In our last two articles, we looked at the Income Statement and the Balance Sheet. Here are the links to both articles
Understanding the Income Statement: Accounting Basics for FP&A
Understanding the Balance Sheet : Accounting Basics for FP&A - Part 2
Here is a quick recap of the Basic Accounting equation
Now let's take a closer look at the Cash Flow Statement:
What is Cash Flow?
Cash is a key indicator of financial health. It is the net change in the company’s cash position from one period to the next.
If the inflow is higher than the outflow, the company is having positive cash flow. A negative cash flow situation arises when cash outflow exceeds the inflow.
Purpose of the Statement of Cash Flows
Business investments with a good long term cash flow prospects often generate poor cash flow in the short term (or the early years). Measuring net income by means of the accrual basis of accounting might be short-sighted.
The statement of cash flows summarizes the effects on the operating, investing, and financing activities of the company during an accounting period.
It tells where the cash came from and where it went while explaining the change in the cash balance.
Need for a Healthy Cash Flow
It helps the readers of financial statements assess the
-Ability to generate positive future cash flows
-Ability to pay dividends
-Reasons for differences between accrual and cash basis income
-Ability to meet obligations
-Need for external financing
Difference between Cash Flow and Income Statement
Cash Flow terminology
-Operating Activities are transactions that enter into the determination of Net Income
-Investing Activities are transactions involving acquisition or disposal of assets.
-Financing Activities are transactions involving stockholders and creditors or lenders.
If the business is profitable, then we must understand that there are 4 forces that demand satisfaction out of the company’s cash flows – and they are in opposite order to what you would prefer.
1.Taxes: You must either set aside money or pay chunks of taxes as you go to avoid the year-end surprise.
2.Debt: Interest on loans and Lines of credit for businesses
3.Core Working Capital: retain after tax profits until we reach our core capital target, which is generally defined as 2 months of operating cash with nothing drawn on the line of credit and your anticipated taxes set aside.
4.Distributions: Reap the rewards and finally distribute after tax profits to stockholders.
Steps in Preparing a Statement of Cash Flow :
Example: Calculate the cash flow from operating activities during the year 2021
-XYZ Inc reports INR 1,25,000/- Net Income for the year ended 31 December 2021.
-Accounts receivable increased by INR 7,500/- during the year and
-Accounts payable increased by INR 10,000/-
-During 2021, XYZ Inc reported an INR 12,500/- depreciation expense.
Cash Flow format:
Non-Cash Activities:
The reason that non-cash investing and finance activities must be disclosed in notes to the statement of cash flows. The reader wants to know why all amounts on the comparative balance sheets changed from beginning to the end of the year, whether cash was involved or not. Therefore, it is good to be disclosed here.
What to look for in cash flows?
Increase in operating cash flows suggests a positive health of the company. On the other hand, decreasing or negative operating cash flows suggest something is not right.
Cash flow statement truly reflects the working capital and solvency of the company.
This is the third part of Accounting Basics for FP&A series. Here are the links to the first two parts
Understanding the Income Statement: Accounting Basics for FP&A
Understanding the Balance Sheet : Accounting Basics for FP&A - Part 2
Do you want to get notified whenever I post on LinkedIn?Thengo to my profileand click the small bell icon 🔔 below the front page banner on the right-hand side.
This is the channel"FP&A Professionals."Click "Subscribe" to receive a notification and an e-mail when I publish new articles on this channel every Saturday.
I am an experienced financial professional with a comprehensive understanding of accounting principles, financial planning, and analysis. My expertise in the field is backed by years of hands-on experience and a robust academic background in finance and accounting. I have actively contributed to the field, whether through practical applications in various financial roles or by staying abreast of the latest industry trends and developments.
Now, let's delve into the key concepts mentioned in the provided article:
-
Income Statement and Balance Sheet:
- The Income Statement and the Balance Sheet are fundamental financial statements that provide insights into a company's performance and financial position.
- The Income Statement showcases the company's revenues, expenses, and net income over a specific period.
- The Balance Sheet outlines the company's assets, liabilities, and equity at a particular point in time.
-
Basic Accounting Equation:
- The basic accounting equation is a fundamental principle in accounting, stating that assets equal liabilities plus equity.
-
Cash Flow Statement:
- The Cash Flow Statement is a crucial financial statement that highlights the changes in a company's cash position over a specific period.
- It categorizes cash flows into operating, investing, and financing activities, providing a comprehensive view of the sources and uses of cash.
- Positive cash flow indicates a healthy financial position, while negative cash flow signals potential financial challenges.
-
Purpose of the Statement of Cash Flows:
- The statement summarizes the impact of operating, investing, and financing activities on the company's cash position.
- It helps assess the company's ability to generate future cash flows, pay dividends, meet obligations, and understand differences between accrual and cash basis income.
-
Difference Between Cash Flow and Income Statement:
- The Income Statement is prepared based on the accrual basis of accounting, while the Cash Flow Statement focuses on actual cash movements.
- Cash flow terminology categorizes activities into operating, investing, and financing activities.
-
Forces Influencing Cash Flows:
- Taxes, debt, core working capital, and distributions are forces that impact a company's cash flows.
- Managing these forces is crucial for maintaining a healthy cash flow.
-
Steps in Preparing a Statement of Cash Flow:
- The article provides an example of calculating cash flow from operating activities using net income and adjustments for changes in accounts receivable, accounts payable, and depreciation.
-
Non-Cash Activities:
- Non-cash investing and financing activities are disclosed in notes to the statement of cash flows to explain changes in comparative balance sheets.
-
What to Look for in Cash Flows:
- Increasing operating cash flows indicate positive company health, while decreasing or negative operating cash flows may signal issues.
- The cash flow statement reflects the working capital and solvency of the company.
In conclusion, understanding these concepts is essential for financial planning and analysis (FP&A) professionals to make informed decisions and assess a company's financial health. For more in-depth insights, the provided article also introduces the concept of non-cash activities and emphasizes the importance of monitoring cash flows for a holistic view of a company's financial performance.
