The primary objective of cash flow statement is to help management in taking a decision and making a plan by providing current information on cash inflow and outflow of any accounting period.
During 1960, the cash flow statement was considered with due importance in the United States of America.
In this context,
International Accounting Standard Committee introduced the International Accounting Standard-7 on cash flow statement considering its importance.
Later, in 1992 it was published in modified forms.
Cash flow statement means inflow and outflow of cash of a particular period which is divided into:
- Cash flow from operating activities,
- Cash flow from investing activities and
- Cash flow from financing activities; and
- Determines the amount separately for each head and presents discloses of the same.
Thereby companies present cash and cash-equivalent items which are shown on their balance sheet.
In section – J of International Accounting Standard – 7 it is stated, a complete financial statement contains income statement, balance sheet, retained earnings statement, cash flow statement, and accounting principles and notes to the financial statement.
cash flow statement is considered an important element of the financial statement.
A cash flow statement means a statement relating to information regarding inflow and outflow of cash. Nowadays, in preparing financial statements, the cash flow statement is considered as an important element.
Cash flow statement plays an important role in taking decision and planning by investors, creditors, and management.
Objectives of Cash flow statement
The main objective of preparing cash flow statement for a particular accounting period is to present information regarding inflow and outflow of cash.
It presents the investment and financial activities of a concern for a particular period. It also fulfills the following objectives;
- Ensuring future positive cash flow of particular concern.
- Ensuring capacity of an organization to pay a dividend.
- Identifying non-cash items ensuring cash income and expenses of a concern.
- Comparing various items of the current year with those of last year.
Knowing cash and cash equivalent and outsource inflow of a concern for a particular period.
Moreover, cash flow statement plays an important role in planning and controlling future course of action of a business concern.
It also helps shareholders and potential investors in taking short-term and long-term decisions.
Classification of Cash flow statement
Cash flow is divided into three parts.
- Cash flow from operating activities.
- Cash flow from investing activities.
- Cash flow from financing activities.
Advantages of Cash flow statement
Cash flow statement is recognized as an indispensable part of the financial statements for its characteristics.
The use of the cash flow statement in the form of cash and cash equivalent as the current asset and its direct influence on fixed assets and other current assets do exist.
The three main elements of the financial statements – balance sheet, income statement, and cash flow statements represent a financial position, trend and business activities of business concern respectively.
The main advantages arising out of the cash flow statement are as follows;
- It provides information relating to cash flow, net assets difference, and liquidity of a business concern.
- It provides information relating to size and kind of cash and cash equivalent.
- It helps a company in getting an idea of future cash position.
- In preparing reports, it presents events and transactions from different angles by which management can take multipurpose decisions.
- Cash flow statement prepared by historical information helps in determining the future cash flow of the company.
- Primarily prepared cash flow statement can be compared to the cash flow statement prepared considering the present rise and fall of price.
- Three-part cash flow statement presents the true financial picture of concern.
Cash and Cash Equivalent
According to section 6 of the International Accounting Standard – 7 cash means cash in hand and cash at the bank.
Cash in hand means cash in notes and coins which are kept in the cash box.
Besides, prize bond, negotiable instruments, postal order, un-deposited check, bank draft, bank pay order are also considered as cash.
Bank deposit means cash deposited into the bank and payable on demand.
In section 6 it is further stated that cash and cash equivalent include short-term highly liquid assets easily convertible into cash and measurable regarding money.’ So, cash equivalents are;
- Convertible into cash within three months.
- Highly liquid and capable of paying debts.
- Easily convertible into cash and risk-free.
Importance of cash flow statement
Cash flow statement is an important and necessary example of cash management. Since the cash flow statement is prepared by cash record, it is very important in the evaluation of the cash position of a business concern.
Sometimes a business concern faces problem in paying dividend and income tax due to the shortage of cash, although it earns sufficient profit.
Again sufficient cash may remain in the business through its profit is not sufficient.
The reasons for which these situations arise cannot be known directly from the income statement and balance sheet but these can be known from cash flow statement.
On consideration of the importance of cash flow statement nowadays, the cash flow statement is also prepared along with financial statements.
The importance and necessity of the cash flow statement are stated below;
Evaluation of cash position
Since the cash flow statement is prepared by cash records, it is very much useful in evaluating the cash position of a business concern.
The expected amount of cash helps the management in deciding for short-term investment.
Contrarily, if the shortage of cash arises, the management can find out the possible sources of cash for meeting various expenditure.
Getting an idea of future cash position
By various information, a probable cash flow statement is prepared so that a clear idea regarding future cash position can be achieved by making a plan and adjustment regarding financial activities.
With the help of this statement, a business concern can find out sources of cash needed and the amount of cash to be spent on different heads.
Correction of decision
The comparison is made between the historical cash flow statement and a projected cash flow statement. If any deviation is marked, the management can take corrective measures.
Picture of liquidity position
Every business organization should possess the required liquidity. In the light of it, cash flow statement is prepared and compared with those of similar business organizations and concerned departments of the organization.
In such a case whether the trend of liquidity is in progress or degrees can be known.
Framing long term-planning
In the case of investment and financing, both cash quantity and time are significant to the management. Projected cash flow statement helps the management in this respect.
Cash flow statement helps largely in respect of loan payment, preference share capital payment, replacement of fixed asset and other long-term plans.
Searching for solutions to various problems
Answers to various questions can be known from the cash flow statement.
For example,how the net profit has been earned, where that profit has gone, why dividend could not be paid despite sufficient profit, how tax will be paid, what types of fixed assets have been purchased in a particular financial year, whether any fixed assets have been sold, if sold how that cash has been utilized etc.
More important than fund flow statement
In the case of short-term investment since cash is more important than working capital, the cash flow statement is more important than a fund flow statement for short-term financial analysis.
Useful to interested outside parties
Cash flow statement is not less important to those who use published financial statements of a company. Potential creditors always remain eager to know about the liquidity position of concern before making any transaction.
They also like to be aware of the profit earning capacity of the concern.
Cash flow statement helps in both cases. Bank and tax authority also depend very much on the cash flow statement.
Limitations of the cash flow statement
Although the cash flow statement is an important element of cash management, it has got some limitations.
The limitations of the cash flow statement are discussed below:
- The difference of opinion relating to the word – ‘Cash’: The word ‘cash’ is easily understandable by common people but difficult to explain or define. In greater sense stamp, cheque, postal order, etc. should be included under cash title. But there prevail great differences of opinion in this matter. The accepted principle is not yet established in this regard.
- A clear picture of cash position not available: The sources of inflow and out the flow of cash can be known from the cash flow statement. But a clear cash picture cannot be known from cash flow statement as some cash equivalent items are excluded.
- Fund flow statement more important: Since the working capital is considered as a larger concept of the fund, the fund flow statement is more important than the cash flow statement. Because the fund flow statement exhibits a clear picture of the fund.
- Incapable of ascertaining the amount to be spent on fixed assets and long-term investment: The cash flow statement cannot ascertain the amount to be spent on fixed assets and long-term investments.
Fix Missing Figures in Cash Flow Statement
Generally, a cash flow statement is prepared for a particular period or for a financial year.
Net cash inflow and cash outflow for a particular period or for a financial year can be known from the cash flow statement.
Closing cash balance is determined to add opening cash balance to net cash inflow.
How to Fix Missing Figures in Cash Flow Statement
The three parts – contain with which cash flow statement is prepared are;
- Cash flow from operating activities,
- Cash flow from investing activities, and
- Cash flow from financing activities.
The techniques of ascertaining missing figures of three parts of cash flow are discussed below;
Cash flow from operating activities
Cash flow from operating activities means inflow and outflow of cash through business activities. The inflow of cash mainly depends on sales and outflow of cash depends on the expenses of the business.
- Cash collection: Cash receipts or cash collection are related to cash flow from operating activities. Since cash collection is not directly mentioned in the problem it is ascertained through adjustment of various accounts. In this case, cash collection is determined to add opening receivables with net sales of the year and to subtract closing receivables therefrom.Besides, other incomes, if any are also added to it. For example, the sale of scraps, interest on investment etc.
- Cash payment: In this case, a total of various expenditure other than depreciation expense is added to the cost of goods sold to determine the total amount of cash payment.
- Increase-decrease of current assets and current liabilities: In this case, the difference between current assets and current liabilities of the current year and last year is accounted for. Adjusting the above mentioned three steps cash inflow or cash outflow from operating activities is determined.
Cash flow from investing activities
Cash inflow or cash outflow for a particular period is determined from inflow and outflow of fixed assets of a business concern. In this case generally, cash outflow is marked.
Cash flow from financing activities
Financing is made for carrying out the overall activities of a business.
The amount of inflow of cash from financing for a particular period or year is determined.
Cash inflow or cash outflow is determined to take into consideration the sale of new shares in the market, payment of dividend, taking a long-term loan, the redemption of bonds etc.
The net result of cash inflow and cash outflow for a particular period of a business can be known from the above-mentioned three steps.
Closing balance of cash is determined to add opening cash balance to net cash flow.
If the determined closing cash balance equals with closing cash balance as shown on the balance sheets it is assumed that cash flow statement is correct.