Every business needs funds on a day-to-day basis to manage its business affairs. However, financial statements such as balance sheets and profit& loss statements focus primarily on the presentation of financial resources and financial performance of an enterprise leaving cash transactions aside. Therefore, to give a microscopic representation of the day-to-day cash receipts and cash payments going on in a business, a Cash Flow Statement is created on a periodical basis.
By definition, a cash flow statement (CFS) is a financial statement that records and summarises the whole series of cash inflows and outflows while examining whether the cash resources within an organization are sufficient to meet the short-term obligations and expenses of business operations for a certain period. Apart from this, it is also one of the key financial statements of the business and complements the balance sheet and the income statement of a business. Though, these statements do not reflect all the financial assets of an enterprise but play a crucial role in the functioning of a business.
It is at this point necessary to also clarify the difference between cash and cash equivalents in a business both of which jointly comprise a cash flow statement. While Cash is nothing but money which means the currency and is immediately available with the business in its currency form, cash equivalents mean something that could be easily converted into known amounts of cash. In other words, its value could be understood as something that has high liquidity value and includes demand deposits, short-term investments, bank overdrafts, etc.
Cash Flow Statement– Meaning & Importance
Businesses need cash to keep the business going without any hurdles. Even with a healthy sales ratio, if the start-up is finding it hard to manage cash for its daily operations, it may have a tiff with success. Therefore, a cash flow statement is prepared to keep track of the movement of cash & cash equivalents to examine and find out the position of the business to meet its short term obligations and maintain a healthy liquidity position that can help a business to overcome financial challenges, secure loans and plan for your financial future.
Not only these statements are useful for the internal management of a business, but they are also useful for investors and interest holders to determine the value of a business, but these are also helpful to assess the ability of an enterprise to generate enough cash to pay its debt obligations, fund its operating expenses, and fund business investments.
A Cash Flow Statement differs from the Income statement in the sense that the cash flows of a business might still be negative while the business is making profits, implying a cash crunch position in the enterprise. For instance, a company makes sales on credit which would though be represented as revenues in the income statement but the actual payments would be collected much later, which will not be the same in the case of the cash flow statement.
Negative Cash Flow vs. Positive Cash Flow
Where the cash-flow statement (CFS) of your business is indicating a negative sign (-) or a negative number at the bottom of your CFS, it means that your business has faced losses during the accounting period. However, negative cash flow for the long term may not suggest business failures always, for instance, it may suggest that a start-up in the early stages has a higher burn rate to become profitable.
Similarly, having a positive number at the bottom of your CFS indicates positive cash flow for the period. However, positive cash flow for the long term is not always the sign of enough profits or even profitability of a business. For example, it may suggest that a start-up has taken more loans to bail out your failing business.
Components of Cash Flow Statement
A cash flow statement could be divided into three main categories – Operating, Investing, and financing which has been described below-
i. Cash Flow from Working/ Operating Activities
Cash flow from operating activities is the first segment depicted in the cash flow statement along with cash from investing and financing activities. The cash flow from operating activities is the amount of cash incoming and outgoing out of the core operations such as manufacturing and selling goods or providing a service to customers, etc. of the business entity.
This measure attempts to throw light on the capacities of a business to generate cash from its key business activities and to understand the values of its profits & investments before going for debt or asset-backed finance. A positive cash flow from operating activities specifies that the core business activities of the company are thriving. It includes money received from sales activities and the money paid to the suppliers, vendors, and employees. Further, it includes depreciation or taxes that are not related to investing or financing activities.
ii. Cash Flow from Investing Activities
Business investments are part of common business activities and generally indicate either sale or purchase of the assets of a company, however, they are not part of working capital. While the money spent on the purchase of assets is an outflow of cash, the money so gained from the sale of assets is considered an outflow of cash. The investing activities include all cash flows occurring on account of long-term fixed assets such as land, buildings, and machinery and financial assets shares/bonds, mutual funds, and any payments received on such investments such as Dividends/ interest received from other companies, etc.
iii. Cash Flow from Financing Activities
The financing activities include the cash inflows & outflows from the financing-related activities of a business i.e. transactions involving the movement of cash between a firm and its owners, investors, and creditors. This report shows the net flow of funds used to run the company including debt, equity, and dividends. It attempts to give an insight to the customers regarding the company’s financial strength and the efficacy of the management of the capital structure of a company.
Under financing activities, if the start-up is purchasing assets from the profit earnings of a company, it is considered to be an ideal situation for the business as it is generating sufficient profits required for its growth & expansion. Similarly, if the company raises term loans or capital against the issue of shares, it is a positive sign for the company. Debt & equity financing are reflected as cash flows under financing activities, however, the format may vary according to the capital structure, dividend policies, or any debt terms of the company. Some examples of cash flows from financing activities include the Issue of equity or stock, borrowing of debt from any bank or creditor or issuing of bonds, etc
How to prepare a Cash Flow Statement?
As discussed, a CFS is a sum of all three segments namely operating, investing, and financing activities. There are two methods to prepare a cash flow statement namely- the direct & the indirect method. The only difference between the two lies in the fact that the computation of operating activities and the computation of cash flows from investing and financing activities are treated similarly in both direct and indirect methods.
i. Direct Method
The direct method uses actual cash inflows and outflows coming in and out of the company’s operations, as an alternative to modification of the operating section from accrual accounting to a cash basis. This method measures the cash that has been received from core operations of the company i.e. money received from customers and cash payments made to vendors or suppliers, etc. Then, all such inflows & outflows from all three activities operating, investing, and financing are summed up to obtain the closing balance of cash and cash equivalents and get total cash flow. The direct method is also known as the income statement method and it is relatively easier to understand as it considers the actual cash transactions.
Steps to calculate cash flow from operations using the direct method have been provided below-
- Cash Receipt- Symbolises cash amounts received during the period.
- Cash Payment-Symbolises cash amounts paid to suppliers, vendors, etc. during the period.
- Cash expenses- Symbolises expenses incurred for purposes like selling, administration, R&D, and changes in other operating liabilities.
- Cash interest-Recognizes interest payment-related expenses paid in cash only.
- Cash Tax- Represents only taxes paid in cash only.
Cash Receipts – Cash Payments – Cash Expenses – Cash Interest – Cash Taxes= Cash Flow
ii. Indirect Method
Under the indirect method of calculating the cash flow statement, the net income on the capital basis is established as the base for calculation. Then, such net income needs indirect adjustments which affect it but do not involve cash transactions. The indirect method adjusts net income for factors such as – changes in current assets, changes in current liabilities, and items included in the net income but does not affect cash transactions.
Steps to calculate cash flow from operations using the indirect method have been provided below-
- Start with establishing net income as the base.
- Identify profits or losses arising from financing and investing activities such as Gains from the sale of land, etc.
- Identify non-cash expenses and subtract all non-cash revenue components.
- Operating Assets- Increase in the balances of operating assets has to be subtracted and a decrease in those accounts has to be added back.
- Operating Liabilities- Increases in the balances of operating liability accounts have to be added back while decreases in values from those accounts have to be subtracted.
Net Income + Gains & Losses from financing & investments activities + Non-cash expenses + Changes in operating accounts = Cash Flow during the period.
What are the advantages of the Cash Flow Statement (CFS)?
Some of the advantages of the CFS statement for a start-up organization have been provided below-
i. Verification of Profitability and Liquidity Positions-Cash Flow Statement helps the management to determine the liquidity and profitability position of businesses to meet their short-term obligations. CFS statement prepared during a period provides a clear picture of the liquidityposition of an enterprise helping the management to take corrective or remedial measures if required to strengthen the position of the organization.
ii. Verifying Capital Cash Balance-Cash Flow Statement also helps to verify the capital cash balance available for investment or any similar purposes. For instance, it is possible for a business is having idle cash resources or have a shortage of funds, which could be analyzed with the help of CFS. The management may examine and review the situation to how to better use idle cash or how to meet cash shortages (either raising capital through the issue of stock or borrowing from outside sources) accordingly.
iii. Management of Cash & Cash Equivalents– If the Cash Flow Statement is accurately prepared, it becomes easier for the business to understand and manage its cash resources. The management can make estimations about the cash inflows & outflows in the future and even prepare budgets and future business plans.
iv. Planning and Coordination– Every business organization must understand the liquidity position of the business by analyzing business aspects for a certain period such as the key business purposes for which cash would be required, the number of funds needed, cash resources that could be generated from internal sources and the amount of cash that could be procured from external sources. The accounting and planning department prepares a CFS on an estimated basis for a given period and prepares a cash budget for a successive year. Through this, the internal managers can coordinate various activities and prepare plans with the help of this statement.
v. Reliable source of Information– As the accrual basis of accounting needs several technical adjustments CFS is more reliable.
vi. Helps Investors & Shareholders to make decisions-Since, the CFS statement is a crucial part of the financial statements, the shareholders, Banks/Financial institutions, and the potential investors read it thoroughly to determine the status of the operations of a company including their source of cash inflows and outflows and find out whether the business uses these resources efficiently. Thus, the CFS helps stakeholders to make decisions after determining the growth, profitability, and reliability of the business through CFS.
vii. Provides data for comparison– The CFS statement offers accurate and reliable information regarding the cash-based transactions in the business. A Cash Flow Statement helps to know the exact amount of cash inflows and outflows from various business activities during a period. It helps to compare the cash budgets of past assessments with the present ones to evaluate the future cash requirements. Further, Cash from operating activities could be compared to the net income of the company to assess the quality of earnings of a start-up. And, if the cash flow from the operating activities is higher than the net income of the business, then the earnings of the business are considered to be of high quality.
viii. Assess the performance of the Business – CFS offers information about various investing and financing cash transactions that took place during the year by evaluating the financial structure of the business. When compared with the data with ratio analysis, it helps to ascertain the profitability of the business.
What are the limitations of CFS?
There are certain limitations associated with the CFS statement that has been provided below-
i. Fails to Present Net Income–
Since the CFS statement fails to consider the movement of non-cash items, it fails to accurately represent the net income for an enterprise for a given period which could be ascertained by an Income Statement.
ii. Failure to represent overall Liquidity & Profitability of the Business –
Basically, a cash flow statement only helps to determine the amount of cash & cash equivalents position at the end of the period that could be used to meet the short-term obligations but fails to adequately represent the real liquidity position. Again, due to exclusion of non-cash items or revenues derived from non-cash items, it doesn’t measure the profitability of a start-up.
iii. Non-conformity with the Companies Act 2013
The standard format of Balance Sheet & the Profit & Loss Statement to be prepared in an organization conforms with the Companies Act 2013. However, a CFS statement is prepared as per Accounting Standard (AS-3).
iv. Cannot Forecast Future Cash-Flows
Since the Cash Flow Statement is based on historical costs, it cannot adequately project future cash flows.
Conclusion
It is quite clear that a Cash Flow Statement is an essential means to measure to assess the capability of a firm. It has several benefits to offer to the internal management and external stakeholders such as investors and banks/financial institutions to determine the liquidity & strength of the business. It is most important for start-ups because it represents how much cash a company is generating from its core operations.
In a true sense, it could be considered as a yardstick that helps them to avoid unnecessary expenses on one side and divert the remaining funds towards useful business investments. A healthy cash flow ensures there is an intricate balance between the inflows and outflow of cash & cash equivalents in the organization. It means that the business makes payment to vendors and salaries to employees on time, pays taxes on time, and use the remaining funds for achieving business stability & growth.
Therefore, a start-up organization must ensure proper cash flow analysis and management for its organization. Regular analysis of business finances ensures accurate projection of the future cash flows and availability of data for comparison for preparation of budgets and planning and taking corrective actions ultimately leads to the success of the business.
