The cash flow statement is important because it is used to measure the cash position of the business, i.e., the inflow and outflow of cash and cash equivalents in the business for an accounting year, and it also helps the business to know the availability of cash in their business.
Why is Cash Flow Statement Important?
Cash Flow Statement Cash Flow Statement A Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more is that it measures the cash inflows or cash outflows during the given period. Such details of the cash position of the company can not only help the company or the financial analyst to plan for the short term or long term and also analyze the optimum level of cash and working capital needed in the company.
There are three categories under which the cash sources and the uses of the cash are divided, which include:
- The Cash flow Statement from operating activities is crucial as it focuses on cash flows from the business’s main activities like selling and buying the merchandise, provisioning the services, etc.
- The Cash flows Statement from investing is important because it provides details of the company’s purchase and sale of the capital assets, i.e., the assets having a useful life of more than one year as per the company’s balance sheet.
- Cash flows Statement from finance is crucial as it considers the stock purchase or sale by the company and any other proceeds or payments concerning the debt financing. Thus they are the section in the company’s cash flow, which reflects the company’s net cash flows, which is used for the funding.
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Importance of Cash Flow Statement
Let us discuss step by step the importance of cash flow statement with examplesCash Flow Statement With ExamplesA cash flow statement is a financial statement that provides a detailed analysis of how the cash inflows and outflows happened because of its operations and any external investment and financing in the given accounting period. read more –
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#1 – Short Term Planning
The Cash Flow Statement is considered a useful and vital tool for the company’s management for short-term planning and keeping control of cash. To meet the various obligations, every business entity must keep a sufficient amount of liquid funds so that as and when the requirement arises, it can pay the same. Thus the cash flow statement helps the financial manager in projecting the cash flow shortly by using the past data of the cash inflows and outflows.
For Example, The company needs the cash to meet the various obligations that could arise shortly, like paying debts, variousOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more, etc.
#2 – Provides the Details where the Money is Spent
Another importance of the Cash Flow statement is that there are additional payments that the company makes and are not reflected in the profit and loss statement. In contrast, the same is present in the cash flow statement. Thus the cash flow statement provides the detailed areas where the company spends the money.
For Example, If the company has the loan and it is paying off the principal amount back to the bank, then, in that case, the payment will not get reflected in the Profit and loss statement of the company. In contrast, the same will be available in the cash flow statement. There might be a situation where the company has the profits, but after paying the principal amount, it has no funds to pay off its obligations. Such situations can be identified using the cash flow statement.
#3 – Creating Excess Cash
Every business enterprise runs with the motive of earning profits. The profit helps create the cash, but other ways also help create the cash in the company. These ways can be identified and implemented by focusing on the cash flow statement. On the other hand, concentrating only on the P & L account makes it hard to focus on creating cash.
For Example, excess cash can be created if the company can collect the receivables from its customers faster, if it efficiently uses the inventory, etc.
#4 – Revealing the Cash Planning Results
Another importance of the cash flow statement is that it helps companies analyze the extent to which the cash planning of the company became successful as the actual results can be compared with the projected statement of the Cash Flow Statement or the Cash budget. The results will then help the company to take the measures accordingly. Thus it helps the company compare the past assessments’ cash budgetCash BudgetCash budget refers to cash inflows and outflows estimations made by a company's management over a given period to evaluate whether the business has adequate cash & cash equivalents to meet its operational needs in the coming future.read more with that of the current budget to assess the cash requirement of the company in the future.
For Example, the company expected that the expenditure on the capital asset for the particular month would be $10,000, but the actual was $20,000. So such a variance between expected and actual should be identified by the company, and the action should be taken accordingly.
#5 – Long Term Planning
This is another importance of the cash flow statement because it helps the management make the long-term planning of the cash. The company must make long-term financial planning as the growth of the company is dependent on that. Thus it reveals vital changes that are required for a company’s financial positioning and helps the management prioritize the business’s crucial activities.
For Example, projected cash flow helps the company’s management identify the possibility of long term debtLong Term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more repayment as the same depends on the availability of the cash.
#6 – Knowing the Optimum Level of Cash Balance
The importance of the Cash Flow Statement is that it helps the company ascertain the Optimum level of Cash Balance. The company must determine the optimum level of Cash Balance because this firm can know whether the funds are lying idle, there is a shortage of cash, or the funds are excess. After knowing the actual cash position, the company’s management can make the decisions accordingly.
For Example, suppose there is a surplus of cash and funds are lying idle. In that case, the company can invest surplus cash, or if there are deficit funds, it can decide to borrow the funds from outside to overcome the deficit situation.
#7 – Helps in Analyzing the Working Capital
Working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)"read more is the component of the cash flow from the operations that can influence the companies’ cash flow. Thus, the investors should be aware of the company’s working capital movement.
For Example, the company can preserve its cash by increasing the time for paying the bills. It can increase cash inflow by reducing the time taken to collect the amount from debtors and delay buying inventory to preserve cash, etc.
Recommended Articles
This article has been a guide to Cash Flow Statement Importance. Here we discuss the top reasons why a cash flow statement is vital, including short term & long term planning, working capital analysis, understanding optimal cash, and more. You may also learn more about Accounting from the following articles –
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