Conventional financial statements i.e. income statement and balance sheet do not give true picture of the cash flows of the firm. Because income statement incorporates many non-cash expenditures and revenues for the sake of ascertaining profitability. Similarly balance sheet tells us the overall financial position with respect to firms’ assets and liabilities and includes monetary and non-monetary items. In reality the business is a matter of earning cash therefore firms receive and spend cash on daily basis. The shareholder must be in loop regarding the cash receipts and disbursements of the firm. Cash flow statement summarizes the firms’ cash flows over a given period of time under a universally accepted and understood format.
The preparation of cash flow statement is a matter of ascertaining cash inflows and outflows with in a given period mainly one year. It summarizes the cash inflows and outflows. Cash inflows means the sources of cash or cash receipts and cash outflow means the uses of cash or cash payments. For example, if a firm’s accounts payable increased by $1000 during a period, the change would be an inflow of cash. Few points need to be understood for the good insight of cash flow statement.
• The cash invested in assets is treated as funds tied up in those assets therefore any decrease in assets is referred to as cash inflow. On the contrary enhancement in assets or cash balances indicates cash outflows because additional cash has been strapped in assets and cash balances. Likewise decrease in cash balance reflects cash inflow.
• Just like amortization and depletion, depreciation is also a non-cash charge that is deducted from revenue to ascertain the profitability for a period. Depreciation is required to be added to the profit after tax to assess the cash flows from operations in cash flow statement.
• To prevent from double counting of depreciation in cash flow statement it is imperative to include gross rather than net changes in fixed assets while preparing cash flow statement.
• Direct changes in retained earnings are not incorporated in cash flow statement.
The statement of cash flows is categorized in three parts namely:
Cash Flow From Operating Activities
Cash flows resulting from those activities relating to purchase and sale of the firm’s products and services. In other words cash flows from operating activities primarily accrue from the major revenue producing activities of the firm.
Cash Flows From Investing Activities
Investing activities relate to the acquisition and disposal of long-term assets. The cash flow from such activities is necessary to disclose because they show the cash invested in assets intended to generate future revenues for the firm.
Cash Flows From Financing Activities
[linkunit]Financing cash flows are cash flows that result from debt or equity financing transactions and include incurrence and repayment of debt cash inflows from the sale of shares and cash outflows to repurchase shares or pay cash dividends. The cash flows from financing activities is necessary to disclose because they represent future claims on the firm from the providers of the funds.
The formation of cash flow statement can be more broadly understood by the following example.
|Cash Flow Statement||$ In thousand||$ In thousand|
|July 1, 2008 to June 30, 2009|
|Cash flow from operating activities:|
|Changes in assets and liabilities:|
|Add Accounts receivables||62,000|
|Add Accounts payables||12,000|
|Less Prepaid expenses||3,500|
|Less Deferred income taxes||6,000|
|Less Income Tax payable||89,900||(193,400)|
|Cash flows from investing activities:|
|Add Other assets||500|
|Less fixed assets||104,000|
|Less long term investments||65,000||(169,000)|
|Cash flows from financing activities:|
|Add Bank Loan||91,000|
|Add Long term debt||4,300|
|Add Common stock||100||95,400|
|Increase in cash and short term investments (Net cash flows)||2,500|
|Cash at the beginning of the period||175,000|
|Cash at the end of the period||177,500|
Importance of Cash Flow Statement
The statement of cash flows allows the financial manager and other stakeholders to analyze the firm’s cash flows. The manager should pay special attention both to the major categories of cash flow and to the individual items of cash flow and outflow to assess whether any developments have occurred that are contrary to the company’s financial policies. In addition the statement can be used to analyze the progress towards the financial goals and deficiencies. From the investors’ point of view cash flow statement provide information about the liquidity position of the firm. They can analyze the future cash streams of the firm and future expected dividends.