OBJECTIVES

• Understand the usefulness of the statement of cash flow in decision making

• Know the classification of the cash flow activities

• Identify the various sources and applications of cash according to firms

• Be familiar with the content and form of the Statement of Cash Flow

HAPPINES IS A POSITIVE CASH FLOW

The Statement of Cash Flow is a financial statement that shows the firm’s cash flows over a given period
of time. This statement reports the amounts of cash that the firm generated and distributed during a
particular period of time.

A cash flow statement is one of the most important financial statements for a project or business.

A cash flow statement is a listing of the flows of cash into and out of the business or project. Think of it
as your checking account at the bank. Deposits are the cash inflow and withdrawals (checks) are the
cash outflows. The balance in your checking account is your net cash flow at a specific point in time.

A cash flow statement is a listing of cash flows that occurred during the past accounting period. A
projection of future flows of cash is called a cash flow budget. You can think of a cash flow budget as a
projection of the future deposits and withdrawals to your checking account.

The primary purpose of a cash flow statement is to provide relevant information about a company’s
cash receipts and cash payments during an accounting period that is useful in evaluating the preceding
items.

USEFULNESS OF THE STATEMENT OF CASH FLOW

Creditors examine it to;

1. To know if the company is generating sufficient positive cash flow

2. The company able to meet its financial obligations to creditors

3. What expansion activities took place and how where those financed

4. Will the company be able to pay their customary dividend

5. Why did cash decrease even though a net income was reported

Even though they report net income they can fail. The difference between net income and net cash
provided by operating activities can be substantial.

6. What extent will the company have to borrow money for the needed investment

7. What happened to the proceeds received from the issuance of capital stocks
ASSESS AND EVALUATE

1. ABILITY TO GENERATE POSITIVE FUTURE NET CASH FLOW

2. TO MEET OBLIGATIONS AND PAY DIVIDENDS

3. NEED FOR EXTERNAL FINANCING

4. REASONS FOR DIFFERENCES FROM NET INCOME

5. CASH AND NON-CASH ASPECTS

OBTAIN INFORMATION

1. CHANGES IN NET ASSETS AND ITS EFFECT

2. ABILITY TO GENERATE CASH AND CASH EQUIVALENTS

3. COMPARABILITY OF REPORTS

PURPOSE

A cash flow statement tells you where the money went. A profit and loss statement says nothing
about principal payments you make to the bank. You could have reasonably good profits, but the
amount of money you pay your bank every month could be putting you out of business.

Cash flow statements tell you where you spent your money. If you increased inventory you used
cash. If you extended more credit to customers you used cash. If you bought lots of capital equipment
you used cash. All three of these issues won’t show up on your profit and loss statement.

A cash flow statement can help you focus on creating excess cash. Having profits is important. Profits
are one of the things that help create cash. There are other things that can also help you create cash.

If you can pay less for capital equipment you need you are creating cash while spending money. If you
can collect receivables from your customers faster you are creating cash. If you use inventory more
efficiently you create cash. Concentrating only on your profit and loss statement makes it difficult to
focus on cash.

Cash flow statements often provide better KPI’s (Key Performance Indicators) than profit and loss
statements. I believe developing excess cash is a great KPI. This is an activity that literally every area of
your company can get involved in through individual drivers.

I think being able to know what moves the needle on developing excess cash often helps to create
value. Knowing what needs to move the needle on profits is only part of the story. Companies that
concentrate on creating excess cash often also create better enterprise value than those companies that
only concentrate on profits.

Cash flow statements help with financing decisions. Buying capital equipment uses cash. Growing
capacity in your company uses cash. Adding inventory uses cash. Adding customers uses cash.
The question when we grow our company isn’t whether we will use cash (we will) it’s how are we going
to finance our growth. Sometimes you’ll just use excess cash provided from profits. Sometimes you’ll
have to borrow money from the bank. Sometimes you’ll need to raise outside capital.

Understanding where your cash goes and how you will provide more cash when you need it are key
parts of running a successful company. Don’t be like me and run out of cash without knowing
why. Understanding your cash flow statement will allow you to make better decisions about your
business.

MEASURING BUSINESS

Liquidity

Net Cash Provided by Operating Activities = __Current Cash___

Average Current Liabilities Debt Coverage Ratio

Refers to the “measure to cash” of assets and liabilities.

The higher the current cash coverage ratio, the less likely a company will have liquidity problems. E’g
1:11 is good

Flexibility

Net Cash Provided by Operating Activities= Cash Debt

Coverage Ratio Average total Liabilities

Refers to a company’s ability to respond and adopt to financial adversity and unexpected needs and
opportunities

The cash debt coverage ratio is a longer –range view

The higher this ratio, the less likely the company will experience difficulty in meeting its obligations as
they come due. It signals whether the company can pay its debt and survive if external sources of funds
become limited or too expensive.

FREE CASH FLOW

To examine financial flexibility. If it is positive, the business firm could have satisfactory financial
flexibility and can

1. Take advantage of profitable investment even in tough terms and

2. Be free from worry about survival in poo economics terms

Examples of Cash
In accounting, a company's cash includes the following:

currency and coins

checks received from customers but not yet deposited

checking accounts

petty cash

Definition of Cash Equivalents

Cash equivalents are short-term, highly liquid investments with a maturity date that was 3 months or
less at the time of purchase. In other words, there is very little risk of collecting the full amount being
reported.

Examples of Cash Equivalents

Examples of cash equivalents include:

money market accounts

Treasury Bills

commercial paper

Operating activities are the activities that comprise of the primary / main activities of an enterprise
during an accounting period. For example, for a garment manufacturing company, operating activities
include procurement of raw material, sale of garments, incurrence of manufacturing expenses, etc.
These are the principal revenue generating activities of the enterprise.

OPERATING

Cash from Operating Activities:

Profit before tax as presented in the income statement could be used as a starting point to calculate the
cash flows from operating activities.

Cash Inflows from operating activities:

Cash receipts from sale of goods and rendering services.

Cash receipts from fees, royalties, commissions and other revenues.

Cash Outflows from operating activities:

Cash payments to suppliers for goods and services.

Cash payments of income taxes unless they can be specifically identified with financing and investing
activities.

Cash flow from investing activities includes the movement in cash flows owing to the purchase and
sale of assets. It relates to purchase and sale of long-term assets or fixed assets such as machinery,
furniture, land and building, etc.

INVESTING

Cash Outflows from investing activities

Cash payments to acquire fixed assets including intangibles and capitalized R&D.
Cash advances and loans made to third party (other than advances and loans made by a financial
enterprise wherein it is operating activities).

Cash payments to acquire shares, warrants or debt instruments of other enterprises other than the
instruments those held for trading purposes.

Cash Inflows from investing activities

Cash receipt from disposal of fixed assets including intangibles.

Cash receipt from the repayment of advances or loans made to third parties (except in case of financial
enterprise).

Dividend received from investments in other enterprises.

Cash receipt from disposal of shares, warrants or debt instruments of other enterprises except those
held for trading purposes.

It includes financing activities related to long-term funds or capital of an enterprise. Financing

activities are activities that result in changes in the size and composition of the owners’ capital and
borrowings of the enterprise.e.g., cash proceeds from issue of equity shares, debentures, raising long-
term loans, repayment of bank loans, etc.

FINANCING

Cash Inflows from financing activities

Cash proceeds from issuing shares (equity / preference).

Cash proceeds from issuing debentures, loans, bonds and other short/ long-term borrowings.

Cash Outflows from financing activities:

Cash repayments of amounts borrowed.

Interest paid on debentures and long-term loans and advances.

Dividends paid on equity and preference capital.

CONTENT AND FORM

NET CASH

- Provided or used by investing activities

- Provided or used by operating activities

- Provided or used by financing activities

Net effect of those flows on cash and cash equivalents during the period in a manner that reconciles the
beginning and ending cash and cash equivalents.
Main heads of Cash Flow statement:

Cash Flow Statement (Main heads only)

(A) Cash flows from operating activities xxx
(B) Cash flows from investing activities xxx
(C) Cash flows from financing activities xxx
Net increase (decrease) in cash and cash xxx equivalents (A + B + C) + Cash and cash equivalents at the
beginning xxx = Cash and cash equivalents at the end xxxx
Methods of preparing the Cash Flow Statements

Operating activities are the main source of revenues and expenditures, thereby cash flow from the same
needs to be ascertained. The cash flow can be reported through two ways:

Direct method that discloses the major classes of gross cash receipts and cash payments and

Indirect method that has the net profit or loss adjusted for effects of (1) transactions of a non-cash
nature, (2) any deferrals or accruals of past/future operating cash receipts and (3) items of income or
expenses associated with investing or financing cash flows.
DIRECT METHOD: REPORT MAJOR CLASSES OF GROSS CASH RECEIPTS AND CASH PAYMENTS

In the direct method, the major heads of cash inflows and outflows (such as cash received from trade
receivables, employee benefits, expenses paid, etc.) are to be considered.

As the different line items are recorded on accrual basis in statement of profit and loss, certain
adjustments are to be made to convert them into cash basis such as the following:
1. Cash receipts from customers = Revenue from operations + Trade receivables in the beginning – Trade
receivables in the end.
2. Cash payments to suppliers = Purchases + Trade Payables in the beginning – Trade Payables in the
end.
3. Purchases = Cost of Revenue from Operations – Opening Inventory + Closing Inventory.
4. Cash expenses = Expenses on accrual basis + Prepaid expenses in the beginning and Outstanding
expenses in the end – Prepaid expenses in the end and Outstanding expenses in the beginning.
INDIRECT METHOD: INDERECTLY BY ADJUSTING NET INCOME TO RRCONCILE IT TO NET CASH FLOW

Indirect method of ascertaining cash flow from operating activities begins with the amount of net
profit/loss. This is so because statement of profit and loss incorporates the effects of all operating
activities of an enterprise. However, Statement of Profit and Loss is prepared on accrual basis (and not
on cash basis). Moreover, it also includes certain non-operating items such as interest paid, profit/loss
on sale of fixed assets, etc.) and non-cash items (such as depreciation, goodwill to be written-off, etc.
Therefore, it becomes necessary to adjust the amount of net profit/loss as shown by Statement of Profit
and Loss for arriving at cash flows from operating activities.

Advantages of Cash Flow Statement

• Cash Flow Statements help in knowing the liquidity / actual cash position of the company which
funds flow and P&L are unable to specify.
 • As the liquidity position is known, any shortfalls can be arranged for or excess can be used for
the growth of the business

• Any discrepancy in the financial reporting can be gauged through the cash flow statement by
comparing the cash position of both.

• Cash is the basis of all financial operations. Therefore, a projected cash flow statement will
enable the management to plan and control the financial operations properly.

• Cash Flow analysis together with the ratio analysis helps measure the profitability and financial
position of business.

• Cash flow statement helps in internal financial management as it is useful in formulation of

financial plans.

Disadvantages of Cash Flow Statement

• Through the cash flow statement alone, it is not possible to arrive at actual P&L of the company
as it shows only the cash position. It has limited usage and in isolation it is of no use and
requires BL, P&L for its projections. Cash flow statement does not disclose net income from
operations. Therefore, it cannot be a substitute for income statement

• The cash balance as shown by the cash flow statement may not represent the real liquidity
position of the business because it can be easily influenced by postponing the purchases and
other payments

• Cash flow statement cannot replace the funds flow statement. Each of the two has a separate
function to perform.