Statement of Cash Flow
Cash flow statement is one of the very important statements prepared by firms.
The cash flow statement enlists the details of cash generated or utilized by operations, investing activities and financing activities. The conventional final financial statements including balance sheet and income statements have less capacity in capturing the timing and extend of cash flows in a firm. The important component of cash flow statement thus enables users to assess cash performance in a better way.Although many stakeholders demand to analyze the financial statement each for own reason, the statement plays a significant role to investors, tax officials, lenders and the management (Pinson, 2008).
Thesis statement The conventional financial statements scantly capture the timing and extend of cash flows in a firm. Cash flow statement becomes the refuge in expounding the short and long-term prospects of a firm which effective outside review displays viability of a firm. Cash flow statementCash flow statement is a financial statement designed to provide details of timing and the extent of cash flows within a firm. The statement has three segments of cash flows. These are the cash flow operating activities, investing activities and financing activities.
The Statement of Cash Flow (SCF) adapted through the Financial Accounting Standards Board (FASB) 1987 Statement No. 95 for SCF to become part of the financial package disclosed by management was provide investors and creditors the highly valued information the firm’s cash receipts and cash disbursements (Benton et al, 1993).Cash generated by operations include profit before tax and interest paid. This is after adjustments from non-cash items and non-cash components of working capital items. Other form of cash included here include cash component of finance costs, taxation, cash received from customers, cash paid to suppliers and employees among other operating expenses (Tracy, 2004).
Moreover, cash component of distribution to owners are part of the operating cash segment. This means the dividend pay outs or dividends received.Cash flow from operating activities sometimes is considered the most important form of cash flow (Pinson, 2008). For instance, a firm that consistently fails to generate positive cash from operating activities is a sign of potential financial difficulties. The second component of cash flow statement is cash effects from investing activities.
Included in this category is the fixed assets either acquired or disposed by a firm within a certain period. Additionally, the other segment of cash flow statement is the cash effects from financing activities (Anderson, 2006).The cash segments included here constitute issuing of ordinary shares capital, movements in preference share capital, long term and short-term borrowings and short-term borrowings repaid or raised. Importance of cash flow statement Cash flow statement provides a systematic breakdown of cash flows like a budget would do (Benton et al, 1993). Ideally, the cash flow is used for internal planning and analysis of the flow of money within the business during a certain period.
Liquidity of a firm is a very vital issue that only good cash flow management can help keep in sustainable levels.It is suicidal for a firm to lack cash at times when they are needed (Pinson, 2008). The cash flow statement reflects in detail the effects of changes to the balance sheet on the opposition of cash while analyzing systematically the operating, investing and financing activities of the firm. The full picture of a firm is depicted by the cash flows particularly the three main components; cash flows provided by operating activities, cash flows from investing activities and cash flows from financing activities (Chang, 2002). The profit of a firm depends on how it balances between cash in flows and cash out flows.Patterns of cash flow statement The patterns of cash flow determine the validity of a firm in the short term and in the loan run.
Considering the cash flows from operating, investing and financing segments of the cash flow statement, it is possible to deduce eight patterns. First, a firm with positive cash flows in three activities would have a (+ + +) pattern. The pattern is unusual. This indicates a firm is generating cash flow from operating activities, disposing part of its depreciated assets and long-term investment and raising additional cash from debt (Benton et al, 1993).This is indicative of a firm that is accumulating funds for future repurchasing of shares, repaying long-term loan or buying a huge investment like buying a subsidiary.
Secondly, a firm with a (+ – -) stands for a firm generating positive cash flows from operating activities, investing in long term assets and reducing its debt and payment of dividends (Tracy, 2004). Firms exhibit this pattern at maturity. The firm can utilize excess operating cash flow in to service debt or repurchasing shares. This firm needs not finance from external market.Additionally, cash flows can exhibit (+ + -) pattern.
This indicates operating and investing cash flows are positive while investing cash flows are negative. This is unusual since investing produces negative rather than positive cash flows (Benton et al, 1993). The firm is unviable since it is contracting operating capacity and investing assets. Moreover, (+-+) pattern, the firm operating cash flows are insufficient to finance investing making the firm to opt for issuing new debt or equity (Berman & Joe, 2006).
This is indicative of a growing firm thus; it requires investing in long term assets. The net cash in flow from issuing debt satisfy investors that the viability of the firm is intact given future cash flows from investments. Another pattern is (- + +). This is unusual pattern, a firm in such scenario can make up by selling depreciating long-term assets to cover the deficit in operating cash flows (Tracy, 2004). Lenders are less impressed to lend the firm unless satisfied the negative operating cash flows are temporary.
The selling of long-term assets may further complicate the operations of the firm. In addition, (- – +) pattern, the firm has negative operating and investing cash flows. This indicates the firm is investing and this is financed by issuing debt or equity (Berman & Joe, 2006). It is deducible that negative operating cash flows are temporary possibly due to a young growing firm fast expanding (Benton et al, 1993). The investors can extend their money in exchange for debt instruments or shares. The firm is viable given negative operating cash flows are temporary.
Additionally, (- + -) pattern, the firm possesses deficit in its operating cash flow and it is shrinking by distributing dividend to shareholders or in repaying creditors. The firm in this pattern normally exhibit losses from income statement (Tracy, 2004). Notably, the sale of long-term assets to generate cash for operation and investing out flows pose a serious threat as if this persists may lead to liquidation of the firm. Lastly, (- – -) pattern indicates all cash flows being negative. It is common when previously accumulated cash getting consumed (Benton et al, 1993).The pattern is unusual.
The firm is purchasing new long-term assets and paying creditors. Operating activities are also using up cash. This trend is not desirable to creditors and investors. Cash flow statement short-term value This statement when analyzed categorically, it informs investors and creditors on the capability and expediency of a firm to fulfill its obligations in paying its bills (Anderson, 2006). Potential employees also deserve to analyze the cash flow of a firm.
This gives them the assurance that a firm is capable of meeting its obligations on them.Investors are normally interested in the long-term strategic cash flows of the firm (Tracy, 2004). This makes the cash flow statement important to enable investors make informed decisions. The importance of cash flow statement to companies with limited fluid assets and additionally commencing operations resonates in the fact that they are vulnerable to experiencing short-term cash shortfalls (Anderson, 2006).
Many firms normally do not release cash flow statements in their quarterly earnings.In real sense, Statement of cash flows indicates why and how the cash amount changed in the short-term. In other words the activities that lead to the generation of cash and how the cash use (Berman & Joe, 2006). The preparation of cash flow statement on quarterly basis satisfies the needs of the cash flow on measuring the validity of a firm in the short run. Cash flow statement long-term value In the corporate sense, many firms consider themselves ‘going concerns’. There assumption is always that the future will take care on the financial status of the firm.
However, contemporary business practices today demand that the management take proactive steps in managing the cash flows for strategic existence of the firm. Investors normally look at the investing and financing segment of a cash flow statement to determine the viability of a firm (Koller et al, 2005). For instance, if the amounts that management is expending on investments for the business is low compared to the size of the firm, this must raise eyebrows to investors and lenders. This is a clear indicator that the management is treating the firm as a ‘cash cow’ (Berman & Joe, 2006).
This implies the management is milking dry the firm disregarding future cash generation of the firm. On the other hand, with the management is directing huge portions of its cash on investment relatively to the size of the firm, this is an implication that the firm values the future and has more faith on the future operations. Over emphasis of future may create present liquidity situation since for more funds to be directed towards investments, it shows unbalanced cash flows on operating and financing segments of cash flow statement (Pinson, 2008).The analysis cash flows gives the management the opportunity to understand the kind of business they are operating. For instance, if a firm is operating in a seasonal industry or the cash flow generation from working capital, it is important to understand the cash flow on the said period is also cyclical (Chang, 2002).
Although firms may have strong balance sheet condition, the cash flows could be the opposite of the impression drawn on the balance sheet. The importance of cash flow revolves around the timing of cash flows, a picture that never displays on mere balance sheet and income statement (Anderson, 2006).For instance, a firm can artificially decorate its income statements and balance sheet by obtaining loan from financial institutions especially at the close of the trading period. There are high chances that some fraudulent firms may indicate the funds to be earnings in order to brighten the appearance of financial statements especially balance sheet and income statements (Koller et al, 2005). However, when cash flow statements are disclosed, the probability of hiding questionable cash flows and committing a fraudulent cover up are minimized.This is because there is comparatively less room for manipulation in the cash flow statement (Berman & Joe, 2006).
However, less room for manipulation does not imply deficiency of any room for manipulation. For instance, a firm that wants to display impressive cash flows may delay paying the suppliers so that the quarterly cash flows, thus pays after disclosing the quarterly cash flows (Berman & Joe, 2006). Fortunately, this is only possible in the short term as when suppliers are delayed over characteristically long time they may cut their supplies.The income statement and the balance sheet are prone to manipulation especially to firms that have weak internal controls (Tracy, 2004).
The less room for manipulation characteristic of cash flow statement has made the document a favorite disclosure preferred by Wall Street investors in America. On the other hand, the industry in which the business operates ought to determine the cash flows. For instance, a firm operating in the service industry relatively invests less in asset than those in the manufacturing industry (Koller et al, 2005).Thus, if it so happens that a management of a service firm is directing more cash on investing of assets in a rush thus is a precursor top misplaced priority (Berman & Joe, 2006). In the same vein, when a management of a manufacturing firm seems to commit relatively low funds to investment compared to their size, this too indicates something is wrong.
Inventors must make decisions accordingly. Balance sheet and income statement The validity of a firm is not captured on cash flow statement only.The Statement of Cash Flows (SCF) requires income statement and balance sheet to give the full impression of the financial performance of the firm. Statement of Cash Flows compliments the information appearing on the accrual basis prepared income statement and balance sheet (Benton et al, 1993). Cash flow never indicates the profit earned by a firm nor does it expose the financial condition of the fir.
The two qualitative characteristics are exposed by income statement and balance sheet respectively. The FASB Statement No. 5 of 1987 demand was in disclosing financial figures; firms need to publish Income Statement, Balance sheet and Statement of Cash Flows (SCF) (Berman & Joe, 2006). Unlike the other two, the Statement of Cash Flows may be prepared on monthly basis. The three statements are traditionally prepared on a quarterly, semi annually or annual basis.
The main rational for this was to equip investors and creditors with the material information that would guide on their decision-making (Koller et al, 2005). Conclusion The financing portion of a cash flow too indicates the validity of a firm.The extent to which a firm depends on financing from outside determines it viability. The validity of a firm is reflected on the three segments of the Statement of Cash Flows. It is the duty of investors and lenders to observe prudence in analyzing the patterns of the cash flow statement. Income statement, balance sheet and SCF when analyzed can offer the investors neutral information on the validity of a firm thus assists them in making economic decisions.
Finally, investors and creditors ought to demand more financial information from disclosure by firms to enable the making of informed economic decisions.