Statement of Cash Flows - Why is it Valuable?
Statement of Cash Flows
A Statement of Cash Flows is also known as a Cash Flow Statement. It is one of the three most important financial documents for a company to have and is a mandatory part of the financial reports. It may not be considered as important as the Balance Sheet or Income Statement , but the statement of cash flows can provide valuable insights in regards to business performance trends.
This statement measures how well a company manages its cash position. Its main purpose is to depict how well a company can generate cash to pay its debts and cover the operating expenses. This is referred to as liquidity . It shows how money moves in and out of a company over a specific period of time . Additionally, this statement is used to show a company’s solvency and ability to alter its cash flow in the future. Future cash flow amounts and probabilities can also be indicated from this statement.
When working with a cash flow statement, there are a few key terms to understand. These include:
Cash Flow: cash flow is money that comes into or leaves your business. Having a positive cash flow is beneficial not only to internal company activities but to outside stakeholders such as lenders or investors.
Cash Balance: The cash balance is the sum of all three sections of the cash flow statement. This depicts the cash position of the company; also known as the Closing Cash Balance when calculated for the period of a year. The Opening Cash Balance can be taken from the previous year’s closing balance.
Cash Equivalents: This is an investment that can be converted into cash within three months or less. These assets need to be easily sold on the market, and it should not take you long to find willing buyers. Anything that does not fit these parameters constitutes as other types of investments.
Structure of A Statement of Cash Flows
The statement of cash flows includes three main areas: the operating, investment, and financial activities of a company. A simple statement of cash flows can be found in Figure 1.
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Operating activities represent the activities by which the company generates revenue. Think of these as daily incomes and expenditures of the business such as sales, cash received, payroll, fees, commission, or supplier invoices.
Investment activities cover larger ticket items such as payments for long term assets or cash from the sale of them. Purchasing, renting out or selling equipment, purchasing land or infrastructure, and buying assets such as securities all constitute investment activities.
These activities include anything to do with income or payments directly related to the company’s equity, such as issuing shares, repurchasing shares, and dividend payments.
Methods for Calculating a Statement of Cash Flows
There are two methods for calculating a statement of cash flows, the direct method, and the indirect method.
In this method, all cash receipts and payments are added together. This can include cash receipts from customers, cash paid to suppliers and employees, interest payments as well as paid income tax and interest or dividends received. These cash flows are calculated using the start and end balances of varied accounts. Most companies do not collect the detailed information required to execute the direct method successfully, and therefore, the Indirect method is more commonly used .
In this method, the statement begins with the net income or net loss, which can be found on the income statement. From this, deductions and adjustments are made until the amount of net cash from operating activities is achieved . This has to be done because the income statement is prepared on an accrual basis and therefore, does not correctly depict the net cash flows from operating activities. Deductions may include depreciation, a change in inventories or payables, profit or loss on asset sale and provisions for the possibility of a loss on accounts receivables.
The Importance of a Statement of Cash Flows
Cash flow can help you make better decisions about your business’ sales and spending. In addition , it can also be used to predict future cash flows and be used as a method for planning. Whether creating a cash flow monthly or yearly, it has various benefits to running a successful business.
Negative Cash Flow
Not all cash flows show healthy numbers, and at first, this may seem alarming, but examining why there is negative cash flow is more important . If a company is expanding, for instance, this negative cash flow is warranted and will likely result in positive outcomes for the business in the future. On the other hand, if the company does not have a suitable explanation for a negative cash flow month over a month, it will need to look into improving its revenue generation methods or reducing costs. Possible revenue generation methods would be raising goods or services prices, while alternatively, cost-cutting measures may include a reduction in marketing costs or excess inventory.
Comparing Cash from Operating Activities to Net Income
If the cash from operating activities is regularly higher than net income, this can indicate that the company is in good financial health. If your net income rises, you will want your cash flow to do the same so that your sales profits are consistent.
The cash flow statement can be more important to investors than the income statement because it actually shows them how much cash the company has. The income statement often includes non-liquid revenues and expenses, and so the two statements differ in importance to some investors. Consistent positive cash flow is looked upon favorably.
In conclusion, the Statement of Cash Flows can be a great tool to help identify where a business’ cash is coming from and going, and when to tackle any related issues. It provides valuable insight into the business’ liquidity and financial strength for lenders and investors. Additionally, it can help managers plan future cash flows in order to help prepare for any possible cash flow challenges that a business might face. Ultimately, regularly preparing and analyzing a cash flow statement is in the best interest of any business .