The three principal financial statements are:
· the profit and loss account
· the balance sheet
· the cash flow statements
These three statements are useful in understanding the financial health, strength and durability of a business. The profit and loss account is a performance statement as it measures profitability and the balance sheet shows the financial position of the business. The cash flow is different as it demonstrates a business’ ability to adapt financially.
The balance sheet and profit and loss accounts are derivative of accounting standards such as SSAPs, IFRS and GAAP to name a few, but the cash flow is a derivative of the hard cash movements that would have happened in the business during the financial year. The cash flow statement therefore demonstrates the quality of the profit on the profit and loss account and the quality of the financial position on the balance sheet.
If cash flows are strong it means that most sales would have been converted into cash and that there will be no necessity in future to write off any sales or debts. Strong cash flows will demonstrate that the business’ balance sheet is strong, which means a company will have cash to support growth, to support day to day activities and to pay creditors when payments are due.
Since cash flows statements are derivatives from cash movements they classify business cash flows into three main cash categories which are:
· Operating activities
· Investing activities
· Financial activities
Operating activities
Cash from operating activities is the cash that the business pays for its day-to-day activities, to creditors for supplying stock, inventory and wages it pays to its employees. It is also the cash receipts from its customers from sales of products and services, receipts from debtors and from payments of taxes such as VAT, PAYE and corporation tax.
Business expenses such as depreciation and provision for taxes and doubtful debts are excluded from operating activities even though they are part of the operating expenses because they do not involve cash out flows. The cash flows from operating activities show the hard cash that was received or paid by the business in conducting its day-to-day business.
A positive net cash flow from operating activities demonstrates that the business is doing well as the business is generating sufficient cash to sustain itself. Such a business is likely to succeed in the long term since it has free cash flows as it does not need to sell assets or to get funding from lenders or investors to fund its day-to-day activities.
Investing activities
Cash flows from disposal of fixed assets and cash out lays to pay for acquisition of assets are the main components that make up cash flows from investing activities. A business that has positive cash flows from investing activities is likely to be selling fixed assets and this could indicate that the business is either in the process of withdrawing from certain markets or it is just having cash flow problems which are forcing it to sell fixed assets.
A business with net negative cash flows from investing activities are likely to be investing in the business’ future because they are acquiring assets to either maintain the current market position or to support business growth.
Financing activities
The cash flow from financing activities is likely to be made up of cash receipts from loans, debentures and issues of new shares or from cash payments arising loans, debentures and issues of new shares. A growing business is likely to have net cash inflows of cash flows for financing and business that are shrinking. Those that are generating free cash flows from operating activities are likely going to have net cash out flows from financing.
Conclusion
The cash flow statement is one of the three principal basic financial statements and it shows the cash movements during the financial year. The cash flow demonstrates a business’ ability to adapt financially. The cash flow statement demonstrates the quality of the profit on the profit and loss account and the quality of the financial position on the balance sheet. Cash flow statements are derivatives from cash movements during the year and they classify business cash flows into three main cash categories which are operating activities, investing activities and financial activities.
Munya Mtetwa - Munya is an ACCA and IFA qualified accountant with over ten years financial management and accounting experience acquired in a plethora of ...
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