Understanding Cashflow Statement & Importance
Cash flow is mostly related to financial accounting as it is statement. It is very crucial and important because it contains information needed for running a smooth business. Cash flow is also known as statement of cash flows, it is a financial statement section that shows how variations in statement of financial position and income statement affects cash and cash equivalents, it also breakdown the analysis to operating, investing, and financing activities as its three sections contained on a typical cash flow statement. Fundamentally, the cash flow statement is concerned with the movement of cash into the business and out of the business.
Cash flow statement represents your entity’s cash inflows and outflows for a specified period. Cash flow is essentially the movement of money in and out of your business. This cycle of cash inflows and outflows determines your business’s solvency. ‘It also showcases the non-cash investing and financing activities of your business for the same period. This information is significant to the various stakeholders of your business. This is because it helps them to assess your business’ ability to generate cash and needs of your enterprise to utilize those cash flows.
Cash flow as an analytical tool, the statement of cash flows is beneficial in defining the short-term capability of a company, predominantly its capacity to offset bills and run the business operations seamlessly. International Accounting Standard 7 (IAS 7) is the International Accounting Standard that deals with cash flow statements. According to an overview of that standard about cash flow by International Financial Reporting Council “IAS 7 Statement of Cash Flows requires an entity to present a statement of cash flows as an integral part of its primary financial statements. Cash flows are classified and presented into operating activities (either using the ‘direct’ or ‘indirect’ method), investing activities or financing activities, with the latter two categories generally presented on a gross basis”. It is the standard that determines how the statement must be prepared and presented. Cash flow statement refers to the statement involving information concerning the inflow and outflow of cash. Nowadays, in preparing financial statements, the cash flow statement is considered as an important element.
The statement of cash flows, or the cash flow statement as may be called, is a financial statement section that abridges the amount of cash and cash equivalents inflowing and parting a company or business. The cash flow statement determines how well a business manages its cash position, connoting how well the business creates cash to set off its debt commitments and finances its operating expenses. The cash flow statement completes the balance sheet and income statement and is a compulsory portion of a company’s financial report.
Well there is are differences between Cash flow statement and Income statements as the income statement is prepared under the accrual accounting concept which requires businesses to record revenues and expenses as they occur not regarding when the payment is actually made. While on the other hand, Statement of cash flow only recognise transactions when the cash is received or paid which is more like the cash basis concept of account.
Gazing into a typical financial statement, one will see it is divided into:
- Corporate Overview
- Statutory Reports and
- Financial Statements.
Further, the financial statements section will show items like:
- Financial Account and
- independent auditor’s report.
It is under the business Financial Account you will see:
- Statement of financial position
- Statement of comprehensive income
- Statement of Changes in Equity
- Statement of Cash Flows
- Notes to Financial Statements
Being the basic parts that will make up the financial statement of the business.
Why Cash Flow Statement
Cash flow is done in addition to business entity’s balance sheet and income statements. The determination behind preparing cash flow statement is that the business income through a period has no straight connection with cash flows of that period. We said this because income statement of the company signifies economic outcomes of your operating activities, investing activities and financing activities through the period in review.
A typical statement of cash flow should contain the following as section as listed below. Not minding whether it is the direct method or indirect method.
- Cash flow from operating activities,
- Cash flow from investing activities and
- Cash flow from financing activities; and
Determines the amount separately for each head and presents each as sub-total.
Classification of Activities in Cash Flow Statement
The above-mentioned activities recognized under the cash flow statement will be further discussed in details for you to gain more traction of what it entails and this will aid your relating it to your business properly. Such activities are classified into three categories: (i) operating, (ii) investing and (iii) financial activities.
1. Cash Flow from Operating Activities
Operating activities include the production, sales and delivery of the company’s product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product.
Under IAS 7, operating cash flows include:
- Receipts for the sale of loans, debt or equity instruments in a trading portfolio
- Interest received on loans
- Payments to suppliers for goods and services
- Payments to employees or on behalf of employees
- Interest payments (alternatively, this can be reported under financing activities in IAS 7)
- buying Merchandise
Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the Income Statement) to arrive at cash flows from operations generally include:
- Depreciation (loss of tangible asset value over time)
- Deferred tax
- Amortization (loss of intangible asset value over time)
- Any gains or losses associated with the sale of a non-current asset, because associated cash flows do not belong in the operating section (unrealized gains/losses are also added back from the income statement).
- Dividends received general reserves
2. Cash Flow from Investing Activities
Investing activities include any sources and uses of cash from a company’s investments. A purchase or sale of an asset, loans made to vendors or received from customers or any payments related to a merger or acquisition is included in this category. In short, changes in equipment, assets, or investments relate to cash from investing. fixed assets such as plant and machinery, land building etc. Additionally, cash flows from investing activities also include cash flows from:
- long term investment securities and
- investments in joint venture or affiliates.
In addition to changes in long term assets, capital expenditure calculation also includes depreciation. This is because depreciation changes the net of property, plant and equipment. Separate footnote disclosures should be used to showcase assets and liabilities obtained or relinquished in acquisition or divestiture.
Following are the examples of cash flows from investing activities:
I. Cash Inflows from Investing Activities
Cash inflows from investing activities include cash:
- receipts from sales of fixed assets
- receipt from repayment of loans or advances made to third parties
- received as interest from loans and advances made to third parties
- received as dividend from investment in other businesses
- obtained by selling shares, warrants or debt instruments of other enterprises
II. Cash Outflows from Investing Activities
Cash outflows from investing activities include payments made:
- to acquire fixed assets
- as loans advances to third parties
- to acquire shares, warrants or debt instruments of other enterprises
3. Cash Flow from Financial Activities
When we refer to financing activities of a business, it refers to the capital or long-term funds of your business. These activities are the outcome of changes in the proportion and structure in the owner’s capital and borrowings of your business. The elements of cash flow from financing activities include (i) inflows from additional borrowing and equity financing and (ii) outflows for repayment of debt, dividend payments and equity repurchase.
Following are the examples of cash flows from financing activities:
I. Cash Inflows from Financing Activities
Cash inflows from financing activities include cash proceeds from issuing:
- debentures, loans, etc
I. Cash Outflows from Financing Activities
Outflows of cash from financing activities include:
- Cash repayments of the amounts borrowed
- Dividends paid on equity
- Interest paid on debt
Importance of preparing or analyzing statement of cash flow as a business are:
- Ensuring Positive cashflow into the business is one of the objectives of preparing the statement as proper projection would have been made after reading what the outcome is.
- The assurance that a business will be able to meet the payment of dividend to its shareholders are further sharpen as the statement will bring to notice the liquidity of the organization after preparing it.
- Identifying non-cash items ensuring cash income and expenses are of major concern and even top priority cause cash flow statement will only deal with cash item which are paid for in cash or received in cash.
- Comparing various items of the current year with those of last year is another importance of cash flow statement as it will give better understanding and made you know which year had more cash inflow or outflow.
- Measurement of Cash is made possible as cash Inflows and outflows of cash can be measure with the help of the statement annually picking them from operating activities, investing activities and financial activities.
- Preparation of cash flow statement will enhance better generation of cash as its analysis will help determine whether the business is liquid enough or not and the result will further let the business know it need to recover more account receivable to be more solvent.
- Cash flow statement will assist the business to properly group it activities better, it will make it know whether an activity is either investing, financing or operating activity.
- With the cash flow preparation, the business is able to make future finance decision for proper running of the business activities. It will enable the business manager to determine if the business will be able to exist in a future date.
- The inflows and outflows of cash and cash equivalent can be known, and, as such, liquidity and solvency position of a firm can also be maintained as timing and certainty of cash generation is known through the preparation of statement of cash flow.
- Through cash flow preparation, the business manager can project and determine the likely future inflow and outflow of cash for the business.
People and groups interested in cash flow statements include:
- Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses
- Potential lenders or creditors, who want a clear picture of a company’s ability to repay
- Potential investors, who need to judge whether the company is financially sound
- Potential employees or contractors, who need to know whether the company will be able to afford compensation
- Company Directors, who are responsible for governance of the company, and are responsible for ensuring that the company doesn’t trade while insolvent
- Shareholders of the business.
There are basically two methods accountants use while preparing statement of cash flow which re:
The direct method that shows each major class of gross cash receipts and gross cash payments. The operating cash flows section of the statement of cash flows under the direct method would appear something like this: (Adapted from International Accounting Standard)
|Cash receipts from customers||xx,xxx|
|Cash paid to suppliers||xx,xxx|
|Cash paid to employees||xx,xxx|
|Cash paid for other operating expenses||xx,xxx|
|Income taxes paid||xx,xxx|
|Net cash from operating activities||xx,xxx|
The indirect method adjusts accrual basis net profit or loss for the effects of non-cash transactions. The operating cash flows section of the statement of cash flows under the indirect method would appear something like this:
|Profit before interest and income taxes||xx,xxx|
|Add back depreciation||xx,xxx|
|Add back impairment of assets||xx,xxx|
|Increase in receivables||xx,xxx|
|Decrease in inventories||xx,xxx|
|Increase in trade payables||xx,xxx|
|Less Interest accrued but not yet paid||xx,xxx|
|Income taxes paid||xx,xxx|
|Net cash from operating activities||xx,xxx|
To conclude this, it is indeed paramount to make known that the preparation of the income statement and the cash flow statement is mandatory for all business organisations. The two statements are used by the readers (stakeholders, i.e. creditors, investors, suppliers, competitors, employees, etc.) of financial statement to know about the company’s performance, steadiness and creditworthiness position. These statements are also used for the purpose of internal and tax audit.
ABOUT THE AUTHOR
Razaq Adedamola AYENI is a creative, talented and innovative Accountant with consolidated expertise in Accounting, Strategy, digital marketing and business development. He has worked in different industries and this has added to his wealth of knowledge.
He is a highly motivated and positive minded person, a business development expert. He has demonstrated his competence in leadership and mentoring in Matog Consulting & Matthew Ogagavworia & Co. in Ikeja Lagos where he is a Consulting associate and an Audit junior