If you want to be a good business manager then you need to learn how to manage your finances/ your cash both cash-inflows and outflows.

Cash refers to a compromise available and demand deposits. That is cash on hand including overdrafts and on demand deposits. Overdrafts are negative elements in cash and cash equivalents. Cash equivalents are defined as short term, highly liquid investments including money market accounts, commercial paper and government bonds that are readily convertible into known amounts of cash and is subject to insignificant risk of changes in value.

Cash flows are inflows and outflows of cash and cash equivalents. A company maintains cash equivalent in order to earn interest on cash that would otherwise temporarily lie idle. Positive cash flow shows that an organization is putting more to its cash reserves, giving it a chance to plough back in the company, pay out money to shareholders or settle future debt payments.

Cash equivalents should not be confused with current investments or marketable securities which are not combined with cash account on the statement of cash flows. Purchases of market securities are treated as cash outflows and sales of marketable securities are treated as cash inflows on the cash flow statement.

The statement of cash flow is a financial statement that summarizes the amount of cash and cash equivalents entering and leaving a company. The cash flow statement measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses. The cash flow statement complements the balance sheet and income statement and is a mandatory part of a company’s financial reports.

The purpose of statement of cash flow is to provide information about cash flows that is useful in providing users of financial statements with a basis to assess the ability of the enterprise to generate cash and cash equivalents, the needs of the enterprise to generate cash and cash equivalents as well as the needs of the enterprise to utilize those cash flows.

Cash flows have both internal and external uses to managers and investors plus lenders respectively; internally, management uses the statement to assess the liquidity of the business to determine dividend policy and to evaluate the effects of major policy decisions involving investments and financing.

Management may use the statement if short term financing is needed to pay current liabilities to decide whether to raise or lower dividends and to plan for investing and financing needs.

Investors and lenders will find the statement useful in assessing the company’s ability to manage cash flows, to generate positive future cash flows to pay its liabilities, to pay dividends and interest and to anticipate its need for additional financing. Additionally they may use the statement to explain the differences between net profit on the income and the net cash flows generated from operations. The statement shows both the cash and non cash effects of investing and financing activities during the accounting period.

Elements of the statement of cash flow

Cash flows from operating activities are in general the cash effects of transactions and other events relating to operating or trading activities. Net cash flows from operating activities represent the increase or decrease in cash resulting from the operations shown in the income statement in arriving at profit from operations. The section of the cash flow statement is reconciliation between profit before tax and cash generated from operations.

The first set of adjustments down to operating profit before working capital changes includes adjustments from any transactions not involving the movement of cash for example depreciation or profits / loss on disposal of fixed assets. Additionally finance cost and investment income, items that disclosed elsewhere in the cash flow statement are added back and subtracted respectively. These adjustments are with the figures as they appear in the income statement. Interest paid is normally shown as part of operating activities. Dividends paid may be shown as part of either financing or operating activities. Cash flows arising from taxes on income should be separately disclosed as part of operating activities.

Cash flows from Investing activities.

Cash flow to appear under investing activities includes:

  • Cash paid for property, plant and equipment and other non-current assets.
  • Cash received on the sale of property, plant and equipment and other non-current assets.
  • Cash paid for investment in or loan to other enterprises.
  • Cash received for the sale of investment or the repayment of loan to other enterprises.
  • Interest received on investment or loan.
  • Dividends received on investment.

Financing activities

Financing cash flow comprises of receipts or repayment of principal from or to external providers of finance.

Financing cash inflows include:

  • Receipts from issuing shares or other equity instruments
  • Receipts from issuing debentures, loans, notes and bonds and from other long term and short-term liabilities (other than overdraft, which is normally included in cash and cash equivalent).

Finance cash outflows include:

  • Repayment of amount borrowed (other than overdraft)
  • The capital elements of finance lease rental payments
  • Payment to reacquire or redeem the entity’s shares

The objective of the standard headings is to ensure that cash flows are reported in a form that highlights the significant components of cash flow and facilitates comparison of the cash flow performances of different business. Each cash flow should be classified according to the substance of the transaction that gives rise to it. The substance of the transaction determines the appropriate standard heading under which to report cash flows that are not specified in the standard categories.

Methods of Preparing cash flow statements

There are two methods used in preparation of cash flow statements that is;

Direct and Indirect methods

In principle, there are two main ways of calculating the first items in cash flow statement (net cash flow from operating activities).

The indirect method begins with operating profit from the income statement and adjusts this figure for non-cash items and for increase and decrease in working capital. We have already seen this method in the format given.

The direct method uses the actual trading cash flow to arrive at operating profit. These cash flows-cash actually received from customers, cash actually paid to suppliers or any other can be derive by inspecting the company’s detailed books of account, but cannot usually be found from inspections of the income statement and balance sheet.

Benefits of cash flow statement /cash flow analysis

1. cash flow statement is useful for short terms planning. A business needs sufficient cash to meet its various obligations in the near future. Such as payment of purchase of fixed asset, payment of debts maturing the near future, expenses of the business.

2. Helps in efficient cash management, cash flow analysis  helps in evaluating financial policies and cash proportion cash is the basis for all operating and hence a projected cash flow statement will enable management to plan for and coordinate the financial operations properly that is know the sources and application of cash.

3.Helps in internal financial management; cash flow provides information about funds which will be available from operation. This will help the management in determining policies, regarding internal financial management for example possibility of repayment of long-term debts, dividend policies planning, replacement of plant and machinery.

4.Disclose the movement of cash flow; cash flow statement discloses the complete story of cash movement; the increase in or decrease of cash and the reason therefore can be known. It discloses the reasons for low cash balances in-spite of heavy profits. However comparison of original forecast with the actual results highlights the trend of movement of cash which may otherwise go undetected.

5.Cash flow cannot be easily manipulated for example by judgments of managers/ accounting policies.

6.A statement of cash flows enhances the understanding of liquidity and viability other than basing on the statement of financial position alone.

7.Historical cash flow information is useful to analysts assessing future cash flows.

8.The statement of cash flow gives an indication of the relationship between profitability and cash-generating potential/ability, and thus of the quality of profit earned.

9.The statement of cash flows may assists users of financial statement in making judgments on the amount, timing and the degree of certainty of future cash flows.

Limitations of cash flow analysis   

1.Cash flow statement cannot be equated with the income statement. An income statement takes into account both cash as well as non-cash items and therefore net cash flow does not necessarily mean net income of the business.

2.Cash flow statement cannot replace the income statement. Each of them has a separate function to perform.

3.The cash balance disclosed by the cash flow statement may not represent the real liquid of the business since it can easily be influenced by postponing purchases and other payments for example delaying payment suppliers till after year end, assets sold and purchased.

4.The cash flow statement is based on historical data and hence it is not good indicator of the future.

5.Cash flow is necessary for survival in the short term but in order to survive in the long term, a business must be profitable. It is often necessary to sacrifice cash flow in the short term in order to generate profits in the long run for example invest in fixed assets. A huge cash balance is not a sign of good management if cash can be invested to generate profits.

Interpretation of cash flow data  

Estimating future cash flows is very important in determining the solvency or otherwise of the business. The financial accounts are of course, the historical records but they can provide some evidence of solvency. Interpreting the cash flow statement should be reviewed first and here are some of the things you should watch out for.

Cash generation from trading operations

There should be compared to the operating profit. The reconciliation note to the cash flow statement is useful in this regard. Over trading may be indicated by high profits and low cash generation, large increase in inventory, receivables and payables.

Dividend and interest payout

These can be compared to the cash generated from trading operations to see whether the normal operations can sustain such payments.

Capital expenditure and financial investment

The nature and scale of a company’s investment in fixed assets is clearly shown.

Management of liquid resources and financing

The sub total inflow and outflow before use of liquid resources and financing indicates the financing required unless the existing cash is available. The changes in financing are clearly shown. There may be a note to the cash flow statement which links and outflows/inflows with the balance sheet movement, there may be a significant non-cash flow changes in the capital structure of the business.

In conclusion, cash flow statement handles the cash that goes out of the business band cash that comes into the business and all other aspects that rotate around as laid down in the previous discussion above.

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