What is a Cash Flow Statement?
An Overview of Cash Flow Statement
Also referred to as the statement of cash flows, the cash flow statement is a financial statement which is maintained by an organisation to keep track of the cash which is generated and utilized by the business for a particular financial period. Unlike the other financial statements that are prepared using the accrual basis of accounting, this financial statement is prepared using the cash basis of accounting. This statement summarises the inflows and outflows of cash from three main activities that are operating activities, investing activities and financing activities. This statement sums the net cash flows under each of the above activities to determine the total net change in cash during the financial period which is adjusted against the opening balance of cash to determine the closing balance of cash (O’Hare 2016).
Similar to other financial statements, this financial statement is also prepared to provide useful financial information to the internal and external users of accounting information. The main purpose of preparing this financial statement is to determine the actual cash position of the business by getting to know the changes in the company’s cash and cash equivalents balance over time. The cash flow statement when used in conjunction with the other financial statements can help the users of accounting information in the following:
- The statement can help to gauge the financial structure of the business which includes gaining an insight into the liquidity and solvency position.
- The cash flow statement can help in assessing the ability of the organisation to generate and predict cash flows over the future period of time.
- It allows for checking the accuracy of all the past assessments of the future cash flows of an organisation.
- The financial statement also allows for examining the relationship in between the profitability of the company and its net cash flows. It is highly possible for a business to be profitable but not generate sufficient cash flows or vice versa. A profitable business may also tend to run out on funds that can affect the efficiency of operations going all the way to affect the going concern of the company.
- The statement can also allow for assessing the changes in the net assets of the company.
- It also allows for evaluating the ability of an organisation to adapt to any changing opportunities and circumstances.
- The statement can be used by potential investors to understand about the historical cash flows of the organisation for future cash flow projections to help base their investment decisions (Atrill and McLaney 2018).
(1) Cash flow from operating activities:
It is best explained as any cash flows arising as a result of the principal revenue generating activities of the business and all other activities that are not investing and financing activities by nature. The results of all the operating activities of the business are typically reflected in the income statement and the statement of other comprehensive income which does not represent the actual cash flows for these are prepared using the accrual accounting basis. Some noteworthy examples of operating activities include the likes of cash receipts from selling of goods/services, cash payments made to suppliers, payment of operating expenses in cash etc. Since the income statement is adjusted for non-cash expenses such as depreciation, amortisation, bad debts etc these do not form a part of the cash flow statement or is adjusted against net income (indirect method) to compute the net operating cash flows. This aspect of cash flows is very important and a positive & constant stream of operating cash flows is indicative of the ability of the business to exist as a going concern (McLaney and Atrill 2020).
(2) Cash flow from investing activities:
These are best explained as those set of activities that relate to acquisitions or disposals of long-term assets and other investments which do not form a part of cash equivalents. Some of the examples forming a part of such activities include purchase of ppe, sale of ppe, cash flows arising from advances made to organisations, purchasing/selling of investments etc. These set of activities are important for an organisation to help allocate cash for the long term in order to grow or expand in the future (Franklin, Grayvbeal and Cooper 2019).
(2) Cash flow from financing activities:
These set of activities result in cash flows which affects the size and composition of the debt and equity position of the organisation (Warren, Reeve and Duchac 2016). It helps investors to analyse the frequency and the dependency an organisation tends to place upon raising capital from different sources of debt and equity alongside the rate at which these are redeemed or returned. Some noteworthy examples of such activities include the likes of issue of shares, share repurchases, payment of cash dividends, issue & redemption of debts etc.
Purpose of Cash Flow Statement
Overview of Investment Appraisal and Techniques
The primary objective of any organisation should from a financial standpoint is to maximise the wealth of its shareholders by creating or enhancing the value provided to them. One of the ways in which value is provided is by undertaking long term capital investments which requires the finance manager to undertake investing decisions. Investment decisions are concerned with optimal utilisation of resources for undertaking long term investments that generates value to the organisation and in turn to its shareholders (Martin, Keown and Titman 2020). Any finance manager before investing is require to judge the financial and non-financial feasibility of the investment. The financial feasibility of the investment is gauged with the help of investment appraisal methods which are further classified into traditional non-discounting techniques and modern discounting techniques. The payback and accounting rate of return are traditional methods of investment appraisal which are non-discounting methods. These are further discussed as follows:
Introduction, Advantages and Disadvantages of Payback Method
The payback period is considered as the point of break even of an investment opportunity and refers to the total time within which the organisation can expect to recover the initial cash outlays associated with the investment. Some of the main advantages of using this method to base investment decisions have been outlined as follows:
- This method is very simple to understand and even easier to calculate.
- The total length of the payback serves as a vague estimate concerning the risk which is involved in the investment. A project with a higher payback will have more amount of risk involved when compared to a project with a shorter payback.
- Since it provides for the best estimate concerning the recouping of cash invested, it is a technique relied by organisations that are having liquidity issues and cash flow constraints as these organisations would want to gauge how quickly can funds be recovered (Block, Hirt and Danielsen 2018).
Although there are some benefits of the payback method, there are several demerits of the method as well for which this method cannot be solely relied upon for basing investment decisions. These are mentioned as follows:
- The method ignores the time value principle for it does not discount cash flows to their present values for a more realistic analysis.
- This method will only place emphasis on short term investments and ignores the future prospects of long-term projects.
- It does not necessarily measure how profitable an investment is for investment purpose. Furthermore, it also ignores all cash flows which are generated beyond the calculated payback period.
- Lastly, the method does not necessarily quantify the value in absolute terms which the investment will bring in for maximising the wealth of the shareholders (Brigham and Ehrhardt 2019).
Introduction, advantages and disadvantages of accounting rate of return method
This technique (abbreviated as ARR) also goes by many different names such as the simple rate of return, the average rate of return or the return on capital employed method. In a nutshell, this method computes the average net profit which the investment will generate over the useful life of the investment. Some of the advantages of this method have been outlined as follows:
- This method makes use of data which is readily available from financial reports thus requiring no efforts for data collection.
- This method is again very simple to comprehend and easier to make decisions with based on understandability.
- This method will quantify the operating results of the investment and provides the profitability of the investment.
There are however several different limitations of the method as well which have been discussed as follows:
- Similar to the payback technique, this method does not discount future values to present values.
- This method is highly dependent upon the accounting net income which is not considered a good measure when it comes to gauging investment performance when compared to cash flows as a metric (Brealey et al.2018).
- This method will not consider externalities that can hinder the profits to be generated from an investment.
Preferred investment appraisal method
The most preferred method of investment appraisal is the npv (net present value). This is because the method is a modern technique which depends upon cash flows and discounts future cash flows to present values for ascertaining the financial feasibility of the investment. The method is one of the most reliable indicators of the total absolute value which is provided in maximising the wealth of the shareholders (Vernimmen, Quiry and Fur 2022). It signifies the absolute returns of the opportunity which is calculated as the difference in between the present value of inflows and the present value of outflows which are linked to an investment.
It is best defined as any formal spending plan that balances the income, expenses and the financial objectives of the business for a specific time period. It is also referred to as a quantitative statement which is approved and prepared for a specific time frame defining the future projected plan of action for attaining any particular set of financial goals (Blocher et al. 2019). It therefore helps the management in acting as an instrument for planning, programming and controlling a set of business activities (Collis and Hussey 2017).
Importance of preparing budgets
Preparing of budgets which is also referred to as budgeting is quite important in an organisation primarily because of the following reasons that have been outlined as follows:
- Budgets help in communicating the plans of the management throughout the different departments in the organisation.
- Budgets allow the management to think and plan for the future. If there were not budgets in place, the departmental managers would waste most of their time dealing with day-to-day contingencies.
- Budgets allow the organisation to controlresources as these are allocated among different parts of the organisation in a way which promotes for effectiveness and efficiency.
- These tend to coordinate the activities in a particular organisation through appropriate integration of strategic plans. It therefore ensures that the entire organisation is pulling for the same direction that implies striving for attaining the common overall goals of the organisation.
- It helps define a particular set of objectives which can serve as benchmarks for the purpose of subsequent performance evaluations (Brewer, Garrison and Noreen 2015).
Over the recent years, several limitations and criticism of budgets especially traditional budgets have garnered quite an attention. This has further led and amplified to abandon the preparation of traditional budgets and move ‘beyond budgeting’. Some of the noteworthy limitations of budgets have been outlined as follows:
- These encourage rigid planning and an incremental thinking as these are prepared upon the basis of previous year activities with minor adjustments to be made for the present year.
- For certain organisations, preparation of budgets is quite a time-consuming process for which the costs may not necessarily justify the benefits to be derived.
- Budgets tend to focus more upon short term results and ignores important drivers which results in value creation for the shareholders.
- The rigidity affects the much-needed flexibility which is pre-requisite in modern times that is very competitive and uncertain at the same time. It also tends to be conflicting with innovation and growth.
- It also promotes for unnecessary spends as managers will be inclined to spend any amount of savings to guard the next year’s budget reduction (Drury 2018).
References
Atrill, P. and McLaney, E., 2018. Accounting and Finance for Non-Specialists 11th Edition. Pearson Education, Limited.
Blocher, E.J., Stout, D.E., Juras, P.E. and Smith, S., 2019. Cost Management (A Strategic Emphasis) 8e. McGraw-Hill Education.
Block, S.B., Hirt, G.A. and Danielsen, B.R., 2018. Foundations of financial management. McGraw-Hill Education.
Brealey, R.A., Myers, S.C., Allen, F. and Mohanty, P., 2018. Principles of corporate finance, 12/e (Vol. 12). McGraw-Hill Education.
Brewer, P.C., Garrison, R.H. and Noreen, E.W., 2015. Introduction to managerial accounting. McGraw-Hill Education.
Brigham, E.F. and Ehrhardt, M.C., 2019. Financial management: Theory & practice. Cengage Learning.
Collis, J. and Hussey, R., 2017. Cost and management accounting. Macmillan International Higher Education.
Drury, C., 2018. Cost and management accounting. Cengage Learning.
Franklin, M., Grayvbeal, P. and Cooper, D., 2019. Principles of Accounting, Volume 1: Financial Accounting.
Martin, J.D., Keown, A.J. and Titman, S., 2020. Financial management: principles and applications. Prentice Hall.
McLaney, E. and Atrill, P., 2020. Accounting and Finance. Pearson Education, Limited.
O’Hare, J., 2016. Analysing financial statements for non-specialists. Routledge.
Vernimmen, P., Quiry, P. and Le Fur, Y., 2022. Corporate finance: theory and practice. John Wiley & Sons.
Warren, C.S., Reeve, J.M. and Duchac, J., 2016. Financial & managerial accounting. Cengage Learning.
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