Interpreting the Cash Flow Statement: Accounting Basics for FP&A - Part 3 (2024)

In our last two articles, we looked at the Income Statement and the Balance Sheet. Here are the links to both articles

Here is a quick recap of the Basic Accounting equation

Now let's take a closer look at the Cash Flow Statement:

What is Cash Flow?

Cash is a key indicator of financial health. It is the net change in the company’s cash position from one period to the next.

If the inflow is higher than the outflow, the company is having positive cash flow. A negative cash flow situation arises when cash outflow exceeds the inflow.

Purpose of the Statement of Cash Flows

Business investments with a good long term cash flow prospects often generate poor cash flow in the short term (or the early years). Measuring net income by means of the accrual basis of accounting might be short-sighted.

The statement of cash flows summarizes the effects on the operating, investing, and financing activities of the company during an accounting period.

It tells where the cash came from and where it went while explaining the change in the cash balance.

Need for a Healthy Cash Flow

It helps the readers of financial statements assess the

-Ability to generate positive future cash flows

-Ability to pay dividends

-Reasons for differences between accrual and cash basis income

-Ability to meet obligations

-Need for external financing

Difference between Cash Flow and Income Statement

Cash Flow terminology

-Operating Activities are transactions that enter into the determination of Net Income

-Investing Activities are transactions involving acquisition or disposal of assets.

-Financing Activities are transactions involving stockholders and creditors or lenders.

If the business is profitable, then we must understand that there are 4 forces that demand satisfaction out of the company’s cash flows – and they are in opposite order to what you would prefer.

1.Taxes: You must either set aside money or pay chunks of taxes as you go to avoid the year-end surprise.

2.Debt: Interest on loans and Lines of credit for businesses

3.Core Working Capital: retain after tax profits until we reach our core capital target, which is generally defined as 2 months of operating cash with nothing drawn on the line of credit and your anticipated taxes set aside.

4.Distributions: Reap the rewards and finally distribute after tax profits to stockholders.

Steps in Preparing a Statement of Cash Flow :

Example: Calculate the cash flow from operating activities during the year 2021

-XYZ Inc reports INR 1,25,000/- Net Income for the year ended 31 December 2021.

-Accounts receivable increased by INR 7,500/- during the year and

-Accounts payable increased by INR 10,000/-

-During 2021, XYZ Inc reported an INR 12,500/- depreciation expense.

Cash Flow format:

Non-Cash Activities:

The reason that non-cash investing and finance activities must be disclosed in notes to the statement of cash flows. The reader wants to know why all amounts on the comparative balance sheets changed from beginning to the end of the year, whether cash was involved or not. Therefore, it is good to be disclosed here.

What to look for in cash flows?

Increase in operating cash flows suggests a positive health of the company. On the other hand, decreasing or negative operating cash flows suggest something is not right.

Cash flow statement truly reflects the working capital and solvency of the company.

This is the third part of Accounting Basics for FP&A series. Here are the links to the first two parts

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