In accrual accounting system, income is reported when earned, not necessarily when cash is received. For example, when company made sales on credit, right to receive money in future is created in exchange of goods or services. These transactions are recorded on the income statement as revenues / sales. However in these type of cases, company has not received any money at the time of sale. Therefore to know cash position for the profit period, statement of cash flows is prepared by summarizing company’s inflows and outflows of cash.
Statement of cash flow is a part of the financial statements published every quarter and year along with balance sheet and income statement to show investors how money flows in and out of the company.
Beginners into investing generally pay attention to company’s revenue and earnings as reported in the income statement. Income statement of a company tells you how profitable a company is and balance sheet tells you how solid company’s financial resources are. However, these statements don’t show you a clear picture on money flow in and out of the business as financial transactions use accrual accounting.
In accrual accounting system, you record revenue and costs as and when they are incurred irrespective of payments. In contrary, cash accounting records revenue when money received and costs when money is paid. Enron and other companies have misused accrual accounting to hide mistakes with their respective financial report. To overcome this problem, in addition to income statement you must look into the statement of cash flow presented to you by the management in company’s annual report.
We have two acceptable methods for preparing the statement of cash flow: the direct method and the indirect method. However indirect method is widely used as information to prepare statements of cash flow under direct method is not available to outsiders.
The indirect method starts the calculation with net earnings published in income statement and then adjust with non cash expenses, and then adjust with the cash flow from investing and financing activities to arrive at net cash inflows. Most common non cash expenses are depreciation and amortization.
Company’s net income is reported in income statements. In indirect method, cash flow from operation, investing and financing is reported in a separate statement known as “statement of cash flow”. Before analyzing, you need to compare both figure to find out how much of net profit is in cash.
If reported cash flow from operation is substantially lower than the net earnings, then it means a substantial portion of the net profit is not materializing in cash. Before taking any investment decisions, you need to analyze the difference and understand the business to know how company is making profit.
Therefore, statement of cash flow is prepared based on the information from both the income statement and balance sheet to give you a complete picture of the company’s money flow. This statement tells you the quantum of money a company generates from its normal course of doing business.
To give a complete picture of the company’s cash flow position, the statement classifies all company cash flows into operating, investing and financing activity. It presents the ability of a company to generate cash flow from running its business.
Cash flow from operating activities determines how much money a company brings into the company during its normal course of business or from activities related to the fundamental business operation of the company i.e. buying and selling of goods and/or services.
Cash flow from investing activities tells you the money company has spent upgrading or investing in, themselves such as purchase or sell of long term assets.
Cash flow from financing activities shows you how much money has been plowed into the company by investors or banks or financial institutions or other lenders.
You can also use certain financial ratios to analyze company’s liquidity position. By analyzing company’s liquidity position, you can easily know when a company will run out of money or how long a company can survive in case of any troubles in economy. Flows of money can examine following aspects of the business:
- What is the source of financing for business operations? Is it through internally generated funds or external source of funds?
- Can company manage its debt obligation in long run?
- Can the company expand its business through operating cash flow?
- The ability of company to pay dividends to shareholders.