Saturday, 24 April 2010

Financial Statements: The Cash Flow Statement

The Cash Flow Statement is the third of the main financial statements, coming after Income Statement and Balance Sheet. Basically, this statement shows how the changes in these earlier statements affected cash held by the business. For example, Cash Profits, i.e. income minus "cash" expenses will increase the cash holdings.

Any such increase as a result one change might be offset by the impact of other changes. For example, the increase resulting from cash profit might be nullified by a corresponding increase in working capital, i.e. increased inventories and receivables. An increase in receivables mean that revenue was not fully realized in cash while increase in inventories mean that part of the realized cash was spent on stocking more materials or merchandise. Both these developments reduce available cash balance.

Similarly, adding new production facilities, such as a new building or machinery, can reduce cash holdings. On the other hand, if money was borrowed from a bank for these additions, it can reduce the reduction in cash holdings.

The cash flow statement thus shows the complex interplay of several changes, viz. revenue, expenses, working capital, new plant and other facilities, dividend payments, borrowings and repayment of borrowings. All of these items involve cash inflows and outflows, and will affect cash holdings. According to current practice, cash flow items are classified under Operating, Investing and Financing activities. Let us now look at a typical cash flow statement.


The Cash Flow Statement example shown starts with identificatory data at the top, indicating the period to which the data in different columns relate to. The first column is for description of the items.

The first line of the statement proper is the Net Income from Income Statement. To this are added the non-cash items that had been included in the Income Statement. Depreciation, amortization, deferred taxes and other non-cash items had thus been adjusted against the Net Income to compute the "cash" profit.

The logic of non-cash items can be illustrated as follows.

An asset with a useful life of 10 years is purchased paying full value in a particular year. It will affect the cash flow in that year. However,  you cannot treat the whole cost as an "expense" in that year because the asset will be in productive use for ten years. So the asset cost is "expensed" over ten years by, say writing off 1/10th of the cost as "depreciation" each year. The depreciation charge does not affect the cash flow of the year, and is "added back" to the net income to arrive at the "cash income."

The next item in the cash flow is "Changes in working capital". As mentioned earlier, increase in inventories and receivables (which are the main items of working capital other than cash) reduce cash balances available. On the other hand, if there is a reduction in these items, cash balance is increased (as in the example cash flow statement).

Cash income plus changes in working capital constitute the "Operating" cash flows.

The next section is the "Investing" cash flows. These include purchases and sales of long-term facilities (capital expenditure) such as buildings, plant and equipment. Investment in stocks and bonds, if any, are also included here. The net total of such investments is the Investing cash flow.

Then comes the "Financing" cash flows, which represent the inflows and outflows related to financing of the business, such as issue or retirement of shares, receipts and repayments of loans, and interest and dividend payments.

The net effect of the above cash flows is a surplus or deficit of cash flows. If inflows exceed outflows, there is a surplus cash flow; otherwise there is a deficit. This surplus or deficit is adjusted against the cash balance that was there at the beginning of the period to arrive at the cash balance at the end of the period.

The Cash Flow Statement indicates the short-term financial position of the business, showing whether the business was in a position to meet all its obligations in a timely manner. For example, if the business had incurred losses, it might not have generated enough cash internally to meet any loan repayments. Such a situation will be clearly highlighted by the cash flow statement.

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