Key Elements of Cash Flow and Interpretation

Chapter 10

What are the key elements of a cash flow statement and how should they be interpreted?

The question requires a description of the purpose of the cash flow statement as measuring the flow of cash over a given period in terms of operating, investing and financing activity.  The 14 key elements (p88 Course guide) need to be identified and their meaning discussed.  

Good answers will  

 Define what a cash flow statement is

 Identify its key elements, give one or more examples of how a cash flow statement works (The example in the course guide is a simple one of a match seller)

 Discuss the meaning that may be ascribed to these elements and the information contained therein.

Cash flow describes real or virtual movement of money. In accounting, cash flow = cash inflow - cash outflow. Cash flow statement, aka funds statement, is a statement that reports the cash receipts and cash payment of any organisation during a particular period of time. Cash includes cash on hand, deposit in bank and other financial institution, and cash equivalents. Cash is crucial to the existence of a successful business operation as cash differs from profit stated in income statement. So, although some business that have high profit, would still wind up due to cash flow problems. Hence, cash is the life-giving force of a business entity where close attention to how cash is managed have be given. Without cash, employees cant be paid, supplies and inventories cant be acquired, debts cant be repaid and owners may not have return on investment.

Cash flow statement includes important information that is not available in other financial statement (ie income statement, balance sheet). It is intended to complete the picture of financial condition and results of operations that is communicated to users. It also helps to explain the underlying events and activities which shows the relationship of net income to changes in cash balance. The reports of past cash flow could aid to predict future cash flow, evaluate management's generation and sue of cash, and determine a company's ability to pay interest and dividends. It also reveals commitment to assets that may restrict or expand future courses of action. In short, it provides a summary of allowing transactions that affected cash in the firm and the allocation on how cash earned and used. There are three categories for presentation in cash flow statement which are operating activities, investing activities and financing activities. Operating activities deal with the noncash current assets while investing and financing cash flow relate to noncurrent assets such as fixed assets, long-term debts, and stockholders' equity.  

Further there are two ways to display the amount in cash flow statement; direct and indirect method. The only different is the procedures involved in calculation of operating activities but giving the same amount. While the content of investing and financing sections will be the same under both method. The use of direct method requires detailed analysis of the cash account. All cash transactions must be classified and summarized which is very difficult and time-consuming to reconstruct cash transactions and obtain data required to complete the cash flow statement and does not provide adequate explanation of differences between net cash flow from operations (cash flow statement) and accrual basis income (income statement). Consequently, supplementary schedule (ie noncash investing and financing activities, reconciliation of net income and net cash flow from operations) is required. On the other hand, the indirect method of calculation begins with the amount of net income reported on the income statement from the accrual basis to the cash basis of accounting. Reconciliation of accrual income to cash income is a part of the cash flow statement hence no supplementary schedule is required. Indirect method is more preferred by many accountants.

First is the operating activities which includes transactions with suppliers, customers, employees, government, etc. Cash flow from operating activities are generally the effects of transactions that affect income statement. Sales can be cash or on credit. Expenses incurred can be paid by cash or on credit. Cash is generated by sales, collected from customers, from interest earned and dividend received while can be used for payments to suppliers for goods and services, wages and benefit to employees, tax paid to government, and interest payment.

Changes in all balance sheet must be identified. These changes are analysed to determine whether transactions that caused changes result in cash inflow or outflow. Cash flow statement starts off with the net income from income statement which is also know as the earnings after interest and taxes. Then check on the non cash charges which includes depreciation of fixed assets and amortisation of intangible assets. Both is an expense but not a cash flow which is deducted in reported net income. Hence this is needed to be added back to net income to get cash from operations. This addition simply cancel out the earlier deduction. Thus, without depreciation and amortisation charges is earnings before interest, taxation, depreciation and amortisation.