A cash flow statement shows inflows and outflows of cash and cash equivalents and is concerned with operating, investing and financing activities of a company within a stipulated time frame. It explains the reasons of receipts and payments in cash balances during an accounting year in a company.
Objectives for preparing Cash Flow Statements:
- It helps to ascertain the gross inflows and outflows of cash and cash equivalents from various activities.
- It is beneficial towards analyzing various reasons that are responsible for change in the cash balances during an academic year.
- These statements are very helpful in analyzing and understanding the liquidity and solvency of a company. Thus, it depicts the true liquidity position to the creditors and the investors.
- It aims to comprehend the requirement and availability of cash in future.
Uses of Cash Flow Statement:
- It assists to make decision about profit distribution in reference to the availability of cash.
- It helps to analyze and study the trends of receipts and payments of cash. The data of the same is available through the various activities of a company. Thus, it helps in drafting various policy measures and creates short and long time planning.
- It helps to determine and assess liquidity and solvency positions of a company.
- It enables to identify the reason for change in cash and cash equivalent balances of a company.
Understanding Cash Equivalents:
Short term investments that are highly liquid and are easily convertible into cash and are subjected to an irrelevant risk of change in its worth are called Cash Equivalents. Cash Equivalents are intended for meeting short term cash obligations and not for investment.
An investment that is held for short-term maturity can be called as Cash Equivalent. Treasury bills, commercial papers, etc. are some examples of Cash Equivalents. It is thus different from Cash Flows. A Cash Inflow results in increase in the total cash balance and a cash outflow leads to decrease in the total cash balance.
Treatment of Preliminary Expenses in Cash Flow Statement:
When there is a decline in the balance of a Preliminary Expense, it indicates that these expenses are written off and does not involve any cash outflow. Thus, in order to prepare a Cash Flow Statement, the Preliminary Expenses are added to the net Profit before Taxation.
Limitations of Cash Flow Statement:
- It ignores the Accrual concept
In Cash Flow Statement, transactions are counted only when the settlement takes place. It thereby ignores the Accrual concept.
- It ignores non-cash transactions
Records involving cash inflows and cash outflows are stored by Cash Flow Statements. Thus, the true financial position of an enterprise remains unrevealed.
- It is complementary in terms of its nature
The Statements have a limited use in isolation without the financial statements. Thus, the holistic financial picture stays unclear.
- Substitution of income statement is not present
Income statements include transactions that are in cash as well as those that are not in cash. Cash Flow Statement, on the other hand considers the cash transactions only. Thus, it fails to act as a substitute of the income statement.
- The true liquidity position cannot be judged
Again, the Cash Flow Statement involves only the cash position of a business. It does not consider the fixed and the current assets. Thus, it fails to reveal the actual liquidity position.
Terms used in Cash Flow Statement
- Cash–
It includes the cash in hand and the deposits in banks
- Cash flows
It involves the movement of cash in and out of the business. A cash inflow means receipt of cash by the business. Cash outflow on the other hand means the payment of cash by the business. An important thing to note here is that, cash inflows increase the total cash balance, whereas cash outflows leads to a decrease in the total cash balance.
- Operating activities
Sale and purchase of services and goods make up the operating activities. These are in fact, the major revenue generation activities.
- Investing activities
They mainly comprise the sale and the purchase of long-term investments and fixed assets. Long term investments are not included in the resale list.
- Financing activities
These activities happen as a result of change in the composition and size of capital structure of an organization.
The tax imposed on a company is on various financial grounds. These are income, profit, capital gain and dividends. Taxes have a lot to do in balances of cash. According to the Accounting Standard-3 (commonly known as AS-3), taxes paid on income is also considered to be part of cash flow from operating activities. This indicates that tax paid is recorded as deduction from cash generated by operations. AS-3 asks to classify taxes as operating, financing or investment based on the category of the financial item on which the tax is paid.