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Business Financials - Cash Flow Statement - How does it Work?

images/Business Financials3.jpgThe 2 most popular financial statements are commonly given for a business - a profit & loss or income statement, a balance sheet or statement of position, but rarely is the cash flow statement (or statement of cash flows) made or supplied.

The purpose of the cash flow statement is to highlight the major activities that directly and indirectly impact cash flows and hence affect the overall cash for the business.

Business owners usually have a “feel” what their cash flow is like and they should monitor cash for a very good reason - without a sufficient cash balance at the right time, a company can 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 $14,000 in a year in which, according to profit & loss / income statement, it lost more than $10,000?

The cash flow statement is a valuable analytical tool for business 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:

  1. Is the company generating sufficient positive cash flows from its ongoing operations to remain viable?
  2. Will the company be able to repay its debts?
  3. Will the company be able to pay its usual dividends?
  4. Why is there a difference between net profit/income and net cash flow for the year?
  5. 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, it is important to use 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 is broadly defined to include both cash and cash equivalents.

Cash equivalents (applicable more for large companies) include 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 large 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

The 3 sections of cash flow statement (each has an inflow and outflow section):

images/Business Cash Flow.JPG

Operating Activities: (mostly income statement / profit & loss)

Operating activities shows the cash effects of transactions such as:

  • Cash receipts from sales of goods and services; and
  • Cash payments to suppliers and employees for acquisition of inventory, taxes, interest on loans.

Investing Activities: (mostly long term assets)

Investing activities generally show long term assets (and sometimes debt/equity securities) which include:

  • Sale/disposing of plant, equipment;
  • Sale of debt or equity securities;
  • Acquiring plant and equipment;
  • Acquiring debt or equity securities.

Financing Activities: (mostly long term liabilities and equity)

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:

  • Increase in debt / loans taken on;
  • Payment/Redemption of debt facilities / loans;
  • Dividends paid.

Next month we will work through an example

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