What is the cash flow statement

In my experience with financial reporting, both as an auditor and in industry, I have noticed that cash flow statement is somewhat neglected and is not given the same level prominence as income statement and balance sheet in the whole reporting process. There could be number of reasons for this, ranging from over emphasis on profitability as opposed to generation of cash to the fact that most performance measures and ratios are derived from income statement and balance sheet.

The cash flow statement is an essential bridge between the two primary statements and provides valuable insight into both business position and performance, which cannot be garnered by looking at the income statement and balance sheet in isolation. The statement combines elements from both income statement and balance sheet and provides insights into liquidity, quality of earnings and even future profitability and viability of the business.

Tip: If you are tasked with preparing a variance analysis of balance sheet and income statement, I would suggest that you prepare a cash flow statement (if it is not already there) and half your analysis will be done.

This is the first of a three part series on cash flows statements. The first part highlights the basic components of an indirect cash flow statement and my take on what each of these components mean in the context of a company’s financial performance and position. Part two will cover a simple and quick guide to preparing a cash flow statement and ensures that your cash flow statement will not out go out of balance. I will share my tried and tested cash flow template in excel, which allows anyone to prepare IFRS compliant indirect cash flows (in case your systems are not capable of churning out cash flow statements). In last part, we will look at some key measures and methods used in analyzing cash flow statement.

Elements of a cash flow statement

Cash flows from operating activities analyzes the inflows and outflows from core operations. The section, in effect eliminates the impact of accrual basis of accounting, estimates and accounting policy choices and converts the company’s net profit into cash profit. This is done so in two parts:

  • Adjusting the non-cash expenses and income components (e.g. depreciation, impairment and unrecognized gains and losses); and
  • adding/subtracting the working capital changes to arrive at the total cash generated from or used in the operations.

Working capital movements are changes in current assets and current liabilities from one period to the next. Once adjusted against the net profit, the movements strip out the impact of accrual basis of accounting from net profit for the period.

To illustrate, revenue / sale of goods is recognized on accrual basis upon meeting the revenue recognition criteria in IFRS 15 and when sale is made on credit terms then this does not translate into actual receipt of cash by the business but recognition of Trade Receivables in current assets. Upon adjusting the gross movement in trade receivables the impact of sale/revenue for which cash has not been collected by the reporting date is stripped out and at the same time the cash collected during the period, with respect to revenue/sale of prior period is included.

Similarly, deferred costs and revenues are spread over multiple accounting periods, even though the actual cash outflow or inflow has already taken place. By adjusting the movements in these current assets and current liabilities accounts as part of the working capital changes section of the cash flow statement, the impact of amortization / recognition of deferred costs and revenues is excluded from the net profit and impact of actual cash flows being incurred is incorporated.

Cash flows from or used in investing activities represents cash spent or realized from investments, acquisitions, disposals and divestitures carried out by the business. This portion of cash flow statement essentially analyzes the movements in the non-current assets of a business and presents cash the movements in non-current assets under cash flows from investing activities. In my experience, companies geared towards future growth usually have negative cash flows in this section.

Capital expenditure incurred on tangible and intangible (computer software, patents and trademarks) are reflected as cash outflows. Whereas, cash realized on receipt of dividends investments and disposal of assets, businesses and investments are shown as cash inflows.

Investments in highly liquid investments (readily convertible into cash) are usually removed from the investing activities and classified as cash equivalent.

Cash flows from or used in financing activities includes cash raised from or paid to providers of capital (debt and equity). Cash movements in long term liabilities (loans and borrowings) and the equity components on the balance sheet are usually captured in this section.

Draw downs on loan facilities, repayment of loans granted previously, equity (preferred or common stock) issued to raise capital are all examples of cash flows generated from financing activities. On the other hand, repayment of loan facilities, issuance of loans, buy back of equity from stock holders and payment dividends constitute cash outflows pertaining to financing activities of a business.

Negative financing activities may not necessarily be a bad thing and similarly positive cash in flows from financing activities cannot be termed as a favorable outcome. To understand the financing cash flows, the composition of the line items within financing activities must be looked at more closely and in addition, cash flows from operations and investing activities must be looked at in-tandem. These measures and analysis will be explored in more detail in a later part.

The bottom line of the cash flow statement represents summation of the three components above and adding it to the opening cash and cash equivalents balance to arrive at the closing cash and cash equivalent balance. Ordinarily, cash and cash equivalents comprises of cash in hand, cash at bank, fixed deposits (usually those with short term maturity), highly liquid short term investments and over draft facilities. There are a number of ways to analyze the movement in cash and cash equivalents balances as well and shall be explored later.

Closing thoughts

Where markets are obsessed with earnings and price earning ratios, I would argue that cash is the lifeblood of a business. Analysts may argue that net income or earnings per share are more important, but a business’s ability to generate cash trumps all other performance measures. Knowing a company’s cash cycle and liquidity potential helps make important decisions surrounding working capital and purchase of equipment.

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