What is the Significance of a Cash Flow Statement? 

A cash flow statement (CFS) helps the company to know the amount of cash at its disposal, the activities that lead to earning cash, and the activities which require cash expenditure for a particular period. The statement represents the liquidity of the company.

An enterprise should prepare a CFS for each period for which financial statements are presented as per accounting standards.

A CFS can help understanding how well a company manages its cash position i.e., generation of cash to fund its expenses and pay off other obligations.

Hence, CFS is mandatory to be provided along with the other financial statements like the Balance sheet and Income statement as a part of the annual accounts of the company.

Format of CFS 

A summarized format for CFS is shown below. The main activities are broken into further sub-activities to know the factors affecting the cash flows of the Company.

Components of CFS 

Let us understand the significance of each of the main components in a Cash Flow Statement.

Cash flow from operating activities

Cash flow from operating activities includes the source and uses of cash from regular business activities. Example cash receipts from the sale of goods and services, cash payments to suppliers, selling, marketing, and advertising activities, etc.

Cash flow from investing activities

Cash Flow from Investing activities includes cash generated from or spent on investing activities. Example cash payments for capital expenditures like for purchase of assets, cash receipts from disposal of assets, cash receipts from disposal of shares, warrants, debt instruments, etc.

After we have calculated the cash flow from operating activities and the investing activities, the leftover balance of cash is called Free cash flow (FCF). This cash flow is then utilized to pay your investor.

Cash flow from Financing activities

Cash Flow from Financing activities includes net cash flow used to fund the company. Example transactions involving debt i.e., borrowing and repaying loans, equity i.e., issuing shares, payment of dividends, etc.

Significance of cash flow from operating activities

Operating cash flows (OCF) help the investors understand how well the Company earns from its business activities. An Income Statement would show you the Working Profit of the Company. Working Profit is the surplus left after deducting expenses from the income earned from business activities.

While making an Income Statement, a Company takes into consideration incomes it has accrued but not received in cash or expenses it has provided for but not yet paid.

There is some kind of uncertainty involved in accrual and provisioning which the Operating cash flow tries to negate. The Operating cash flow thus shows a clearer picture of the company’s performance from its business activities basis the fund movement.

Methods used to calculate cash flows

There are two methods of presenting a CFS i.e., direct and indirect method.

The direct method determines changes in cash receipts and payments that are reported in the cash flow. It takes into account the actual cash inflows and outflows to determine the changes in cash over the period.

The indirect method takes into consideration net income generated and adds or subtracts changes in the assets and liabilities to determine the implied cash flow.

Example of Direct Method Cash Flow Statement 

Indirect Method Cash Flow Statement

Here, Cash & Cash Equivalents consist of cash in hand, balance with banks, and investments in money market instruments.

The most commonly used method is the indirect method which is recommended. Hence, in this write up we will explain the operating cash flows using the indirect method.

Formula and factors affecting Operating Cash flows

Formula

$$\text{Operating Cash flow}=\text{Operating Income}+\text{Depreciation}–\text{Taxes}+\text{Change in Working Capital}$$

Format 

Expenses added back to the profit to arrive at the Operating cash flows are as under 

Depreciation is calculated to expense the amount spent on purchasing a fixed asset. While buying fixed assets requires cash outflow, in the CFS, it is a part of cash flow from investing activities. Non-cash expense in depreciation is therefore added back to the net income of the Company.

Movement in working capital (current asset less current liabilities) calls for either spending money or receiving it. The net amount is added back to the cash flow statement.

Incomes reduced from CFS

Unearned revenue is added back to the cash flow statement. Example amount receivable which has not been collected yet is reduced from the net income or profit of the company. After we have calculated the cash flow from operating activities, it is important to understand what it represents.

If the company is earning positive cash flows from these activities, it shows that the company is earning a good amount of money through its primary business activities and also has a better collection efficiency. It also shows that the company is self-sufficient and can run its business smoothly.

If a company has negative cash flows from operating activities it shows that collections efficiency is low and the company now needs to finance its business activities either by using other sources of finance or by not spending on investment and expansion activities.

These other sources will be limited and temporary. The reason being, if a company is not having good cash flows from business activities, indicates the company is not doing its business well. If the business is not doing well then, no investor or borrower would be ready to source their funds in long term.

This can only be used as a short-term solution. Accordingly, the management of the company will have to take a call about how to stabilize the business.

Common Mistakes 

• Not classifying the activities correctly in the CFS.
• Assuming that company has better cash flows but not considering the fact that it has not paid the liabilities just to inflate the cash surplus
• Using the direct method for calculation which although correct doesn’t provide inputs for management decisions

Context and Applications

This topic is significant in professional exams for both undergraduate and graduate courses especially following: 

• B. Com Banking and Finance 
• Chartered Accountancy: Financial Management 
• CIMA (Management Accounting) 
• MBA 
• CFP 
• CFA 
• CPA