Cash Flows are inflows and outflows, i.e., the movement of cash and cash equivalents. All transactions that lead to an increase in cash and cash equivalents are classified as inflows of cash and all those transactions that lead to a decrease in cash and cash equivalents are classified as outflows of cash.
Meaning of Cash Flow Statement
The Cash Flow Statement, therefore, is a statement that shows the flow of cash and cash equivalents during a period. The cash flow statement is prepared classifying the transactions into:
1. Operating Activities
2. Investing Activities
3. Financing Activities.
Objective of Cash Flow Statement
The objectives of the cash flow statement are:
1. To ascertain the sources from activities (i.e., operating/investing/financing activities) from which, cash and cash equivalents were generated by an enterprise.
2. To ascertain the uses by activities (i.e., operating/investing/financing activities) for which cash and cash equivalents were used by an enterprise.
3. To ascertain the net change in cash and cash equivalents indicating the difference between sources and uses from or by the three activities between the dates of two balance sheets.
The information about the cash flows of the enterprise, when provided to the users of financial statements in the above manner, provides them a basis to assess the ability of the enterprise to generate cash and cash equivalents and the needs of the enterprise to utilize those cash and cash equivalents.
Uses of Cash Flow Statement
1. Short Term Planning:
The cash flow statement gives information regarding sources and application of cash and cash equivalents for a specific period so that it becomes easier to plan investments, operating and financing needs of an enterprise.
2. The cash flow helps understand liquidity and solvency:
Solvency is the ability of the business to meet its current liabilities. Quarterly or monthly cash flow statements help ascertain liquidity in a better way. financial institutions, like banks prefer the cash flow statement to analyze liquidity.
3. Efficient Cash Management:
The cash flow statement provides information relating to surplus or deficit of cash. An enterprise, therefore, can decide about the short term investments of the surplus and can arrange the short term credit in case of deficit.
4. Comparative Study:
A comparison of the cash flows for the previous year with the budgeted figures of the same year will indicate to what extent the cash resources of the business were generated and applied according to the plan. It is, therefore, useful for the management to prepare cash budgets.
5. Reasons for Cash Position:
The cash flow statement explains the reasons for lower and higher cash balances with the enterprise. Sometimes, a lower cash balance is found in spite of higher profits or a higher cash balance is found in spite of lower profits. Reasons for such situations can be analyzed with the help of the cash flow statement. Sometimes in spite of high profits cash is inadequate to pay dividends. Where have the profits gone? Answers to such questions can be found from the cash flow statement.
6. Test for the Management Decisions:
It is a general rule that fixed assets are purchased from the funds raised from long term sources, and the best way to repay the long term debt is out of profits. The cash flow statement shows clearly whether the cash inflows from operations have been used for the purchase of fixed assets or whether these assets have been purchased from cash inflows from long-term debts. Similarly, it also explains whether the debentures have been redeemed out of profits or not. Thus, the cash flow statement can be used to test the credibility of the management decisions.
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