Components of a Cash Flow Statement
The cash flow is used to show the flow of money within an organization for a specific period. The cash flow shows money flowing in and also out of the company. The cash flow can be subdivided into three distinct components that include financing activities, operating activities and investing activities.
Operating activities deal with those costs that are incurred in the course of goods and services production. This is the first activity to be reported in the cash flow. It also deals with the sales made in each day’s business operations. Operating activities include cash inflows such as revenue from sales of products and services to customers, dividend, interest payments, and sale of securities. This component may however include outflows such as taxes, payments made to employees and suppliers, operating expenses, and interest. Using this component, the cash flow can be computed in two ways: the direct and the indirect method (Mulford & Comiskey, 2005, p. 115). The operating activities also include depreciation, inflow from accounts receivable, outflow in accounts payable, and inventories. The direct method utilizes operating activities in concluding cash outflows and inflows. The other method, the indirect method, requires the adjustment of the cash flow statement items that affect the investing and financing cash flow to find the net income. These adjustments are necessary since not all the transactions in the cash flow are cash items.
Investing activities as a component of the cash flow deals with the buying of non-current assets by a business for the purpose of generating revenue in future within a given period. It also deals with the purchase of all securities that can not be classified as cash equivalents. Revenue generated from the sale of an organization’s equipment or plant is also a source of cash inflow for the business. Giving and receiving loans, and buying and selling of stocks are also considered as investing activities. In most cases this component involves cash outflows. However, in the event that an organization divests one of its assets, this is considered a cash inflow when calculating cash for this component.
Financing activities are when an organization makes dividend payments to various groups, gives out equity stock, and is loaned money and then repays it (Heyler & Reider, 2002, p. 96). The cash flow helps in showing the amount of sales generated and the percentages utilized for various situations, for example seeking a loan. Cash inflows in this component are instances for raising capital while cash outflows are payment of dividends. Hence things such as issuing of public bonds fall under this component.
Benefits of a Cash Flow Statement
Contrary to data given by the income statement, the cash flow shows whether a business is generating any cash. This is significant since cash is an integral part of the livelihood of any business. The data given by the cash flow statement helps the business know whether it has adequate cash to meet its expenses and also buy the required assets (Knight, Berman & Case, 2009, p. 31).
The cash flow statement is also important as it helps the business secure business loans. This is mainly due to the fact that banks, investors and other lending institutions require past cash flow statements of a business before investing in it or lending it any funds. It is from these past cash flows that the creditors will check to see whether the business is in a position to repay the loan being asked for. Cash flows also help show investors the possibility and actuality of getting the returns they are promised on their investments.
For any business that seeks to grow and expand its business, cash flows come in handy. They help the business establish how much cash it has available to develop new products, venture into new markets, start marketing campaigns, and conduct other activity relevant to its growth. Maintaining a cash flow statement may also be used as competitive advantage where other competitors are not keen on their cash flow but rather only on their profits and losses.
Maintaining a cash flow statement is advantageous to a business as it helps it have cash at hand to cover for expenses. The cash flow statement is significantly important now than a decade ago since it is emerging that clients have a trend of taking a longer time to pay the amount owed to the business while suppliers want to be paid sooner. A cash flow statement hence helps the management to bridge this gap and ensure that it has cash at hand to pay its suppliers while at the same time not rushing its clients to make payments. It is a fact that not doing the above will result in delayed payments to suppliers or rushing clients to make their payments which would both impact negatively on the business.
In the business plan or financing proposal, the cash flow statement helps in adding credibility to the other financial information given. The cash flow is also useful in establishing the effect of a new project or investment on an organization’s finances. These two significances are mainly due to the fact that the cash flow statement does away with all allocations in accounting and gives a clearer representation of the cash outflow and inflow.
The cash flow statement is also advantageous in that it allows for strategic financial and management planning based on historical and/or future cash flow projections. This helps the business make plans on what it intends to achieve within a set period of time.
Problems experienced when Cash Flow Analysis is not conducted
If the cash flow analysis is not done, it may lead to financial distress. This is a scenario whereby the business may have adequate cash at a particular period and yet not be able to meet its financial obligations. This could consequently result in the business being forced into negotiating with its lenders on a disadvantaged position or even result in the business going bankrupt.
Also, not conducting a cash flow analysis may end up causing a business to have an uncontrollable working capital. This may be as a result of the inventory being obsolete or the business selling too many products and services on credit, making it have a large portfolio accounts receivable. This possess a problem as the company may end up being unable to meet its short term obligations making the business get into tough negotiations with its creditors.
Mulford, C. & Comiskey, E. (2005). Creative Cash Flow Reporting: Uncovering Sustainable
Financial Performance. New York: Wiley.
Knight, J., Berman, K. & Case, J. (2009). Why Cash Matters: The Importance of Understanding
a Cash Flow Statement. New Jersey: Prentice Hall.
Heyler, P. & Reider, R. (2002). Managing Cash Flow: An Operational Focus. New York: Wiley.