Cash Flow Statement: Meaning, Importance and Preparation

After reading this article you will learn about Cash Flow Statement:- 1. Meaning of Cash Flow Analysis 2. Importance of Cash Flow Statement3. Limitations 4. How to Prepare?.

Meaning of Cash Flow Statement:

A Cash Flow Statement is a statement which is prepared by acquiring Cash from different sources and the application of the same for different payments throughout the year. It is prepared from analysis of cash transactions or it converts the financial transactions prepared under accrual basis to cash basis.

The information about the amount of resources provided by operational activities or net income after the adjustment of certain other charges (including depreciation) can also be obtained from it. The changes in Cash both at the beginning and at the end can also be known with the help of this statement and that is why it is called Cash Flow Statement.

The sources of cash should also be analysed. That is, how much has been received from what sources?

Sources of cash are of two types; viz:

(i) Sources from operation;

(ii) Cash from the other sources.

The first one indicates the amount that is derived from the normal course of business through buying and selling transactions (this constitutes the major bulk). The second one is: Issue of Shares and Debentures, Long-term and Short-term Loans, Selling of fixed assets etc.

On the other hand, the application of Cash is also to be analysed, i.e., how much is to be paid for what purposes, viz., the amount on account of repayment of Long-term and Short-term loans, acquisition of fixed assets, payment for tax and dividend, losses arising from normal operational activities etc.

In short, Cash Flow Statement tells us the story about the different forms of inflow of Cash and the outflow of the same for its different activities.

Differences between Cash Book and Cash Flow Statement:

Generally, ‘Cash Flow Statement’ may be assumed to be a summarized form of Cash Book. But they are not identical in all respects although they have some similar character­istics.

The points of difference are:

(a) Cash Flow Statement presents the amount of cash flow from operation with careful study and interpretation which is not done in the case of a Cash Book.

(b) There are items which do not appear in Cash Book but the same are to be recorded in Cash Flow Statement, such as, amount written off against Goodwill or Prelimi­nary expenses, depreciation etc., as they are not directly involved in any cash payment. Items for which no payment is made, but which incur losses, are to be shown in Cash Flow Statement also.

(c) Cash Flow Statement is prepared after analysing and re-investigating the items appearing in the Financial Statement, i.e., in Profit and Loss Account and the Balance Sheet. But Cash Book reveals only the continuous day-to-day monetary transactions.

Differences between Cash Flow Statement and Funds Flow Statement:

There are no major differences between a Cash Flow Statement and a Fund Plow Statement.

But the following points of difference may be noted:

(a) In the case of a Cash Flow Statement how much of the opening cash and bank balances is to be changed at closing cash and bank balances due to normal operational activities of the business throughout the year, can be known.

But a Fund Flow Statement reveals the consolidated result of changes of current assets and current liabilities without, however, giving any particular importance to change of cash only. In short, the former deals with changes of cash position whereas the latter with the changes of the working capital position.

(b) Cash Flow Statement deals with the actual amount of cash receipts of income and payment of expenses, i.e., cash basis of accounting. On the other hand, Fund Flow Statement deals with those adjustments which are involved in making adjusted trading profit (from Profit and Loss Account) i.e., accrual basis of accounting.

(c) Cash Flow Statement is prepared by taking the opening balance of Cash and Bank and closes with the closing balance of Cash and Bank. This is not followed in preparing Fund Flow Statement.

Importance of Cash Flow Statement:

Needless to say that Cash Flow Statement is particularly useful in short-term planning. In order to meet the various obligations, a firm needs sufficient amount of cash (e.g., payment for expenses, purchase of fixed assets, payments for dividend and taxes etc.). It helps the financial manager to make a cash flow projection for immediate future taking the data relating to cash from the past records.

As such, it becomes easy for him to know the cash position which may either result in a surplus or a deficit one. However, Cash Flow Statement is an important financial tool for the management to make an estimate relating to cash for the near future.

The importance of Cash Flow Statement is presented below:

(a) Helps to make Cash Forecast:

Cash Flow Statement, no doubt, helps the management to make a cash forecast for the near future. A projected Cash Flow Statement helps the management about the cash position which is the basis for all operations and thus, the management finds the light relating to cash position, viz., how much cash is needed for a specific purpose, sources of internal and external issues etc.

(b) Helps to the Internal Management:

It helps the internal management to determine the financial policy to be adopted in future since it supplies information relating to funds, e.g., taking decision about the replacement of fixed assets or repayment of long- term liabilities etc.

(c) Reveals the cash position:

It is a significant pointer about the movement of cash, i.e., whether there is any increase in cash or decrease in cash and the reasons thereof which helps the management. Moreover, it explains the reasons for a small cash balance even though there is sufficient profit or vice-versa.

Besides, the management can compare the original forecast with the actual one in order to understand the trend of movement of cash and the variation thereof.

(d) Reveals the result of Cash Planning:

How far and to what extent, the cash planning becomes successful, that story is told by the analysis of Cash Flow Statement. The same is possible by making a comparison between the projected Cash Flow Statement/Cash budget and the actual one and the measures to be taken accordingly.

Limitations of Cash Flow Statement:

Cash Flow Statement is, no doubt, an important tool in financial management which exits the movement of funds in various ways of a firm. It assists the management to understand the amount of capital blocked up in a specific segment of a firm. Although the Cash Flow Statement performs as an important financial tool, it is even not free from snags.

Some of them are given below:

(i) Cash Flow Statement fails to present the net income of a firm since it does not consider non-cash item.

(ii) It is neither a substitute of Funds Flow Statement nor an Income Statement. So, the functions which are performed by the Funds Flow Statement or Income Statement cannot be done by the Cash Flow Statement.

(iii) Cash Flow Statement does not always represent the real liquid position.

How to Prepare a Cash Flow Statement?

There are two methods of its preparation. The first one is that it will commence with opening Cash and Bank balances and with this, certain amounts are to be added on account of issue of Shares and Debentures, Cash received from Debtors, selling fixed assets etc.

The following items are to be deducted from the above total: payment to Creditors, payment for liabilities and expenses, purchases of assets, payments for dividend and taxation etc. the balance will represents the closing balance of Cash and Bank.

The second method is to be followed particularly when the amount of purchases, sales, and expenses are not given. This will be similar to Fund Flow Statement. The only difference is that the total changes in working capital are to be considered in Fund Flow Statement, but here, net increase or decrease of each component of current assets and current liabilities is to be recognized.

This can be represented in the following form:

Cash from Operation:

It is the trading profit which is determined on cash basis, i.e., the transactions relating to cash. We can easily ascertain the trading profit under cash basis if details of cash transactions are presented before us. We know that profit under cash basis is followed usually by professional people, e.g., doctors, lawyers etc.

An outline of such Profit and Loss Account may be presented below:

Alternative Approach:

With the amount of Trading Profit if we make the necessary adjustments relating to non­cash items and non-trading items (e.g., Provision for bad and doubtful debts, write-offs, loss on sale of fixed assets, depreciation, outstanding liabilities for expenses etc.) which have already been debited or credited (items like, profit on sale of fixed assets, dividend received etc.) to Profit and Loss Account, we will get the Cash Trading Profit or Cash from operation.

The same is out-lined below:

Illustration:

From the following Income Statement ascertain the amount of Funds from Operation:

Solution:

Statement showing the computation of Funds from operation.

Illustration:

Following are the comparative Balance Sheets of Mr.Sudhansu Talukdar.

Solution:

Illustration:

From the following prepare a Cash Flow Statement of Sumana Ltd. For the year ending 31.12.1983:

Solution:

Note:

1. Depreciation, being a non-cash item excluded from the computation of Cash from Operations.

2. Here, increase in stock will not appear in Cash Flow Statement since it does not make any change in Cash. If it is started from profit, instead of starting from sales, in that case, the variation is to be recorded.