What is meant by cash flow statement analysis?

A company's cash flow is the movement of its cash inflows and cash outflows. A cash flow statement is prepared to determine changes in an organization's cash position. A cash flow statement shows how much money was generated and spent on the business during the fiscal year. The cash flow analysis is a method of analyzing an organization's investing, financing, and operating activities. A cash flow statement reveals an organization's liquidity and solvency, as well as its ability to change cash flows in the future. It eliminates the other effects of accounting methods by improving the comparability of different organizations' operational performance.

Cash flow statement components

The balance sheet and income statement are the two most important financial statements for any business. An income statement summarizes a company's total revenue, expenses, and non-cash items such as depreciation over a given time period. A balance sheet summarizes an organization's total assets and liabilities over the course of a fiscal year. The cash flow statement, on the other hand, records the cash inflows and cash outflows for a fiscal year. The cash flow statement informs managers, creditors, investors, and shareholders about the amount of cash generated by the organization during the fiscal year. The cash flow statement is divided into three sections: cash flow from operating activities, cash flow from investing, and cash flow from financing.

Cash flow resulting from operating activities

Operating activities are the primary sources of income for an organization. The cash flow from operating activities indicates whether enough cash has been generated to sustain an organization's day-to-day operations, such as paying dividends, repaying loans, and making new investments, without the need for additional funding from outside sources. A direct or indirect method can be used to prepare an operating cash flow activity.

Direct method

Only the actual inflow and outflow of cash transactions are recorded in this method to determine the changes in cash over the period. The net operating cash flow from operating activities is the difference between cash receipts and cash payments. This method disregards some items such as depreciation, amortization, and preliminary expenses.

Examples for direct method

• Fees, commissions, and other revenue sources
• Payments have been made to suppliers and employees.
• An insurance company's receipts and payments for premiums and claims, annuities, and policy benefits.

Indirect method

The cash flow from operating activities is calculated by adjusting net income by adding or subtracting differences in income, expenses, and changes in the value of assets and liabilities; these adjustments are necessary because non-cash items are included in the income statement and balance sheet.

Examples for indirect method

• Interest, commission, loan recoveries, securities sales, and dividends received on securities
• Depreciation, foreign exchange, and amortization are all terms used in accounting.
• Payments made for interest on loans, deposits, securities purchases, and employees.

Cash flow resulting from investing activities

The cash flow from investing activities in the cash flow statement includes the purchase and disposal of long-term assets as well as short-term assets such as marketable securities. Investing activities define an organization's growth. The total expense for resources used to generate future income and cash flows is represented by cash flow from investing activities. Investing activities record any changes in fixed assets such as equipment and investments on the balance sheet. Expenses are deducted from cash flow because they serve as growth for the organization in order to increase future operating profits.

Examples

• Payment in cash for the purchase of fixed assets, shares, or debt instruments in other companies.
• Cash receipts derived from the sale of fixed assets, shares, warrants, or debt instruments in other companies.

Cash flow resulting from financing activities

Financing activity causes changes in the composition and size of an organization's shareholder capital and borrowing. It reflects transactions involving debt, equity, and dividends. The cash flow generated by financial activities aids in forecasting a firm's future claims from fund providers. Financing activities include changes in non-current liabilities and changes in equity statements. When a loan is taken out, the money flow within the firm that generally receives money is a positive flow of cash, whereas paying to individuals is a negative flow of cash.

Examples

• Proceeds from the issuance of shares, loans, notes, debentures, bonds, and short- and long-term borrowings.
• Repayments of debentures, bonds, and preference shares.

Treatment of some special items

The following section discusses some common items that have an impact on the treatment of cash flow in a cash flow statement:

Extraordinary items

Extraordinary items have emerged as a result of operating, investing, and financing activities. These items are recorded separately so that users can calculate their impact on current and future cash flow.

Interest and dividend

Interest and dividends received and paid must be entered separately in the cash flow statement in order to track the interest paid during the period and to determine whether it is recognized as an expense in the profit and loss statement. This treatment differs depending on the fiscal year and other organizations. Cash flow from interest paid, interest and dividend received should be considered operating activities for financial organizations. For other organizations, the flow of cash from interest paid must be treated as a financing activity, whereas interest and dividends received must be treated as investment activities. Dividend payments must be considered investing activities.

Income tax

Income tax must be recorded separately. Unless specifically stated as an investing or financing activity, income tax is generally considered an operating activity. The payment of taxes is always considered an operating activity.

Non-cash transactions

Some investing and financing activities have no direct impact on cash flow, despite the fact that they affect an organization's capital and asset structure.

Examples

• The acquisition of a company through the issuance of shares.
• Converting debt into equity.

Context and Applications

The students who are preparing for professional exams can use the above topic for the courses like,

• Bachelor of Science in Accounting
• Master of Science in Accounting
• Bachelor of Business Administration in Accounting
• Masters of Business Administration in Accounting

Practice Problems

Question 1: Cash flow statement disclose the management about _____________ from the business operation.

1. Cash source and its uses
2. Total balance sheet
3. Income statement

Answer: Option 1 is correct.

Explanation: A cash flow statement is prepared for management to show how much cash is generated and how much cash is spent during a specific fiscal period. It reports the total cash payments made and total cash received during a period. There is a change in operating activity, financing activity, and investing activity.

Question 2: An organization’s primary source income-generating activity is ____________.

1. Income statement activities
2. Operating activities
3. Financing activities

Answer: Option 2 is correct.

Explanation: Operating activity is the primary source of revenue generation in a business. The operating cash flow indicates whether the cash generated by the organization is sufficient to run the day-to-day business operations. Dividend payments, loan repayments, salary payments, and other expenses must be paid on a regular basis in order to run the business.

Question 3: Cash payment made for purchasing a fixed assets is an example of ___________ in cash flow statement.

1. Investing activities
2. Financing activities
3. Operating cash flow activities

Answer: Option is 1 correct.

Explanation: Any acquisitions of fixed assets or dispositions of long-term assets fall under the category of investing activity. As it represents those expenses that are incurred in order to generate future income. These costs are deducted, but they serve as a source of future operational profit.

Question 4: List the examples of financing activity in the cash flow statement.

1. Commission received, premium paid, interest received
2. Gain on sale of assets, loss of on sale of assets, issue of shares
3. Proceeds by issuing of shares, issuing of debentures, repayment of a loan

Answer: Option 3 is correct.

Explanation: Financing activity in the cash flow statement deals with changes in an organization's shareholders' capital size and borrowings. It is made up of cash flow generated by issuing shares, repaying loans, and issuing debentures.

Question 5: Any transaction that increases the cash flow is _______ and transactions that decreases the cash is _________ in cash flow statement.

1. Cash outflows, cash inflows
2. Cash inflows, cash outflows
3. Non-cash asset, non-cash liability

Answer: Option is 2 correct.

Explanation: Cash flow refers to the cash transactions that occur within and outside of the organization. Any transaction that increases the cash is referred to as an inflow of cash, while any transaction that decreases the cash is referred to as an outflow of cash.