The Concept of Cash Flow-Classification!

Cash Flow:

The statement of cash flows reports the cash receipts, cash payments, and net change in cash resulting from the operating, investing, and financing activities of an enterprise during a particular period.  The main aim to prepare the statement is to identify and analyze the causes of differences between cash amount in the beginning and ending balance sheet The Financial Accounting Standards Board (FASB) and International Accounting Standards -7 say the same purpose for preparing the statement of cash flows. It provides the answer of three questions, such as:

• Where did the cash come from during the period?
• What was the cash used for during the period?
• What was the change in the cash balance during the period?

Classification of Cash flows:

The statement of cash flows classifies cash receipts and cash payments by operating, investing, and financing activities. Transactions and other events of each kind of activity are as follows:

• Operating activities include the cash effects of transactions that create revenues and expenses and thus enter into the determination of net income.

• Investing activities include acquiring and disposing of non-operating assets like investments, property, plant and equipment and other long-live assets.

• Financing activities include cash from issuing debt and borrowing, repaying the amounts borrowed, obtaining cash from stockholders and providing them with a return on their investment.

The category of operating activities is the most important because it shows the amount of cash provided by company operations. This source of cash is generally considered to be the best measure of a company’s ability to generate sufficient cash to continue as a going concern and to repay the bank loan.

Summary of Cash Flow:

Steps to Prepare the Statement of Cash Flows:

• Determine the net increase / decrease in cash: The difference between the beginning and ending cash balances can be easily computed from comparative balance sheets.

• Determine net cash provided/ used by operating activities: This step involves analyzing not only the current year’s income statement but also comparative balance sheets and selected additional data.

• Determine net cash provided/ used by investing and financing activities: This step involves analyzing comparative balance sheet data and selected additional information for their effects on cash.

Usefulness of the Statement of Cash Flows:

The information in a statement of cash flows should help bankers, investors, creditors and others to assess various aspects of the firm’s financial position:

• The entity’s ability to generate future cash flows: A banker and others can make predictions of the amounts, timing, and uncertainty of future cash flows by examining relationships between items such as net cash provided by operating activities and increases or decreases in cash.

• The entity’s ability to repayment of bank loan, dividends and meet obligations: Loan repayment, employee payment, debt settlement, dividend payment depend on the company’s adequate cash flow. Bankers should be particularly interested in this statement, because it alone shows the flows of cash in a business.

• The reasons for the difference between net income and net cash provided by operating activities: A banker wants to know the reasons for the difference between net income and net cash provided by operating activities, which can be know from this statement.

• The cash investing and financing transactions during the period: A banker can understand why assets and liabilities increased or decreased during the period by examining a company’s investing activities and its financing transactions,

Sources of Information for Preparation of Cash Flow Statement:

Information to prepare this statement usually comes from three sources

• Comparative Balance Sheet
• Current Income Statement
• Additional Information

The cash flow statement deals with cash receipts and payments, so the accrual concepts is not used in the statement of cash flow.

Methods of Preparing Cash Flow:

• The Indirect Method

The indirect method derives from cash flows from accrual basis statements. Indirect method starts from net operating profit. Net cash provided by operating, financing and investing activities are adjusted with the profit. The indirect method is used extensively in practice and it is favored by the company for two reasons

• It is easier to prepare
• It focuses on the difference between net income and net cash flow from operating activities.

• The Direct Method

The direct method determines cash flows directly for each source or use of cash. This method shows main receipts and payments starting from cash receive from customer under cash from operating activities heading.

The only distinctive area between direct and indirect method is cash flow from operating activity. In indirect method, increase in current liabilities and decrease in current assets are added with net operating profit or decrease in current liabilities and increase in current assets are deducted from net operating profit to get the net cash flow.