Primary objective of cash flow statement is to help management in taking decision and making plan by providing present information of 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 are 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 clearly 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 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 investment and financial activities of a concern for a particular period. It also fulfills the following objectives;
- Ensuring future positive cash flow of a particular concern.
- Ensuring capacity of an organization to pay dividend.
- Identifying non-cash items ensuring cash income and expenses of a concern.
- Comparing various items of 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.
(1) Cash flow from operating activities.
(2) Cash flow from investing activities.
(3) 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 own characteristics.
The use of cash flow statement in the form of cash and cash equivalent as current asset and its direct influence over 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 financial position, trend and business activities of business concern respectively. The main advantages arising out of 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 on the basis of which management can take multipurpose decisions.
- Cash flow statement prepared on the basis of historical information helps in determining future cash flow of the company.
- Primarily prepared cash flow statement can be compared to the cash flow statement prepared considering present rise and fall of price.
- Three-part cash flow statement presents the true financial picture of a concern.
Cash and Cash Equivalent
According to section 6 of International Accounting Standard – 7 cash means cash in hand and cash at the bank.
Generally, cash in hand means cash in notes and coins which are kept in 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 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 in terms of 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 cash flow statement is prepared on the basis of cash record, it is very important in the evaluation of 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 though 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, cash flow statement is also prepared along with financial statements. The importance and necessity of cash flow statement are stated below;
- Evaluation of cash position: Since cash flow statement is prepared on the basis of cash records, it is very much useful in evaluating cash position of a business concern. Expected amount of cash helps the management in taking decision for short-term investment.
Contrarily, if 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: On the basis of various information a probable cash flow statement is prepared so that a clear idea regarding future cash position can be achieved for making 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 in different heads.
- Correction of decision: Comparison is made between historical cash flow statement and projected cash flow statement. If any deviation is marked, the management can take corrective measures.
- Picture of liquidity position: Every business organization should posses 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 in degrees can be known.
- Framing long term-planning: In case of investment and financing both cash quantity and time are very important 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 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 has been sold, if sold how that cash has been utilized etc.
- More important than fund flow statement: In case of short-term investment since cash is more important than working capital, cash flow statement is more important than fund flow statement for short-term financial analysis.
- Useful to outside interested 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 a concern before making any transaction.
They also like to be aware of profit earning capacity of the concern. Cash flow statement helps in both cases. Bank and tax authority also depend very much on cash flow statement.
Limitations of cash flow statement
Although cash flow statement is an important element of cash management, it has got some limitations.
The limitations of cash flow statement are discussed below:
- 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 prevails great differences of opinion in this matter. Generally 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 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.