Statement of Cash Flow Essay Example

includes the amount of distributions to owners that are in cash, such as dividend payments and receipts. Pinson (2008) considers cash flow from operating activities as the most important type of cash flow. If a company consistently has negative cash flow from operations, it may indicate financial issues. The second component of the cash flow statement is the impact on cash due to investing activities.

This category covers fixed assets that a firm acquires or disposes of during a specific period. The cash flow statement also includes cash effects from financing activities such as issuing ordinary shares, preference share capital movements, and long and short-term borrowing transactions, whether repaid or raised. It's important to note that the cash flow statement breaks down cash flows in a budget-like way, providing a systematic overview of the company's money flow during a particular period. This statement is mainly used for internal planning and analysis purposes. (Anderson, 2006; Benton et al, 1993).

Having effective cash flow management is vital for maintaining sustainable liquidity levels within a company. A lack of necessary funds when required can result in disastrous consequences (Pinson, 2008). The cash flow statement presents a detailed analysis of a firm's financing, investing, and operational activities, highlighting the impact that changes to the balance sheet have on its cash reserves. It divulges three primary components that make up a company's financial position: financing activity, operating activity and investing activity (Chang, 2002). Success hinges on striking equilibrium between income and outlay of money. The trends seen in the cash flow statement can determine both short-term and long-term business viability.

When examining the cash flow statement's segments for operating, investing, and financing

activities, there are eight distinguishable patterns. The initial pattern, labeled as (+ + +), is unusual and implies a company with positive cash flows in all three areas. This signifies that the organization is generating cash from their operations while also selling some depreciated assets and making long-term investments. Moreover, they are raising additional funds by obtaining debt financing (Benton et al., 1993). Typically associated with firms accumulating funds for future share repurchasing or repayment of long-term loans, this pattern can also indicate significant investments such as acquiring a subsidiary.

According to Tracy (2004), a firm with a (+ - -) generates positive cash flows from operating activities, invests in long term assets, and reduces its debt and dividends. This is common among mature firms who use the excess cash flow to service debt or buy back shares without needing external financing. It's also possible for cash flows to show a (+ + -) pattern.

The positive operating and investing cash flows and negative investing cash flows suggest an uncommon situation, as investing typically generates negative cash flows (Benton et al, 1993). This indicates an unviable firm that is reducing operating capacity while investing in assets. Additionally, due to the (+-+) pattern, the firm's operating cash flows are insufficient to cover investing expenses, forcing the firm to seek new debt or equity financing options (Berman & Joe, 2006).

Investing in long-term assets is necessary for a growing firm. Issuing debt to generate net cash inflow can assure investors of the firm's viability and future cash flows from investments. If a firm has an unusual pattern of (- + +), it can sell depreciating long-term assets to cover the

deficit in operating cash flows. However, lenders may be hesitant to lend to a firm with negative operating cash flows unless they are convinced it is a temporary situation (Tracy, 2004).

Complicating the operations of the firm even further would be the selling of long-term assets. Furthermore, in the pattern of (- - +), the firm is experiencing negative cash flows from operating and investing activities. This suggests that the firm is currently investing and is financing these investments through issuing debt or equity (Berman ; Joe, 2006). It can be inferred that the negative operating cash flows are only temporary, possibly due to the firm being in its early stages of growth with rapid expansion (Benton et al, 1993). Investors have the option to invest their money by purchasing either debt instruments or shares. Overall, the firm appears to be viable given that the negative operating cash flows are only a temporary issue.

Furthermore, the company is experiencing a shortfall in its operating cash flow and this is being exacerbated by either distributing dividends to shareholders or repaying creditors, resulting in losses reflected on the firm's income statement (Tracy, 2004). The sale of long-term assets to generate cash for operation and investments represents a potential threat, as if it persists, it could lead to the company being liquidated. Lastly, the (- - -) pattern, which indicates all cash flows are negative, is rare and generally occurs when previously accumulated cash has been depleted (Benton et al., 1993).

The company is acquiring new assets for the long term and settling debts, while its operating activities are depleting cash. This is unfavorable for creditors and investors. The cash flow

statement provides information on a business's ability and timeliness to meet its payment obligations, as well as its short-term value. According to Anderson (2006), potential employees should also review a company's cash flow.

Having a strong cash flow statement assures investors that the company can fulfill its obligations to them and meets their long-term strategic cash flow concerns (Tracy, 2004). For companies starting out or with limited liquid resources, the cash flow statement is particularly important as they are at risk of experiencing short-term cash deficits (Anderson, 2006).

Many companies omit cash flow statements in their quarterly earnings reports, but these documents are crucial for illustrating short-term changes in cash and the related activities that generated or used it (Berman & Joe, 2006). Regular creation of cash flow statements allows for measurement of a company's immediate financial stability. Furthermore, such statements have lasting relevance for "going concerns" that depend on future financial viability.

Nowadays, it is necessary for management to be proactive in managing a company's cash flows to ensure strategic survival. According to Koller et al. (2005), investors typically inspect a firm's investing and financing sections of their cash flow statement to assess their feasibility. If the amount being spent on business investments is disproportionately low compared to the firm's size, it can raise concern for investors and lenders. This indicates that management perceives the company as a "cash cow" (Berman & Joe, 2006).

According to Pinson (2008), the management's disregard for future cash generation can be seen as they are currently draining the firm. However, if a considerable amount of cash is being directed towards investments in proportion to the size of the

company, it is indicative of the company valuing and having faith in future operations. Putting too much emphasis on the future may cause current liquidity problems as an unbalanced cash flow may be reflected in the operating and financing segments of the cash flow statement. Chang (2002) suggests that analyzing cash flows can help management understand the type of business they are running. For example, if a firm is in a seasonal industry or generates cash flow through working capital, it is crucial to recognize that the cash flow during that period would also be cyclical.

Despite having a strong balance sheet, a company's cash flows may not reflect the same positive condition. The importance of cash flow lies in its timing, which is not reflected in the balance sheet or income statement alone (Anderson, 2006). Certain companies may manipulate their financial statements by obtaining loans from financial institutions towards the end of the trading period and recording these as earnings in order to enhance the appearance of their statements (Koller et al., 2005). However, such fraudulent activities can be minimized if cash flow statements are disclosed, since there is less room for manipulation in this statement (Berman & Joe, 2006).

Nevertheless, even if there is less opportunity for manipulation, it does not mean that there is no room for it. An example of this is when a company aims to showcase impressive cash flows by intentionally delaying payments to suppliers. This allows them to pay after disclosing their quarterly cash flows (Berman & Joe, 2006). However, this strategy can only be short-term because prolonged delays may lead suppliers to cut their supplies. Weak internal controls

make the income statement and balance sheet vulnerable to manipulation (Tracy, 2004).

Wall Street investors in America prefer the cash flow statement due to its reduced susceptibility to manipulation. The industry a business operates in affects their cash flows, with service firms typically investing less in assets than manufacturing firms (Koller et al., 2005). Therefore, if a service firm's management invests heavily in assets too quickly, it could indicate misplaced priorities (Berman ; Joe, 2006). Conversely, if a manufacturing firm's management invests relatively little compared to their size, it may signify issues.

Inventors must remember that a company's validity cannot be determined solely by its cash flow statement. To gain a comprehensive understanding of the company's financial performance, both the income statement and balance sheet should be considered alongside the Statement of Cash Flows (SCF). The SCF complements the information provided in the accrual basis prepared income statement and balance sheet, as noted by Benton et al. (1993). It is crucial to note that relying on cash flow alone does not provide an accurate indication of a company's profitability or financial well-being.

The disclosure of financial figures is mandated by FASB Statement No.5 of 1987, which requires firms to publish Income Statement, Balance sheet and Statement of Cash Flows (SCF) (Berman ; Joe, 2006). The Income Statement and Balance Sheet respectively expose two qualitative characteristics, while the Statement of Cash Flows can be prepared on a monthly basis, in contrast to the quarterly, semi-annually or annually prepared statements.

The aim of providing material information through financial statements is to aid investors and creditors in their decision-making processes, as stated by Koller et al in 2005. The cash flow statement's

financing section is a reliable indicator of a firm's viability based on its dependence on external financing. A company's validity can be evaluated through the analysis of the three segments of its Statement of Cash Flows. Investors and lenders should exercise prudence in scrutinizing the patterns in the cash flow statement. By analyzing the income statement, balance sheet, and SCF, investors can obtain impartial information concerning a firm's validity, assisting them in making informed economic decisions.

It is imperative that firms disclose more financial information to allow investors and creditors to make informed economic decisions.