Cash flow statement provides relevant information in assessing a company’s liquidity, quality of earnings and solvency.
Further, cash flow statement is a summary of cash payments and receipts. Information about cash flow is useful in providing users of financial statements with a basis to assess of the enterprise to utilize those cash flows.
The economic decisions that are taken by users require an evaluation of the ability of an enterprise to generate cash and cash equivalents and timing and certainty of their generation.
What are the benefits of cash flow statement?
- CFS provides information about the changes in cash and cash equivalents of an enterprise.
- Identifies cash generated from trading operations.
- The operating cash surplus which can be applied for investment in a fixed assets.
- Portion of cash from operation is used to pay dividend and tax and the other portion of ploughed back.
- Very useful tool of planning.
What is the purpose of CFS?
Cash flow statements are prepared to explain the cash movements between two points of time.
What are the components of CFS?
The main components of cash flow statements are as flows:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities.
A) Cash flow from operating activities:
These are the principal revenue generating activities of the enterprise. Further, it shows how much cash is generated from the company’s goods or services.
Moreover, the amount of cash flow from operating activities is a key indicator of the extent to which the operations of the enterprises have generated sufficient cash flows to:
- Maintain the operating capability of the enterprise;
- Pay dividends , repay loans ; and
- Make new investments without recourse to external sources of financing.
It provides useful information about financing through working capital.
Information about the specific components of historical operating cash flows is useful, in conjunction with other information, in forecasting future operating cash flows.
The operating activities includes following:
- Cash receipts from sale of goods and the rendering of services.
- Cash receipts from royalties, fees, commissions, and other revenue.
- cash payments to suppliers for goods and services.
- cash payments to and behalf of employees.
- Cash receipts and cash payments of an insurance entity for premiums and claims, annuities, and other policy benefits.
- Cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities.
B) Cash flow from investing activities:
These are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
Further, separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which the expenditures have been made for resources intended to generate future incomes and cash flows.
Investing activities represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.
Cash flow from investing activities includes following:
- Cash payments to acquire fixed assets. These payments include those relating to capitalized research and development costs and shelf constructed fixed assets.
- Cash receipts from sale of properties, plant and equipment , intangibles and other long term assets.
- Cash payments to acquire equity or debt instruments of other entities and interest in joint ventures (other than payments for those instruments considered to be cash equivalents or those held for dealing or trading purposes).
- Cash receipts from sale of equity or debt instruments of other entities and interest in joint ventures (other than payments for those instruments considered to be cash equivalents or those held for dealing or trading purposes).
- cash advances and loans made to other parties (other than advances and loans made by a financial institution).
- cash receipts from the repayment of advances and loans made to other parties (other than advances and loans of a financial institution).
C) Cash flow from financing activities:
These are the activities that result in changes in the size and composition of the owner’s capital (including preference share capital) and borrowings of the enterprise.
Further, the separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings) to the enterprise.
Cash flow from financing activities includes following:
- Cash proceeds from issuing shares or other equity instruments.
- Cash payments to owners to acquire or redeem the entity’s shares.
- Cash proceeds from issuing debentures, loans, notes bonds, mortgage and other short-term or long-term borrowings.
- cash repayments of amount borrowed.
- And cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease.
Methods of calculating cash flow statement
There are two methods of calculating cash flow statement i.e.
- Direct Method
- Indirect Method
Lets Understand these methods in detail.
1. Direct Method
The direct method, whereby major classes of gross cash receipts and gross cash payments are considered. Like cash paid to suppliers or cash receipts from customers and cash paid out in salaries etc.
This method is suitable for very small business that uses the cash basis of accounting system.
Following information is require for computing CFS by direct method.
- Gross receipts or payments obtained from accounting records to ascertained cash flows from operating activities.
- For instance – information about cash received from trade receivables , payment to trade payable’s , cash expenses etc.
- In actual practice relavant information is obtained by adjusting sales , cost of sales, and other items in profit and loss account for:
- i) Changes during the period in inventories and operating receivables and payables
- ii) Other non-cash items such as depreciation on fixed assets, goodwill written off, preliminary expenses written off, loss or gain on sale of fixed assets etc.
- iii) Other items for which the cash effects are investing or financing cash flows. Examples are interest received and paid, dividend received and paid etc., which are related to financing or investing activities and are shown separately in the cash flow statement.
2. Indirect method
The indirect method, whereby net profit or loss is adjusted for the effects of transaction of a non cash nature, deferrals or accruals of past or future operating cash receipts or payments, and items of income or expenses associated with investing or financing activities.
It brief, company will identify any increase or decrease in assets and liabilities that is to be added back or removed from net profit , in order to calculate actual cash inflow and outflow.
Following information is require for computing CFS by indirect method.
Under the indirect method, the net cash from operating activities is determined by adjusting net profit or loss instead of individual items appearing in the profit and loss account. Net profit or loss is also adjusted for the effect of:
- changes during the period in inventories and operating receivables and payables;
- non-cash items such as depreciation; and
- all other items for which the cash effects are financing or investing cash flows.
Conclusion
- It is worth noting that both direct and indirect methods adjust current assets and current liabilities related to operating activities to determine cash from operating activities.
- But direct method adjust individual items of profit and loss account and indirect method adjusts overall net profit (or loss) to determine cash from operation.
- Therefore, indirect method fails to provide break-up of cash from operations.
