Cash is a legal tender in hand or in a bank in the form of notes and coins. Negotiable instruments, prize bond, bank pay order, un-deposited check, postal order and bank draft are all considered cash. Cash equivalents are short-term, highly liquid and risk-free assets that can be easily converted into cash within three months and are capable of paying debts.
Stable cash flow is a key aspect of maintaining a healthy business. Managers must be aware of its importance and be effective in analyzing it for both short- and long-term benefits. A cash flow statement is the most important part of analyzing cash flows related to financing, operations, investments and profits. This helps in critical periods, so they’re prepared when making investments, taking loans, repaying debts and even reducing the workforce if it’s affecting the business. We have to understand that profits strengthen our ability to pay bills, suppliers and employees, but it’s no good if there’s zero cash on hand. Similarly, using profits to invest in other departments shouldn’t be seen as a loss. Smart investments can ensure increased profits but without cash, even a profitable business can perish.
Before we see what a statement of cash flows includes, we’ll have to clearly understand how cash flow differs from net profit. If an organization earns $1 million in revenue and records $600,000 in expenses, then the net profit will be $400,000. But businesses don’t run just on numbers. What if it collects only $800,000 from revenue and pays $500,000 for expenses, forwarding the rest of the payments and collections to next year? The organization that made a profit of $400,000 will actually have a net cash inflow of only $300,000.
Consider Amazon as an example. They recorded a loss of $124 billion in the same year when their investing activities generated a cash outflow of $262 billion and financing raised $214 billion. Investors were particularly intrigued because Amazon even raised $31 billion in cash from their operating activities. With $20 billion increase in inventory and $78 billion in accounts payable, Amazon built a strong image of a growing organization. Amazon’s 2018 statement of cash flows includes records of acquired businesses and fixed assets that were purchased for nearly $50 billion. Amazon was bound to see an increase in its net income, cash flows and profits in the future.
What Is A Cash Flow Statement?
Financial statements offer analysts and investors a clear picture of all transactions of a business and which transactions contribute to its success. Cash flow statement is a financial statement that records all the cash and cash equivalents entering and leaving an organization. It’s generated during a predetermined and specific period of time and differs from an income statement as it records the actual cash instead of that in theory. For example, an income statement can record the depreciating value of an asset as a loss but the net cash on hand will remain unaffected if it’s already paid for.
It’s considered an intuitive financial statement that shows how effectively an organization has managed its cash positions by following cash from investment, operations and financing—the sum of these three is the net cash flow.
An organization may sell products by extending credit to its customers and still show those sales as revenue. Even though they record profits, they’ll have less cash. Managers, analysts and investors should know how to effectively evaluate changes to working capital, as businesses can boost their cash flow before reporting. By understanding the three components that a statement of cash flows includes, they can effectively analyze positive and negative cash flows in a business.
Cash Flow From Operations
The first section of a cash flow statement includes operational business activity transactions and primarily decides if a business can be financially viable long-term. It considers the cash involved directly with the production and sale of goods. It shows whether an organization can pay for operating expenses or not by analyzing the incoming funds. It reports cash inflows and outflows that happen directly due to an organization’s main business activities. These activities include inventory and supply transactions, employee salaries and bills. These operational costs are subtracted from the net income of the organization to calculate the positive or negative flow of cash. That’s why it’s considered the net income of a business in cash. Accounts payable, amortization and depreciation are also considered while calculating cash flow from operations.
Cash Flow From Financing
Cash flow from financing represents the financial strength of an organization and reveals how effectively its capital structure is managed. It gives an overview of the cash involved in business financing that’s annually reported to the shareholders. It shows how the cash involved in funding for debts, equity and dividends moves between owners, investors and creditors. By analyzing the flow of cash in this section, we can determine what an organization has paid via share buybacks and dividends. It’s also helpful when determining how an organization funds its operational growth. This section lists the cash paid back or obtained from capital fundraising and also the loans paid back or taken out. Positive cash flows in financing activities mean there’s more money coming in than going out from an organization. Negative figures usually mean debt payments, dividend payments or stock buybacks.
Cash Flow From Investing
Cash flow from investing is fundamental even if it’s negative and a result of gains and losses from investment. The cash that goes toward the long-term health of a business is accounted for. Cash spent on research and development, plant, property and equipment falls in this section, as analysts look for changes in capital expenditure. Increasing capital expenditure indicates reduced cash flow but that may not necessarily be a bad thing. Negative flow of cash can mean that a business is making strategic investments for future operations. Usually, growing organizations display higher capital expenditure. Although positive cash flows in investing activities may seem good, investors usually prefer organizations that invest for improvement and innovation while aiming to generate cash from operations. However, in times of crisis, businesses generate cash in this section by selling property or equipment.
Shareholders and investors of an organization will want to get as much cash out of their investments as possible. Therefore, information about an organization’s payables and receivables are of key importance. Cash flow statement is an effective way of collecting vital information about the movement of money in and out of a business. Although it can be done annually, organizations analyze their cash flows more frequently to show investors how healthy their businesses are and have a clear financial picture for framing strategies.
Objectives Of Cash Flow Statement
Let’s look at the main objectives of cash flow statement:
- A cash flow statement must provide vital information on an organization’s solvency and liquidity when it comes to changing cash flow in the future
- It must offer information to evaluate changes in equity, liabilities and assets
- It must eliminate all effects of different methods of accounting and improve comparability of the operating performances of different firms
- Cash flow statement should indicate the probability, timing and amount of future flow of cash
- It should aid in the short-term planning of financial activities
- It should facilitate cash management efficiently
- It must help in formulating cash budgets and sound business policies
- It should assess net changes in cash and cash equivalents
The aim of a cash flow statement is the effective evaluation and management of operating, investing and financing activities.
Purpose Of Cash Flow Statement
Let’s look at the purpose of cash flow statement:
- Cash flow statement helps in identifying the sources of cash inflow and whether or not it’s utilized within a specific period of time
- It’s significant for proper planning and management of cash and maintaining a balance between cash inflow and outflow
- Investors get to easily spot the efficiency, or the lack of it, with which a business generates its cash flow
- Appraisal of capital investment programs is done with the help of a cash flow statement, which determines their viability and profitability
- It enables assessment of net assets and other financial reports
- It’s essential for stabilizing and optimizing an organization’s cash flow
- It determines the overall health of a business and allows investors, creditors and shareholders to determine its financial reliability and efficiency to pay for operational expenses
Cash flow statement is a tool to provide information that can help businesses assess their cash position and either develop strategies to improve it or use it to strengthen their market positions.
Cash flow analysis is an important aspect of business management as low cash can become a recurring problem. Cash flow statements are great in achieving transparency within an organization to optimally manage finances and reassure investors about their reliability. Harappa Education’s Creating Solutions program is a course that teaches the art of analyzing such problems. It teaches how to explore perspectives with an open mind while solving problems. Get to the source of a problem using root cause analysis (RCA) while you use logic and data to understand its various aspects. Get accustomed with the AQR framework to evaluate data before analysis, the synthesis technique to draw actionable insights and the S-O-R model to communicate solutions effectively. Get certified and build a successful career!
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