What is the Purpose of the Cash Flow Statement?
Preparation of a cash flow statement serves various purposes like stating the cash movements with respect to cash inflows and outflows, the performance of strategic decisions taken by the management, and provides relevant information about the financial well-being of an organization so that its liquidity status can be derived and projected to the readers of its financial statements.
Cash flow statement is a financial statement that depicts the details of such transactions during an accounting period. It gives a clear picture of the amount of cash flowing into the firm and the amount of cash flowing out of the firm. Additionally, along with the information of cash inflow and outflow, it also provides the sources of these activities.
Such disclosure helps in understanding if the core business of the firm is self-sustainable and has long term growth prospects. Because of the clarity it provides, a cash flow statement is considered as an important document demanded by both regulators and investors.
Top 5 Purpose/Objective of the Cash Flow Statements
#1 – The Explanation for the Changes in Cash
The objective of the Statement of cash flow is to provide a detailed description of how and in what amounts the cash is flowing in and flowing out of the firm. More than that it explains how the cash was generated and how it was used further during a particular accounting period.
Consider the following cash flow statement where the cash generated, cash distributed and on what activities it was done is clearly depicted.
#2 – Information about Non-Cash Investing and Financing Activities
It provides a description of how much money was used in non-core activities like investing and financing activities. These activities even though non-core have a significant effect on the current and future cash flows of the firm.
Analyzing our cash flow statement example, it can be depicted that the cash flow from these activities was 12000 and -2000 respectively as shown below.
Such information is required to be reported with additional exposures if any as it is followed closely by both regulators and investors.
#3 – Financial Condition of the Firm
It not only focusses on financial numbers but also on how these numbers have been achieved. There might be a case where the cash flows numbers look promising but are only one time and might not repeat in the future. For instance, consider the following cash flow statement
Looking at the final numbers one might say that the firm is doing well as it has a cash surplus of 27000. Such an interpretation should be enough for the stock prize to shoot upwards.
However, analyzing further a prudent investor should be able to identify that the core activities of the firm have posted negative numbers. It’s only the non-core activities like sale of land and old machinery because of which the final number looks better. Such activities are only one time payments and should be taken with pinch of salt. If we remove the cash generated from these activities the situation changes and its clear that the firm has posted bad results for the current financial year. Once this is clear it won’t take much time for the stock euphoria to disappear and stock price to go southwards.
#4 – Provides a View of Management Strategy
The primary purpose/objective of Statement of cash flow is to provide an indication of the management strategy and the future outlook of the firm. Consider the following example
Here the management is trying to liquidate its assets when the core operating activities of the business are yielding negative numbers, should raise alarm bells. Investors should take a clue that such negative numbers are not at the expense of a growth strategy. In fact, there might be a scenario that the firm is finding it difficult to find investors or raise money from the market. Management in such a scenario is trying its best to remain solvent. This requires further investigation and investors should follow management commentary closely to dive in further.
#5 – Legal Requirements
It is imperative for firms to report the cash flow statement in accordance with accounting standards. These are required and closely watched by regulators to make sure that the investor’s money is safe, and any financial fraud can be detected in initial stages to remove any catastrophic events in the future. It is widely debated that during the financial crisis of 2008-09 if the regulators across the world have been more vigilant, the effects of the recession could have been identified and diagnosed at the right time. For example, If SEBI would have analyzed the cash flow statement of SATYAM where a lot of money was being spent on MAYTAS rather than on any operational activities, the SATYAM scam could have been detected much earlier and a lot of investors’ money could have been saved.
The cash flow statement is an indicator of the liquidity of the firm. It provides useful information to the investors about the cash inflows and outflows. More importantly by providing how this cash was generated it helps in eliminating any creative accounting illusion provided and identifying if the firm is solvent or facing a cash crunch.
This has been a guide to the Purpose & Objective of the Cash Flow Statement. Here we discuss the top 5 purposes of the cash flow statement along with practical examples and explanation. You can learn more about Accounting from the following articles –