After understanding your financial condition and performance by reading your balance sheet and income statement, you may now have the picture of how your business is running. However, seeing a positive equity in your balance sheet or a profit in your income statement doesn’t make your financial understanding complete. That’s where cash flow statements come in.
The cash flow statement is one of the five main financial statements of a company. The cash flow statement tells us how sustainable a company is in a short run. If cash is increasing and cash flow generated by operations is positive, then we can tell that a company is healthy in the short-term. Increasing or stable cash balances means that a company is capable of meeting its cash needs, and remains solvent.
This information cannot always be seen in the balance sheet or income statement of a company. For example a company may be generating profit, however still it cannot meet or pay its short –term payables or obligations.
Three sections of a cash flow statement
The cash flow statement is divided into three sections: operating cash flows, investing and financing. This different section allows the reader to determine where the company is obtaining or using its cash. For example a company may be earning a couple of profits however still not generating a positive operating cash flow.
This is a case when a company is generating lots of profits through selling of goods or services to customers on account and has not been efficient in collecting those receivables, therefore not generating cash. Another example that a business may generate negative operating cash flow is when it purchases goods or services from suppliers through cash payment instead of purchasing on credit.
The operating cash flow involves the operating assets and liabilities of the company. It includes accounts that have a direct effect on income. Example of these asset and liability accounts are accounts receivables (which directly affects sales or revenues), inventories (cost of goods sold), prepaid insurance (insurance expense), and accounts payable (purchases and cost of goods sold). The following are some points that should be observed when understanding the operating cash flow.
a. An increase in accounts receivable decreases operating cash flow. (Increase in accounts receivable may be due to inefficient collection of the company’s receivables)
b. An increase in inventory decreases operating cash flows. (Increase in inventory may be caused by an inefficient disposal and sale of the company’s inventory to customers.
c. An increase in accounts payable increases operating cash flow. (Increase in accounts payable may be a result of a purchasing on account rather than on cash payment therefore decreasing operating cash outlay.
The next section of the cash flow statement is the investing cash flow. This section helps the user of the financial statement to determine the inflow and outflow of cash used and generated from the company’s investing activities. Non current assets like property and equipment and long term investments fall out on this section.
A cash purchase of equipment or long-term investment results in an outflow of cash in investing activity. On the other hand, cash proceeds from sale or disposal of those assets results in an inflow of cash in investing activity.
The last section of the cash flow statement which is the financing cash flow includes long-term liability and equity accounts in the balance sheet. Cash proceeds from loans and borrowings from banks increases the financing cash inflow of a company.
Likewise, cash proceeds from additional capital contribution from owners or cash proceeds from issuance of capital stock in a corporate world also increase the financing cash flow of a company. In reverse, payment of loans, cash drawings (for proprietorship and partnership companies) and payment of cash dividends to stockholders results to a decrease or an outflow in the financing cash flow of a company.
Cash flow statement summary
A cash flow statement as the name suggests, should only involve all “cash” flows. Hence, money management tips and activities involving non-cash transactions like depreciation and amortization of assets should be taken out from the cash flow statement.
Depreciation and amortization of long-term assets decreases income although it does not require cash outlay. Since net income is part of the operating cash flow of the statement, depreciation and amortization are added back to the net income to eliminate the non-cash element of the net income.
The cash flow statement is used by the users of the financial statement as a significant financial report to completely understand the financial status of a company. This should be understood together with the other financial statements namely the balance sheet, income statement, statement of retained earnings and notes to financial statements.
The cash flow statement also serves as a useful entrepreneurial tool to determine the validity and reconciliation of the balance sheet to the income statement. Sometimes it is the cash flow statement which will give us the clues whether a company is free from fraud or irregularities.
