Purpose of Cash Flow Statements

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.

The Cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities.read more is a financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more 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 an important document demanded by both regulators and investors.

Purpose of Cash Flow Statements

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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 out of the firm. More than that, it explains how the cash was generated and how it was used further during a particular accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more.

Consider the following cash flow statement. It depicts, the cash generated, cash distributed, and on what activities it was done.

example1

#2 – Information about Non-Cash Investing and Financing Activities

It describes the money spent on 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.

On 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.

example2

Reporting of such information is along with additional exposures, if any, as both regulators and investors closely follow it.

#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 flow numbers look promising but are only one time and might not repeat in the future. For instance, consider the following cash flow statement

Financial Condition of Firm example3

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 price 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 have to be taken with a pinch of salt. If we remove the cash generated from these activities, the situation changes, and it’s 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 the Statement of cash flow is to indicate the management strategy and the future outlook of the firm. Consider the following example

example 4

Here the management is trying to liquidate its assets when the core operating activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more 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. It requires further investigation, and investors should follow management commentary closely to dive in further.

Firms must 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. If the detection of any financial fraud happens in the initial stages, it removes any catastrophic events in the future. There is a common debate about the financial crisis of 2008-09. If the regulators across the world have been more vigilant, the identification and diagnosis of effects of the recession had bee done at the right time. E.g., In the case of SATYAM scam, a lot of money was being spent on MAYTAS rather than on any operational activities. Thus if SEBI could have analyzed the cash flow statement of the SATYAM, they had detected the scam much earlier. Thus, a lot of investors’ money could have been saved.

Conclusion

The cash flow statement is an indicator of the liquidity of the firmLiquidity Of The FirmLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more. 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 accountingCreative AccountingCreative accounting is a method used to make or interpret accounting policies falsely to misuse the accounting techniques and standards set by the accounting bodies. The purpose of doing so is to make profits by not reporting the exact figures and exploiting loopholes in our accounting system.read more illusion provided and identifying if the firm is solvent or facing a cash crunch.

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