Three major financial statements are ordinarily required for external reports―an income statement, a balance sheet, and a statement of cash flows. The purpose of the statement of cash flow is to highlight the major activities that directly and indirectly impact cash flows and hence affect the overall cash balance. Managers focus on cash for a very good reason―without sufficient cash balance at the right time, a company may miss golden opportunities or may even fall into bankruptcy. The cash flow statement answers questions that cannot be answered by the income statement and a balance sheet. For example a statement of cash flows can be used to answer questions like where did the company get the cash to pay dividend of nearly $140 million in a year in which, according to income statement, it lost more than $1 billion? To answer such questions, familiarity with the statement of cash flows is required.
The statement of cash flows is a valuable analytical tool for managers as well as for investors and creditors, although managers tend to be more concerned with forecasted statements of cash flows that are prepared as a part of the budgeting process. The statement of cash flows can be used to answer crucial questions such as the following:
Is the company generating sufficient positive cash flows from its ongoing operations to remain viable?
Will the company be able to repay its debts?
Will the company be able to pay its usual dividends?
Why is there a difference between net income and net cash flow for the year?
To what extent will the company have to borrow money in order to make needed investments?
For the statement of cash flows to be useful to managers and others, it is important that companies employ a common definition of cash. It is also important that a statement be constructed using consistent guidelines for identifying activities that are sources of cash and uses of cash. The proper definition of cash and the guidelines to use in identifying sources are discussed in coming paragraphs.
Definition of Cash:
In preparing a statement of cash flows, the term cash is broadly defined to include both cash and cash equivalents. Cash equivalents consist of short term, highly liquid investments such as treasury bills, commercial paper, and money market funds that are made solely for the purpose of generating a return on temporary idle funds. Instead of simply holding cash, most companies invest their excess cash reserves in these types of interest bearing assets that can be easily converted into cash. These short term liquid investments are usually included in marketable securities on the balance sheet. Since such assets are equivalent to cash, they are included with cash in preparing a statement of cash flows
Sections of cash flow statement:
The cash flow statement is usually divided into three sections: Operating, investing and financing activities.
Operating activities involve the cash effects of transactions that enter into the determination of net income, such as cash receipts from sales of goods and services and cash payments to suppliers and employees for acquisition of inventory and expenses
Investing activities generally involve long term assets and include (a) making and collecting loans (b) acquiring and disposing of investments and productive long lived assets.
Financing activities involve liability and stock holder’s equity items and include obtaining cash from creditors and repaying the amounts borrowed and obtaining capital from owners and providing them with a return on, and a return of, their investment. Below is the typical classification of of cash receipts and payments according to operating, investing and financing activities.
Operating Activities: Cash inflows:
From sales of goods or services.
From return on loans (interest) and on equity securities. dividends Cash outflows:
To suppliers for inventories.
To employees for services.
To government for taxes.
To lenders for interest.
To others for expenses.
Income Statement Items
Investing Activities: Cash inflow:
From sale of property, plant and equipment.
From sale of debt or equity securities of other entities.
From collection of principles on loans to other entities. Cash Outflows:
To purchase property, plant and equipment.
To purchase debt or equity securities of other entities.
To make loans to other entities.
Generally Long Term Asset Items
Generally Long term Liability and Equity Items
Financing Activities: Cash inflows:
From sale of equity securities.
From issuance of debt ( bonds and notes ). Cash outflows:
To stock holders as dividends
To redeem long term debt or reacquire capital stock.
Some cash flow relating to investing or financing activities are classified as operating activities. For example, receipts of investment income ( interest and dividend ) and payment of interest to lenders are classified as operating activities. Conversely, some cash flows relating to operating activities are classified as investing or financing activities. For example, the cash received from the sale of property plant and equipment at a gain, although reported in the income statement, is classified as an investing activity, and effects of the related gain would not be included in net cash flow from operating activities. Likewise a gain or loss on the payment of debt would generally be part of the cash out flow related to the repayment of the amount borrowed, and therefore it is financing activity.
Format of the cash flow statement:
The three activities discussed in preceding paragraphs constitute the general format of the statement of cash flows. The cash flows from operating activities section always appears first, followed by the investing section and then financing activities section. The individual inflows and outflows from investing and financing activities are reported separately. That is, they are reported gross, not netted against one another. Thus, cash outflows from the purchasing of property is reported separately from the cash inflow the sale of property. Similarly, the cash inflow from the issuance of debt is reported separately from the cash outflow from its retirement. The net increase or decrease in cash reported during the period should reconcile the beginning and ending cash balances as reported in the comparative balance sheets.
The Skelton cash flow statement is presented as follows: This is also called cash flow statement pro forma.
Cash Flow Statement Format
Cash Flows From Operating Activities:
Net income Adjustment to reconcile net income to net cash provided by operating activities:
(List of individual items)Net cash flows from operating activities. Cash Flows From Investing Activities:
(List of individual inflows and outflows)
Net cash provided (used) by operating activities Cash Flows from Financing Activities:
(List of individual inflows and outflows)
Net cash provided (used) by financing activities
Net increase (decrease) in cash
Cash at beginning of period
Cash at the end of period
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