According to Accounting Standard 3, two approaches can be taken to create a cash flow statement: the indirect and the direct methods. Regardless of the chosen method, the outcome for all three activities, namely operating, investing, and financing should be the same.
A cash flow statement is a document that offers a snapshot of a company’s cash in and out during a specific period. It is vital for assessing a business’s liquidity, solvency, and overall financial well-being.
Companies must collect and analyze data from their general ledger, bank accounts, and other sources, organize it according to the cash flow statement sections, calculate the net cash flow for each section, and then combine the sections to get the total cash flow for the period. The result will enable companies to make informed decisions and plan for future cash needs.
The cash flow statement also considers non-cash transactions, which are not based on the direct exchange of money. These transactions are reported separately to represent the company’s cash flow accurately. An example of a non-cash transaction would be depreciation expenses, which are reported apart from the cash flow statement to give an accurate overview of a firm’s actual cash flow.
Preparation Under Indirect Method
The indirect cash flow statement begins with net income, which is then adapted to account for any non-cash items such as depreciation, amortization, and gains or losses on the sale of investments. Adjustments are made to reflect the changes in the balance sheet, such as increases or decreases in accounts receivable, inventory, prepaid expenses, and accounts payable, and their effects on cash flow. Finally, the cash inflows and outflows from operating, investing, and financing activities are combined to arrive at the overall change in cash.
Operating Activities
The cash flow from operating activities is determined by going through two steps: calculating the operating profit before alterations in working capital and then considering the effect of any changes in working capital. Operating profit before changes in working capital can be calculated as the operating profit before changes in working capital is an important indicator of the company’s financial strength and helps to paint a picture of how efficiently the business is performing. It excludes any alterations in the amount of working capital, allowing investors and analysts to gain a more accurate view of the company’s financial situation. By subtracting operating expenses from total revenue, this figure reveals the true profit the company makes through its daily activities.
The overall effect of changes in working capital on cash flows is therefore determined by whether the changes result in an increase or decrease in current assets or liabilities. If the changes result in an increase in current assets and a decrease in current liabilities, the overall effect will be an increase in cash inflows. Conversely, if the changes result in a decrease in current assets and an increase in current liabilities, then the overall effect will be a decrease in cash inflows. In short, cash from operating activities is equal to the operating profit before any changes in working capital, plus any reductions in current assets and increases in current liabilities, and minus any increases in current assets and decreases in current liabilities.
Investing Activities
The cash generated from investments is determined by combining all the money coming in from the sale or completion of assets and subtracting all the cash spent on acquiring or paying for new long-term assets or investments. The net amount of cash generated after expenses and taxes are paid results from income from dividends, interest, capital gains, and other forms of revenue.
Dividends are paid to shareholders from company profits, interest is earned from a principal sum invested in a savings or fixed-income account, and capital gains tax are realized when a security is sold for a higher price. Other income sources may be derived from real estate rental income, royalties, or other investments.
This cash can be used to pay bills, purchase investments, or save for the future. Investing in stocks, bonds, mutual funds, and other instruments is a great way to generate cash and build wealth. However, it is important to consider the risks involved and diversify one’s portfolio to minimize risk.
Cash flow resulting from Investing activities generally includes payments for the purchase of Fixed Assets, receipts from the sale of Fixed Assets, payments for the acquisition of stocks or bonds, and receipts from the repayment of advances and loans made to external parties.
Investing activities involve purchasing and selling long-term assets such as property, plant, and equipment. Examples of investing activities in a cash flow statement include
- Purchases of property, plant, and equipment
- Investments in joint venture, associates, and subsidiaries
- Acquisition of intangible assets.
The company has seen a marked rise in revenue from the collection of its loaned Principal amounts to outside parties.
Examples of cash outflows related to investing activities include acquiring fixed assets such as land, buildings, furniture, and machinery; purchasing intangible assets like goodwill and trademarks; investing in shares and debentures; buying government bonds; and giving loans to third parties.
Financing activities
Cash inflows and outflows associated with transactions involving long-term debt and equity investments are classified as financing activities.
Cash generated from Financing activities may include Receipts from the issuance of stocks or other similar securities, Income from debentures, loans, notes, bonds, and other short-term borrowings Payment of the amounts borrowed back.
Repaying long-term debt or acquiring long-term investments are two of the financial activities that could be included in a cash flow statement. Additionally, purchasing or selling real estate or other investments and capital expenditures, such as the purchase of fixed assets like a new office building, factory, or fleet of vehicles, may be documented as financing activities.
Furthermore, the receipt of funds from venture capitalists issuing stock options to executives and employees and the issuing warrants to investors are other financing activities that can be seen in a cash flow statement.
Examples of cash inflow through financing activities include obtaining funds by issuing Equity and preference shares and taking out Debentures, Bonds, and long-term notes. Examples of cash outflow from financing activities are the Distribution of profits to shareholders, Repayment of borrowed funds, including debentures and bonds, Retirement of preferred stock, and Purchase of treasury stock.
Preparation Under the Direct Method
The cash flow statement is prepared using the Indirect method by starting with net income, adding non-cash expenses and non-operating items, and then subtracting out changes in working capital and other cash flow items. The result of this process is the net cash flow from operating activities.
Illustration of a Direct method
In the Direct method, a cash flow statement is prepared by beginning with cash received from customers and cash paid to suppliers and employees.
Changes in working capital and other cash flow items are added or subtracted to arrive at the net cash flow from operating activities. The small differences between the Direct Method and Indirect methods are mostly in terms of the presentation of the statement.
The Cash Flow Statement is an essential component of a firm’s financials. It is a useful resource for both shareholders and lenders to examine the fiscal well-being of a business. Looking at the Cash Flow Statement, one can gain insight into the company’s capacity to produce cash flows and fulfill its fiscal commitments.
Additionally, the Cash Flow Statement may pinpoint areas where the company can optimize its operations.
Conclusion
In order to properly generate a cash flow statement, one must accurately and promptly document all cash inflows and outflows of the entity. This should include all payments and receipts related to the entity’s operating, investing, and financing activities. Once all the cash inflows and outflows are logged, the entity can place them in their appropriate categories on the cash flow statement.
Additionally, the statement should be checked regularly to ensure proper financial management and accuracy. Vakilsearch also provides knowledge regarding the information about Cash flow statements. You can get in touch with us to know more in this regard.
Also, Read:
