Cash flow statement: What is it and what is its purpose?
Amandeep Singh, 34, runs a flourishing electrical cable-manufacturing company in Noida. Singh’s employees—numbering around 300—are happy too. But the situation was very different last year. At the time, Singh was under fire from all quarters. He was struggling to pay off his staff on time. Yet, there was apparently nothing wrong with his business. Order booking was fine, and there were no backlogs. The income statement showed a net profit of Rs 30 crore net profit. Revenues had touched an all-time high of Rs 120 crore. What could have gone wrong? That is when it dawned on Singh. He was yet to receive payment from his two biggest clients.
This can be a classic example of how cash flow statements make a difference to a company. Singh only needed to check his company’s cash flow statements closely. Had he done so, he would not have faced such a situation. Balance sheets can throw up impressive sales and profit figures. These look good on paper. But there may not be any cash left in the company’s account. This is precisely what Singh faced.
Importance of cash flow statement
All businesses need to understand what is a cash flow statement.
A cash flow statement is a key accounting practice. It explains what a company is doing with its cash. Together with a balance sheet and an income statement, a cash flow statement forms the core of a company’s accounting practice. This needs close monitoring. Otherwise, a company or business may get bankrupt in no time.
A cash flow statement helps predict future cash flow. It helps businesses make informed decisions on budgetary allocations for the future. From the investor’s point of view, cash flow statements reflect a company’s financial health. They do so by indicating its cash availability. The more the cash, the better is the company’s health. From an investor’s point of view, it is wiser to invest in such companies.
Breaking down cash flow statement
Now that you understand the meaning of cash flow statement, consider its components. In the business world, a cash flow statement narrates the flow of cash. This could be moving in or out of the company. The cash flow statement is usually drawn up annually. It covers the flows of cash over a given period. There are three categories of cash flow:
· Operating: Create revenue, expenses, gains, and losses from the company’s core activities—whether products or services
· Investing: Relates to buying long-term assets like equipment or buildings
· Financing: Relates to long-term liabilities and owner’s equity, like payout of dividends to shareholders
Direct and indirect cash flows
You can prepare cash flow statements by either a direct or an indirect method.
Cash flow statement—indirect method: Almost all companies prepare the statement based on the indirect method. The two methods differ in how they report the company’s cash flow from its operations. Cash flows reported from financing and investing get the same treatment in both methods.
Cash flow statement—direct method: Here, the cash flowing in from the operating activities includes the amounts for lines such as ‘cash from customers’ and ‘cash paid to suppliers’. This is in contrast to the indirect method, which shows the net income. The direct method also factors in the adjustments needed to convert the total net income to cash.
While preparing the statement, the cash from operating activities is compared to the company’s net income. Suppose the cash from operating activities is greater than the net income. In this case, the company’s net income or earnings are of high quality. But it could be that the cash from operating activities is less than the net income. This raises questions about why the reported net income is not turning into cash.