization, deferred tax, gains or losses associated with a noncurrent asset, and dividends or revenue received from certain investing activities are also included. However, purchases or sales of long-term assets are not included in operating activities.

Preparation of cash flow statement

Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences in revenue, expenses, and credit transactions (appearing on the balance sheet and income statement) resulting from transactions that occur from one period to the next. These adjustments are made because non-cash items are calculated into net income (income statement) and total assets and liabilities (balance sheet). So, because not all transactions involve actual cash items, many items have to be re-evaluated when calculating cash flow from operations.

As a result, there are two methods of calculating cash flow, the direct method, and the indirect method.

There are two ways in which this statement can be drawn up.

The first method is the direct method whereby major classes of gross cash receipts and gross cash payments are disclosed.

The second method is known as the short-cut or indirect method. Under this method net profit or loss is taken as the basis and adjusted for the effects of transactions of non-cash nature, changes in current assets and current liabilities and transactions of income or expenses associated with financial cash flows.

Direct Method

Under the direct method, you are basically analysing your cash and bank accounts to identify cash flows during the period. You could use a detailed general ledger report showing all the entries to the cash and bank accounts, or you could use the cash receipts and disbursements journals. You would then determine the offsetting entry for each cash entry in order to determine where each cash movement should be reported on the cash flow statement.

Another way to determine cash flows under the direct method is to prepare a worksheet for each major line item, and eliminate the effects of accrual basis accounting in order to arrive at the net cash effect for that particular line item for the period. Some examples for the operating activities section include:

Cash Receipts from Customers:

• Net sales per the Income Statement
• Plus beginning Balance in Accounts Receivable
• Minus ending Balance in Accounts Receivable
• Equals Cash Receipts from Customers
• Cash Payments for Inventory:
• Ending Inventory
• Minus Beginning Inventory
• Plus Beginning Balance in Accounts Payable to Vendors
• Minus Ending Balance in Accounts Payable to Vendors
• Equals Cash Payments for Inventory

Cash Paid to Employees:

• Salaries and Wages per the Income Statement
• Plus Beginning Balance in Salaries and Wages Payable
• Minus Ending Balance in salaries and Wages Payable
• Equals Cash Paid to Employees
• Cash Paid for Operating Expenses:
• Operating Expenses per the Income Statement
• Minus Depreciation Expenses
• Plus Increase or Minus Decrease in Prepaid Expenses
• Plus Decrease or Minus Increase in Accrued Expenses
• Equals Cash Paid for Operating Expenses

Taxes paid:

• Tax Expense per the Income Statement
• Plus Beginning Balance in Taxes Payable
• Minus Ending Balance in Taxes Payable
• Equals Taxes Paid

Interest paid:

• Interest Expense per the Income Statement
• Plus Beginning Balance in Interest Payable
• Minus Ending Balance in Interest Payable
• Equals Interest Paid

Under the direct method, for this example, you would then report the following in the cash flows from the operating activities section of the cash flow statement:

• Cash Receipts from Customers
• Cash Payments for Inventory
• Cash Paid to Employees
• Cash Paid for Operating Expenses
• Taxes Paid
• Interest Paid
• Equals Net Cash provided by (used in) Operating Activities.

Similar types of calculations can be made of the balance sheet accounts to eliminate the effects of accrual accounting and determine the cash flows to be reported in the investing activities and financing activities sections of the cash flow statement.

Indirect Method

In preparing the cash flows from the operating activities section under the indirect method, you start with net income per the income statement, reverse out entries to income and expense accounts that do not involve a cash movement, and show the change in net working capital. Entries that affect net income but do not represent cash flows could include income you have earned but not yet received, amortisation of prepaid expenses, accrued expenses, and depreciation or amortisation. Under this method you are basically analysing your income and expense accounts, and working capital. The following is an example of how the indirect method would be presented on the cash flow statement:

1. Net Income per the Income Statement
2. Minus Entries to Income Accounts that do not represent Cash Flows
3. Plus Entries to Expense Accounts that do not represent Cash Flows
4. Equals Cash Flows before movements in Working Capital
5. Plus or minus the change in Working Capital, as follows:

• An increase in current assets (excluding cash and cash equivalents) would be shown as a negative figure because cash was spent or converted into other current assets, thereby reducing the cash balance.
• A decrease in current assets would be shown as a positive figure, because other current assets were converted into cash.
• An increase in current liabilities (excluding short-term debt which would be reported in the financing activities section) would be shown as a positive figure since more liabilities mean that less cash was spent.
• A decrease in current liabilities would be shown as a negative figure, because cash was spent in order to reduce liabilities.
• The net effect of the above would then be reported as cash provided by (used in) the operating activities. The cash flows from investing activities and financing activities would be presented the same way as under the direct method.

Different Aspects

Accounts Receivable and Cash Flow

Changes in accounts receivable (AR) on the balance sheet from one accounting period to the next must also be reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the company from customers paying off their credit accounts—the amount by which AR has decreased is then added to net sales. If accounts receivable increases from one accounting period to the next, the amount of the increase must be deducted from net sales because, although the amounts represented in AR are revenue, they are not cash.

Inventory Value and Cash Flow

An increase in inventory, on the other hand, signals that a company has spent more money to purchase more raw materials. If the inventory was paid with cash, the increase in the value of inventory is deducted from net sales. A decrease in inventory would be added to net sales. If inventory was purchased on credit, an increase in accounts payable would occur on the balance sheet, and the amount of the increase from one year to the other would be added to net sales.

The same logic holds true for taxes payable, salaries payable, and prepaid insurance. If something has been paid off, then the difference in the value owed from one year to the next has to be subtracted from net income. If there is an amount that is still owed, then any differences will have to be added to net earnings.

Investing Activities and Cash Flow

Investing activities include any sources and uses of cash from a company's investments. A purchase or sale of an asset, loans made to vendors or received from customers or any payments related to a merger or acquisition is included in this category. In short, changes in equipment, assets, or investments relate to cash from investing.

Usually, cash changes from investing are a "cash out" item, because cash is used to buy new equipment, buildings, or short-term assets such as marketable securities. However, when a company divests an asset, the transaction is considered "cash in" for calculating cash from investing.

Cash From Financing Activities

Cash from financing activities include the sources of cash from investors or banks, as well as the uses of cash paid to shareholders. Payment of dividends, payments for stock repurchases and the repayment of debt principal (loans) are included in this category.

Changes in cash from financing are "cash in" when capital is raised, and they're "cash out" when dividends are paid. Thus, if a company issues a bond to the public, the company receives cash financing; however, when interest is paid to bondholders, the company is reducing its cash.

Analyzing an Example of a CFS

Below is an example of a cash flow statement:

Cash flow statement example

From this CFS, we can see that the cash flow for FY 2017 was $1,522,000. The bulk of the positive cash flow stems from cash earned from operations, which is a good sign for investors. It means that core operations are generating business and that there is enough money to buy new inventory. The purchasing of new equipment shows that the company has the cash to invest in inventory for growth. Finally, the amount of cash available to the company should ease investors' minds regarding the notes payable, as cash is plentiful to cover that future loan expense.

Negative Cash Flow Statements

Of course, not all cash flow statements look this healthy or exhibit a positive cash flow, but negative cash flow should not automatically raise a red flag without further analysis. Sometimes, negative cash flow is the result of a company's decision to expand its business at a certain point in time, which would be a good thing for the future. This is why analyzing changes in cash flow from one period to the next gives the investor a better idea of how the company is performing, and whether or not a company may be on the brink of bankruptcy or success.

Balance Sheet and Income Statement

As we have already discussed, the cash flow statement is derived from the income statement and the balance sheet. Net earnings from the income statement are the figure from which the information on the CFS is deduced. As for the balance sheet, the net cash flow in the CFS from one year to the next should equal the increase or decrease of cash between the two consecutive balance sheets that apply to the period that the cash flow statement covers. (For example, if you are calculating cash flow for the year 2019, the balance sheets from the years 2018 and 2019 should be used.)

Thus,

A cash flow statement is a valuable measure of strength, profitability, and of the long-term future outlook for a company. The CFS can help determine whether a company has enough liquidity or cash to pay its expenses. A company can use a cash flow statement to predict future cash flow, which helps with matters of budgeting. For investors, the cash flow statement reflects a company's financial health since typically the more cash that's available for business operations, the better. However, this is not a hard and fast rule. Sometimes a negative cash flow results from a company's growth strategy in the form of expanding its operations. By studying the cash flow statement, an investor can get a clear picture of how much cash a company generates and gain a solid understanding of the financial well being of accompany.