We know the very aim of setting up a business is to earn profit. The profit is ascertained when the company prepares financial statements. The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions. The different types of Financial Statements are Income Statement, Balance Sheet, and Cash Flow Statement.

 

The Cash Flow Statement also referred to as statement of cash flows is one of the three financial statements commonly used to measure a company’s performance and overall health.

 

 

The statement of cash flows summarizes a company’s cash flows for a period of time. The statement of cash flows explains how a company’s cash was generated during the period and how that cash was used. Knowing where the cash comes from is important to project whether cash will be generated from those sources in the future. Knowing where the cash goes is important to assess the organization’s future cash needs. When presenting cash flow statements, most companies combine cash and cash equivalents because short-term investments classified as cash equivalents are used primarily as a substitute for cash.

 

It consists of three sections:

  1. Operating activities:

Cash flows from operating activities are primarily derived from the principal revenue producing activities of the entity. Therefore, they generally result from the transactions that enter into the ascertainment of profit or loss. The amount of cash flows arising from operating activities helps to know the extent to which the operations of the entity have generated sufficient cash flows to repay loans, pay dividends and make new investments without using external sources of financing. Examples of cash flows from operating activities are Cash receipts from the sale of goods and the rendering of services, Cash receipts from Interest and Dividend, Cash receipts from royalties, fees, commissions and other revenue, Cash payments to suppliers for goods and services, Cash payments to and on behalf of employees.

Cash Received from Sale of Goods and Services – Cash paid for purchase of Goods and Services = Cash Flow from Operations

 

  1. Investing activities:

Investing Activities refer to transactions that affect the purchase and sale of fixed or long term assets and investments. When a company divests an asset, the transaction is considered a cash inflow. A healthy company generally invests continually in plant, equipment, land and other fixed assets. Examples of cash flow arising from Investing activities are Cash payments to acquire fixed Assets, Cash receipts from disposal of fixed assets, Cash payments to acquire shares, or debenture investment, Cash receipts from the repayment of advances and loans made to third parties.

Cash received from sale of investments – Cash paid for Investments = Cash Flow from Investing

 

  1. Financing activities

The third section of the cash flow statement reports the cash paid and received from activities with non-current or long term liabilities and stockholder’s equity. Examples of cash flow arising from financing activities are Cash proceeds from issue of shares or other similar instruments, Cash proceeds from issue of debentures, loans, notes, bonds, Cash repayment of amount borrowed etc.

Cash Received from Issue of debt or Capital Stock – Cash paid for dividends and requisition of debt or capital stock= Cash Flow from Financing.

 

Therefore, Cash Flow from operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities = Net change in cash for the period

 

A strong, positive cash flow from operations is a good sign of a healthy company. The Income Statement and Balance Sheet are important tools for evaluating a company’s health. However, the Cash Flow Statement is an important complement to these, and should not be overlooked.

The Cash Flow Statement is the best resource for testing a company’s liquidity. It’s also useful in determining the short-term viability of a company. It’s important to note that the Cash Flow Statement reflects a firm’s liquidity and not profitability.

About the author

FAME is a leading Accountancy training provider. FAME brings together under one roof a wide range of accounting courses blended with real world experience and practical application. FAME aims to bridge the gap between theoretical knowledge and practical challenges that accountants face in their day to day working. We provide practical workplace skills for finance staff meeting the needs of employers, bankers, government and learners, both now and in the future. Our students are integral to the success of an organisation and at the heart of ensuring the smooth running of an accounting department.