Today’s Masterclass looks at what is cashflow and the Cashflow Statement, what does it tell us and why it is as important along-side the Profit & Loss and Balance Sheet.
What is the Cashflow Statement:
Cashflow looks at the ACTUAL CASH and is essential to showing the solvency of a business. It is a record of what has happened in the past, like inflow such as the sale of service or product, what was spent and on what in three key areas – Operations, Investing or Financing. In other words, it shows what a business took in and spent. It can also be projected into the future to predict what is coming and where cash will be short. Cashflow is crucial to managing business survival. Having adequate cash on hand will ensure that suppliers/creditors, employees and others are paid on time. When a business or person does not have enough cash to support its operations, it is said to be insolvent, and a possible candidate for bankruptcy if the insolvency continues, depending on the circumstances.
The Cashflow statement of a business’s cashflows can be used to gauge financial performance. Companies with spare cash on hand are able to invest the cash back into the business in order to generate more cash and profit.
Cash inflows usually arise from one of three activities – Operations, Investing and Financing (as well as a result of donations or gifts in the case of personal finance).
Cash outflows are for expenses or investments in assets (both business and personal finance) in the same three activities.
Examples of cash transactions are sales paid into the bank, expenses paid from the bank or purchasing inventory, loans of actual money into the bank, loan instalment payments, prepayment of interest or insurance premiums. NON-cash transactions that will NOT be on the Cashflow Statement are increase in asset value, depreciation, invoicing such as payment terms 30 days, placing an order for stock to pay in 45 days.
The statement is calculated by adding the noncash charges (such as depreciation etc) back to net income after taxes. Cashflow can be reported for a specific project, or for the business as a whole. Cashflow is an indication of a company’s financial strength.
The areas of the statement are:
- Operating activities – Reports the received and paid parts from the income statement (no invoices outstanding to be paid or to pay) ;
- Investing activities – Reports the cash-paid purchase and sale of long-term investments and property, plant and equipment;
- Financing activities – Reports loans taken and re-payments on loans, as well as the issuance and repurchase of the company’s own bonds and stock and the payment of dividends;
- Supplemental information – Reports the cash of significant items and reports the amount of income taxes paid and interest paid. Although these are sometimes included in the Operating area above.
Because the Income Statement or Profit & Loss Statement reports under the accrual basis of accounting, the sales/revenues reported may not have been collected yet. Similarly, the expenses reported on the income statement might not have been paid yet. We can review the Balance Sheet changes to see what occurred (debtor or accounts payable increase or decrease, etc), but the cash flow statement already has included all that information.
To use the Cashflow Statement: The cash from Operating activities is compared to the company’s net income on the Profit & Loss. If the cash from operating activities is consistently greater than the net-profit income, we say the company’s net income or earnings are of a “high quality”. If the cash from operating activities is less than net income, a red flag is raised and we need to look at why the reported net income is not turning into cash.
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