Cash Flow Statement: Meaning, Features, Objectives and Importance

Meaning of Cash Flow Statement:

A cash flow statement is a statement of changes in the financial position of a firm
on cash basis. It reveals the net effects of all business transactions of a firm during
a period on cash and explains the reasons of changes in cash position between two
balance sheet dates.
It shows the various sources (i.e., inflows) and applications (i.e., outflows) of cash
during a particular period and their net impact on the cash balance.
According to Khan and Jain:
“Cash Flow statements are statements of changes in financial position prepared on
the basis of funds defined as cash or cash equivalents.”
The Institute of Cost and Works Accountants of India defines Cash Flow statement
as “a statement setting out the flow of cash under distinct heads of sources of
funds and their utilisation to determine the requirements of cash during the
given period and to prepare for its adequate provision.”

Thus, a cash flow statement is a statement which provides a detailed explanation

for the changes in a firm’s cash balance during a particular period by indicating the
firm’s sources and uses of cash and, ultimately, net impact on cash balance during
that period.

Features of Cash Flow Statement:

The features or characteristics of Cash Flow Statement may be summarized in
the following way:
1. It is a periodical statement as it covers a particular period of time, say, month or
year.
2. It shows movement of cash in between two balance sheet dates.
3. It establishes the relationship between net profit and changes in cash position of
the firm.
4. It does not involve matching of cost against revenue.
5. It shows the sources and application of funds during a particular period of time.
6. It records the changes in fixed assets as well as current assets.
7. A projected cash flow statement is referred to as cash budget.
8. It is an indicator of cash earning capacity of the firm.
9. It reflects clearly how financial position of a firm changes over a period of time
due to its operating activities, investing activities and financing activities.

Objectives of Cash Flow Statement:

Cash Flow Statement is prepared to fulfill some objectives.
Some of the main objectives of Cash Flow Statement are:
1. It shows the cash earning capacity of the firm.
2. It indicates different sources from which cash been collected and various
purposes for which cash has been utilised during the year.
3. It classifies cash flows during the period from operating, investing and financing
activities.
4. It gives answers to various perplexing questions often encountered by
management, such as why the firm is unable to pay dividend instead of making
enough profit. Why there is huge idle cash balance in spite of loss suffered? Where
have the proceeds of sale of fixed assets gone? Etc.
5. It helps the management in cash planning and control so that there is no shortage
or surplus of cash at any point of time.
6. It evaluates the ability of the firm to meet obligations such as loan repayment,
dividends, taxes etc.
7. A prospective investor consults the cash flow statement to ensure that his
investment gets regular returns in future.
8. It discloses the reasons for differences among net income, cash receipts and cash
payments.
9. It helps the management in taking capital budgeting decisions more
scientifically. 10. It ensures optimum use of funds for the maximum benefit of the
enterprise.

Utility or Importance of Cash Flow Statement:

Cash Flow Statement is useful for short-term planning and control of cash. A
business entity needs sufficient amount of cash to meet its various obligations in
the near future such as payment for purchase of fixed assets, payment of debts,
operating expenses of the business etc.
It helps the financial manager to make a cash flow projection for the immediate
future taking the data relating to cash inflows and cash outflows from past records.
As such, it becomes easy for him to know the cash position which may either result
in a surplus or a deficit one. Thus, cash flow statement is another important tool of
financial analysis for the management.
Its main advantages are:
1. Evaluation of Cash Position:
It is very helpful in understanding the cash position of a firm. Since cash is the
basis for carrying on business operations smoothly, the cash flow statement is very
useful in evaluating the current cash position of the business.
2. Planning and Control:
A projected cash flow statement enables the management to plan and coordinate
the financial operations properly. The financial manager can know how much cash
is needed, from where it will be derived, how much can be generated internally,
and how much could be obtained from outside.
3. Performance Evaluation:
A comparison of actual cash flow statement with the projected cash flow statement
will disclose the failure or success of the management in managing cash resources.
Deviations will indicate the need for corrective actions.
4. Framing Long-term Planning:
The projected cash flow statement helps financial manager in exploring the
possibility of repayment of long-term debts which depends upon the availability of
cash.
5. Capital Budgeting Decision:
A projected cash flow statement also helps the management in taking capital
budgeting decisions.
6. Liquidity Position:
Liquidity position of a firm refers to its ability to meet short-term obligations such
as payment of wages and other operating expenses etc. From cash flow statement
the financial manager is able to understand how well the firm is meeting these
obligations.
At the same time the ability of the firm in cash earning can be known from cash
flow statement. As a matter of fact, a firm’s profitability is ultimately dependent
upon its cash earning capacity.

Limitations of Cash Flow Statement:

Cash Flow Statement is, no doubt, an important tool of financial analysis which
discloses the complete story of cash management. The increase in—or decrease of
—cash and reasons thereof, can be known, However, it has its own limitation.
These limitations are:
1. Since cash flow statement does not consider non-cash items, it cannot reveal the
actual net income of the business.
2. Cash flow statement cannot replace fund flow statement or income statement.
Each of them has a separate function to perform which cannot be done by the cash
flow statement.
3. The cash balance as disclosed by the projected cash flow statement may not
represent the real liquid position of the business since it can be easily influenced by
the managerial decisions, by making certain payments in advance or by post
ponding payments.
4. It cannot be used for the purpose of comparison over a period of time. A
company is not better off in the current year than the previous year because its cash
flow has increased.
5. It is not helpful in measuring the economic efficiency in certain cases e.g.,
public utility service where generally heavy capital expenditure is involved.
In spite of these limitations, it can be said that cash flow statement is a useful
supplementary instrument. It helps management in knowing the amount of capital
blocked up in a particular segment of the business. The technique of cash flow
analysis—when used in conjunction with ratio analysis—serves as a barometer in
measuring the profitability and financial position of the business.

Format of a cash flow statement

There are three sections in a cash flow statement: operating activities, investments,
and financial activities.
Operating activities: Operating activities are those cash flow activities that either
generate revenue or record the money spent on producing a product or service.
Operational business activities include inventory transactions, interest payments,
tax payments, wages to employees, and payments for rent. Any other form of cash
flow, such as investments, debts, and dividends are not included in this section.
The operations section on the cash flow statement begins with recording net
earnings, which are  obtained from the net income field on the company’s income
statement. This gives an estimate of the company’s profitability. After this, it lists
non-cash items involving operational activities and convert them into cash items. A
business’ cash flow statement should show adequate positive cash flow for its
operational activities. If it doesn’t, the business may find it difficult to manage its
daily business operations.
Investment activities: The second section on the cash flow statement records the
gains and losses caused due to investment in assets like property, plant, or
equipment (PPE) thus reflecting overall change in the cash position for a company.
When analysts want to know the company’s investment on PPE, they check for
changes on a cash flow statement.
Capital expenditure (CapEx) is another important line item under investment
activities. CapEx is the money which a business invests on fixed assets like
buildings, vehicles or land. An increase in CapEx means the company is investing
on future operations. However, it also shows that there is a decrease in company
cash flow.
Sometimes a company may experience negative cash flow due to heavy investment
expenditure, but this is not always an indicator of poor performance, because it
may be leading to high capital growth.
Financial activities: The third section on the cash flow statement records the cash
flow between the company and its owners and creditors. Financial
activities include transactions involving debt, equity, and dividends. In these
 transactions, incoming cash is recorded when capital is raised (such as from
investors or banks), and outgoing cash is recorded when dividends are paid.
Operating activities: In this section, we can see incoming cash values recorded as
positive while outgoing cash values are negative and are usually represented in
brackets. When you subtract the outgoing value from the incoming value, you
arrive at the net cash flow for operating activities. In this example, we can see that
the net value for operating activities is positive, which is a good sign for investors.
Investing activities: Since the core operating activities are generating income, the
business can now invest in equipment. Because the company is investing
$500,000 in equipment, its cash flow in this section is negative. This negative
value isn’t a bad thing—you can say that the company’s capacity to invest in PPE
reflects its growth.
Financial activities: After investing in equipment, the company still has $10,000
to pay off its debts—in this case, notes payable. Besides this the company will still
have plentiful to cover its loans in future.
 Net cash flow: When you add all three net values from the three sections on the
cash flow statement, you arrive at the net cash flow value, which in this case is $
2,528,000. This shows that the company has enough cash to continue operating.

Cash flow from Operating Activities

This section explains the cash flows from normal operational activities of the
Company whether it is the sale of goods or rendering of services. There are 2
methods of presenting operating cash flows i.e. direct and indirect method.
Direct method:
Under this method operating cashflow is differentiated between various types of
cash inflows and outflows such as:
 Cash inflow from Sale of goods/services
 Cash outflow on payment against purchase of inventories
 Cash outflow on payments of utilities, other operational expenses
 Cash outflow on payment of taxes
Indirect method:
Under this method operating cash flows are calculated using net income for the
period and adjusting it for:
 Working capital changes (ie. Differences between opening and closing balances
of stock in trade, advances & prepayments, creditors & trade liabilities, and trade
debts)
 Non-cash items such as depreciation and provision (as these do not result in any
cash flow);
 Losses/ gains on assets or other investing items (as these items are clubbed under
investing activities)
 Other income (as these are included in investing activities)
 Financial charges (as these are included in financing activities)
Cash flow from investing activities
This section explains the cash flows from investing activities such as:
 Purchase of operating assets – (cash outflow)
 Disposal of operating assets – (cash inflow)
 Purchase of investments – (cash outflow)
 Sale of investment – (cash inflow)
 Dividend received on investment – (cash inflow)
 Interest income on long term deposits – (cash inflow)
Cash flow from financing activities
This section explains the cash flows from financing activities such as:
 Issuance of share capital – (cash inflow)
 Payment of dividend on share capital – (Cash outflow)
 Issuance of preference shares  – (cash inflows)
 Payment of interest on preference shares – (Cash outflow)
 Long term loan from banks – (cash inflow)
 Repayment of long term loan  – (cash outflow)
 Payment of interest on long term loan– (cash outflow)

Steps for solving example: 

  1. According to the question prepared Adj. P & L Account and other necessary
Account.
2. Apply all adjustments on the respected items which are connected to the
accounts.
3. Mark on the particular transactions which are going to record in CFS also.
4. Find out balance for Adj. P & L Account and all other accounts.
5. Now, prepare CFS with Adj. Profit before tax and after depreciation and non‐
cash items.
 6. Identified operating items like changes in working capital record first and then
deduct tax liability form it, you will get answer that Cash Flow from operating
activity.
   7. Now, identified changes in fixed assets and investments and find out changes
in Cash Flow from investing activities.
8. Finally, check about changes in financing activities and find out changes in Cash
Flow from it like Equity capital, Pref. Cap., Debenture, Bank Loan, Dividend and
Interest paid etc.  
9. At last, make total of changes in all activities and added opening Bank and Cash
balance on it.  Answer will be showing it that is closing bank and cash balance.

What is negative cash flow?

Negative cash flow is a situation where a company has more outgoing cash than
incoming cash. The money that the company is earning from sales may not be
enough to cover its expenses, and it may have to borrow from external sources to
cover the differences.
A negative cash flow doesn’t always imply that the company’s financial
performance was bad. Sometimes the company’s incoming profit might be good,
yet there is little money in the bank to pay off debts. Negative cash flow is
common for small businesses, but it is unhealthy if it goes on for a long period.

Conclusion
A cash flow statement is a valuable document for a company, as it shows whether
the business has enough liquid cash to pay its dues and invest in assets. You cannot
interpret a company’s performance just by looking at the cash flow statement. You
may need to analyse long term trends after referring to balance sheet and income
statement in order to get a somewhat clear picture of how the company is faring.