What is a Cash Flow Statement?
The movement of cash & cash equivalents or inflow and outflow of cash is known as Cash Flow. Cash inflows are the transactions that result in an increase in cash & cash equivalents; whereas, cash outflows are the transactions that result in a reduction in cash & cash equivalents. Hence, a statement showing flows of cash & cash equivalent during a specified time period is known as a Cash Flow Statement. Simply put, a cash flow statement is a summary of different sources and applications of cash during a specific time period and analyses the reasons behind changes in cash balance between the two balance sheet dates. (Here, ‘cash’ means cash & cash equivalent) Hence, one can prepare a cash flow statement if the two comparative balance sheets of a company are given. A cash flow statement includes only those items which affect cash. This is the reason why a cash flow statement is also known as Statement of Changes in Financial Position – Cash Basis, or a Funds Flow Statement – Cash Basis.
A cash flow statement can be prepared for the past or can project the future. The transactions of a cash flow statement are categorised into three activities; namely, Cash flow from Operating Activities, Cash flow from Investing Activities, and Cash flow from Financing Activities. The Institute of Chartered Accountants in India has issued Accounting Standard AS – 3 revised for the preparation of cash flow statements. Besides, with the introduction of the Companies Act 2013, the preparation of a Cash Flow Statement is now mandatory for every type of company except OPC (One Person Company) [Section 2(40)].
Objectives of Cash Flow Statement
The main objectives of preparing a cash flow statement are as follows:
1. Useful for Short-term Financial Planning:
A cash flow statement helps an organisation by providing it with information for planning its short-term financial needs. As this statement provides information regarding the different sources and applications of cash during a specific time period, it makes the assessment of a firm’s financial position easier and the organisation can know whether or not it will have sufficient cash to meet its day-to-day expenses and pay the trade payables in time, whether or not it has enough cash for payment for the purchase of fixed assets, and whether or not it will have enough cash with it to pay the long-term loans and interests thereon.
2. Useful in Preparing the Cash Budget:
An organisation can also use a cash flow statement prepared for the future, for the preparation of its cash budget. The management with the help of a cash flow statement can know about the surplus or deficit period of cash; i.e., in which months the cash receipts will be more than cash payments and in which months the cash payments will be more than cash receipts. Thus, it helps in planning the investment of surplus cash in different short-term investments and also helps in planning short-term credit in advance for deficit periods.
3. Comparison with the Cash Budget:
A cash budget is prepared at the beginning of the year; however, a cash flow statement is prepared at the end of the year. By making a comparison between the cash budget and cash flow statement, an organisation can ascertain the extent to which its financial resources have been generated and used according to the plan made in cash budget. With comparison. an organisation can analyze the causes of variation between the figures of these two statements and can take proper corrective measures.
4. Study of the Trend of Cash Receipts and Payments:
A cash flow statement reveals the speed at which the current liabilities are being paid and cash is being generated from inventory, trade receivables, and other current assets by the company. By doing so, the management of the company can easily assess its true position of cash in future.
5. Explains the Deviations of Cash from Earnings:
It is quite possible that a firm is earning huge profits, yet it lacks cash. Similarly, it is also possible that a firm is suffering losses, yet it has plenty of cash with it. A cash flow statement helps the user in understanding the reason behind it by describing the deviation of its cash from earnings.
6. Helpful in Ascertaining Cash Flow from Various Activities Separately:
A cash flow statement separately highlights the Cash flow from operating, investing, and financing activities. It does so by indicating how much cash has been generated or used in these activities.
7. Useful to Outsiders:
A cash flow statement not only helps the organisation(insiders), but also the outsiders such as bankers, shareholders, lenders, creditors, etc. The outsiders can easily analyze the financial position of the organisation and can take proper decisions on the basis of the analysis.
8. Helpful in Making Dividend Decisions:
An organisation has to deposit the amount of the dividend in a separate Dividend Bank A/c within 5 days of its declaration. The management can thus, take the help of the cash flow statement in ascertaining the position of the cash generated from its operating activities which can ultimately be used for paying dividends.
9. Test for the Managerial Decisions:
There is a general rule for the purchase of fixed assets, which is, they should be purchased from the funds raised by the company from its long-term sources, like issue of debentures, issue of shares, long-term loans, etc., and these sources should be repaid out of the cash generated from the firm’s operating activities. The cash flow statement of an organisation shows whether or not this policy/rule has been followed by the management.
Importance of Cash Flow Statement
A cash flow statement is of great importance to Financial Management as it is an essential tool of financial analysis for short-term planning. The basic advantages of a cash flow statement are as follows:
1. As a cash flow statement is based on cash basis of accounting, it helps in the evaluation of the cash position of an organisation.
2. It provides information about all the activities of an organisation classified as operating, investing, and financing activities.
3. A cash flow statement prepared according to AS-3 (Revised) is more useful and suitable for an organisation than a fund flow statement. It is because there is no standard format for a fund flow statement that can represent a better picture of the firm’s position.
4. A cash flow statement also helps in planning the repayment of loans, replacement of fixed assets, and other related long-term planning of cash. Besides, it is also significant for capital budgeting decisions.
5. Sometimes a firm is in a poor cash position in spite of having substantial profits. A cash flow statement helps in determining the reason behind the same by throwing light on different uses of cash generated by the firm.
6. If a firm wants to analyse its short-term financial position, cash flow analysis is more useful instead of a fund flow analysis. It is because, in a short period, cash is more relevant for the firm than the working capital to forecast its ability to meet its immediate obligations.
7. A firm can also prepare a projected cash flow statement and can know how much cash will be generated into the firm and how much cash will it need to make payments. In the end, the firm can plan well for the arrangement for its future cash requirements.
8. An organisation can also make a comparison between historical and projected cash flow statements and can hence find the variations and deficiencies in its performance. It ultimately helps the firm in taking immediate and effective actions.
9. With the help of inter-firm and intra-firm cash flow statements, a firm can also get to know about its liquidity position; i.e., whether its liquidity position is improving or deteriorating over a period of time. It can also compare its liquidity with other organisations over a period of time.
Limitations of Cash Flow Statement
1. Not Suitable for Judging the Liquidity:
The liquidity of an organisation does not only depend on the cash alone; hence, a cash flow statement does not represent a true picture of an organisation’s liquidity. A firm’s liquidity also depends upon the assets which can be converted into cash easily which are excluded in a cash flow statement, obstructing the true picture of a firm’s ability to meet its liabilities when they become due for payment.
2. Possibility of Window Dressing:
Window Dressing means showing a false and better picture of an organisation by manipulating its statements. The possibility of window dressing of cash in cash flow statement is much higher as an organisation can easily manipulate its statements by postponing purchases and payments, and by quickly collecting cash from its trade receivables before the balance sheet date. Therefore, a fund flow statement presents a more realistic picture of a firm than a cash flow statement.
3. Ignores Non-cash Transactions:
All the non-cash transactions like issue of bonus shares, purchase of fixed assets by issue of debentures or shares, etc., are ignored under a cash flow statement. Therefore, a firm’s true position cannot be judged by a cash flow statement.
4. Ignores the Accrual Concept of Accounting:
As a cash flow statement is prepared on a cash basis, it ignores one of the basic concepts of accounting; i.e., the accrual concept. Accrual Basis of Accounting is a system where the transactions are recorded whenever they occur, no matter if actual cash is received or not in the case of income or actual cash is paid or not in the case of payment.
5. No Substitute for an Income Statement:
Just like Income Statement, a cash flow statement does not take both cash and non-cash transactions into account, it is not a substitute for an income statement. It also means that net cash flow does not mean the net income of the business.
6. Historical in Nature:
The information revealed by a cash flow statement is historical in nature, as, it is prepared with the help of two comparative balance sheets of the past years. Hence, a cash flow statement can provide useful information if it is accompanied by a projected cash flow statement.
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