Understand how the cash flow statement works and assess your company’s financial health!
According to the cash flow statement definition, it is one of the 3 mandatory financial reports, alongside the income statement and balance sheet. These are reports which every organisation is expected to file at regular intervals.
The statement helps companies track cash inflows, outflows, and overall financial performance. This is in terms of their ongoing operations, business activities, and external investments.
Before investing in a company's stock, check its cash flow statement. Understanding the cash flow statement meaning could help you better evaluate the financial standing of the business. It shows how the organisation uses the money earned from operations and manages debt.
Companies offering stocks to the public must comply with cash flow statement applicability and file these reports with SEBI, as mandated by the Companies Act 2013. The statement of cash flows is based on the cash accounting method. It records payment receipts and expenses at the time of their receipt or payment.
A large number of companies make profits yet fail to manage their cash flows effectively. Understanding why a cash flow statement is prepared helps highlight how this document makes a major difference in financial analysis. The cash flow statement provides insight into the kind of transactions a company makes.
This statement aids in evaluating a firm's ability to generate cash and meet expenses. Positive cashflow shows that a company is financially stable. However, negative cash flow indicates potential financial challenges that the firm might be experiencing.
The cash flow statement format includes three main components. Here's a detailed explanation of each of these activities, typically shown in a sample cash flow statement:
1. Cash Flows from Operations
This covers cash inflows from business activities operating at a given point in time. It gives an account of money that a company generates from its core products and services.
It includes receipts from sales, rent payments, and other operational expenses. For investment companies, the receipts might vary significantly. They may consist of inflows from the sale of loans, equities, or debt instruments, as these also qualify as business activities.
2. Cash Flows from Investing
This gives you an idea of the gains and losses incurred through investment activities. Cash flows from investing activities include money spent on long-term investments, such as property, plant, and equipment.
This section includes transactions such as selling or purchasing assets, loans extended to vendors, or loans received from customers. It also covers payments associated with mergers or acquisitions. Typically, this category represents cash outflows, referring to the funds utilised for purchasing new equipment or other assets.
3. Cash Flows from Financing
This provides a detailed account of the cash utilised for business financing purposes. It comprises payments a company makes for stock repurchases, dividends, and loan repayments. Analysts use this component to determine the amount paid through share buybacks or dividends. Additionally, it shows how a company raises funds to support its operational growth.
To clearly understand how to prepare cash flow statement, the net income must undergo several adjustments. The firm must add or subtract differences in revenue recognition, credit transactions, and recorded expenses.
The preparation of cash flow statement involves two main methods:
1. Direct Cash Flow Method
Under this method, the company explicitly lists all cash payments and receipts made during the reporting period.
2. Indirect Cash Flow Method
This approach starts with net income, then adjusts the amount by deducting or adding changes related to non-cash transactions.
Every business requires adequate cash for the smooth functioning of its operations. Understanding the cash flow applicability is crucial, as the statement plays a vital role in helping a business achieve success in the following ways:
1. Provides Information About Outflows
A cash flow statement helps analyse a company’s ability to make payments to creditors. The statement also provides a detailed record of all transactions, clearly outlining the financial commitments of the business.
2. Maintains Cash Balance Record
It provides a clearer picture of whether there is a cash surplus or shortage. With this information, the company can strategically utilise surplus funds or plan effectively to borrow additional cash when required.
3. Focuses on Cash Generation
Every company aims to generate profits from its business ventures. This profit is significantly influenced by effective cash generation. A well-prepared cash flow statement enables businesses to make informed decisions, maximising growth and sustainability.
4. Helps in Short-term Planning
A detailed cash flow statement helps with effective short-term planning. It allows businesses to maintain adequate liquidity to meet obligations promptly. Historical data from cash flow statements can be leveraged to project future inflows and outflows, facilitating timely payments.
One of the primary limitations of cash flow statements is that they might sometimes reflect negative cash flow, potentially causing unnecessary concern among investors. However, negative cash flow does not always mean the company is nearing bankruptcy.
An organisation might deliberately decide to expand operations anticipating future gains. Consequently, it might experience temporary cash flow challenges. Investors and analysts should carefully assess changes in cash flow between accounting periods to better understand the company's financial health.
Additionally, another aspect of the disadvantages of a cash flow statement is that it only considers cash-based transactions. This limitation means it doesn't reflect future receivables and payables, which could provide deeper insights into a company's potential liquidity and long-term sustainability.
Frequently Asked Questions
Why is a cash flow statement required?
A cash flow statement is required because it provides essential insights into the flow of cash in and out of a business. Understanding the cash flow statement requirement helps investors assess a company’s transactions, liquidity, and profitability.
What does a cash flow statement format include?
The cash flow statement format includes three primary categories: cash flows from operations, investing activities, and financing activities.
How to calculate cash flow?
Cash flow can be calculated using several methods. A commonly used formula for calculating it is:
Free Cash Flow = Net Income + Depreciation and Amortisation – Change in Working Capital – Capital Expenditure
What is the difference between cash flow and net income?
Net income refers to the profit earned by a company during a particular period. Cashflow, however, represents the actual money that moves in and out of a company due to its business activities.
What is the difference between a cash flow statement and an income statement?
A cash flow statement tracks all cash inflows and outflows during a specific accounting period. An income statement, on the other hand, records revenues, expenses, losses, and gains over the same period.
What is the difference between a cash flow statement and a balance sheet?
A cash flow statement gives details of money flowing in and out of a company due to its operational, investing, and financing activities. A balance sheet summarises the organisation’s assets, liabilities, and shareholders’ equity at a specific point in time.
What factors affect cash flow?
Factors affecting cash flow include credit terms, inventory management, accounts receivable, credit policies, and accounts payable practices.
What is negative cash flow?
Negative cash flow occurs when a company’s outgoing funds exceed incoming funds during a given period. Companies often manage negative cash flow through external financing or investments.
How to prepare a cash flow statement?
To understand how to prepare cash flow statements, gather financial statements, identify the reporting period, and select a calculation method. Calculate cash flow from operating, investing, and financing activities, then reconcile the final cash balance with the beginning balance.
What methods exist for calculating cash flow statements?
A company may prepare a cash flow statement using either the direct or indirect method.
What does the direct method of calculating cash flow statements mean?
Under the direct method, companies explicitly record all cash receipts and payments from operating activities.
What is a cash flow statement?
A cash flow statement is a crucial financial document providing valuable insights into an organisation’s liquidity, financial flexibility, and solvency.
What are the two methods for preparing a cash flow statement?
The two methods for preparing a cash flow statement are the direct method and the indirect method. The direct method lists all major cash inflows and outflows explicitly, whereas the indirect method adjusts net income by accounting for non-cash transactions like depreciation and changes in working capital.
What is cash flow in finance?
Cash flow refers to the net movement of cash in and out of a business. Positive cash flow indicates more money is incoming than outgoing, signifying financial health. Negative cash flow means more cash is outgoing, potentially highlighting financial concerns.
Other Investment Products
Quick Links
Know Your Tax Liability | Calculate Your Income Tax Now!
