Literature Review on Cash Flow Statements
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The previous chapter has discussed the enquiry of the study, highlighted the overviews background of the company.This chapter looks at the concept of cash flow statement as given by other authors and researchers with importance to accountability, profit measurement, solvency, ambiguity, and disclosure and their specific relevance for proper financial management of commercial company .one of the aim and objectives of this dissertation was to review conceptual though and theoretical framework related to cash flow analysis. Developing a critical review of cash flow literature and any related issues help the researcher, manager and any potential reader to better understand the subject and also provide a framework for data analysis. Governance as stated in the UK charity commission standard for good governance code is “the systems and processes concerned with ensuring the overall direction, effectiveness, supervision and accountability of an organization.”
This chapter begins with a clarified concept of cash flow as stated by the Financial Accounting Standard Board (FASB) and also develop and update and utility of cash flow when managing commercial activities. How the better knowledge on that topic helps in business decision making nowadays.
2.1 Expansion of the reporting standard
The Financial Accounting Standards Board (FASB) introduced Statement of Financial Accounting Standards No. 95 which is the Statement of Cash Flows in November 1987. The requirement of FASB 95 regarding a full set of financial statements classified cash flow as the fourth required financial statement (along with a balance sheet, income statement, and statement of retained earnings). This statement established standards for cash flow reporting, and dated out the Accounting Principles Board (APB) Opinion No. 19, Reporting Changes in Financial Position. In March 1971, the APB Opinion No.19 gave chances to enterprises to report cash flow information in a statement of changes in financial position commonly called a funds statement. During that time, there was no formal or universally accepted definition to catalogue each statement even though the term “funds” was not sufficiently defined (Alves et al 2008). Every single industry however had different funds constitution to others since the statement referred to changes in funds. The term funds referred sometimes to cash for some company meanwhile some used cash and short term investment and some used quick asset, some used working capital. The relevance and the valuation of funds statement has been recognised in most company but the lack of consistency in format and focus from one firm to another was responsible of the main reason that the FASB obviously took up the matter and with extensive commentary from accountants and any other interested parties, adopted the standards espoused in FASB 95.it effectively took place in 1988 had not encouraged use of the world “funds” because it had been stated with so much (Alves et al 2008).
2.2 Cash flow statement
A cash flow statement is an important indicator of financial health because it is possible for a company to show profits while not having enough cash to sustain operations. It is a financial report that shows to the user the source of a company's cash and how it was spent over a specific period of time. A cash flow statement counters the ambiguity regarding a company's solvency that various accrual accounting measures create. It also categorizes the sources and uses of cash to provide the reader with an understanding of the amount of cash a company generates and uses in its operations, as opposed to the amount of cash provided by sources outside the company, such as borrowed funds or funds from stockholders. The cash flow statement also tells the reader how much money was spent for items that do not appear on the income statement, such as loan repayments, long-term asset purchases, and payment of cash dividends (Ryan 2007).
2.3 Requirements for cash flow statement
Thornton (2008) indicated that FASB 95 requires a statement of cash flows to classify cash receipts and cash payments in accordance with the prescribe format whether they start from operating activities, investing activities, or financing activities. The provisions given by FASB are as follows on the presentation of cash flow statement are:
- it provides that the cash flows statement should be prepared under either direct or indirect method and provides examples of how to use each method when preparing statements.
- It also provides that under the core concept, cash is stated as “cash and cash equivalents”. while cash is the most liquid assets within the asset portion of a company's balance sheet including currency and bank deposit, in the other hand cash equivalents are asset that are ready to be converted into cash such as money market holding, short term government bond, bills, marketable securities and commercial paper. Other sources of investments such as stocks, bonds, futures contracts, and so forth are not considered cash.
2.4 Cash and profitability concepts
Cash is one of the most important aspects of running any large or small business. It is one of the single most important reasons why many businesses fail regardless of how good the business is. The physical aspect of cash can be any currency, coins on hand, bank balances, negotiable money and so forth. Managing cash flow therefore is vitally important in the soft running, survival and success of a business (Atrill P. 2004).
The use of some examples has illustrated how cash flow can make the difference between success and failure. The meaning of failure in this case is insolvency that is, the company is unable to pay its debts. The term bankrupt is sometimes used to describe that situation, even though it is only individual who can be declared bankrupt. But sometimes both terms can be confusing.
2.4.2 Significance of non-cash transactions
Also known as profitability, non-cash transactions are not included in the statement of cash flows, but often they need to be disclosed elsewhere in financial statements. Examples of these types of transactions include:
Conversion of bonds to stock
Acquisition of assets by assuming liabilities.
When there are some few of such transaction, it may be fairly recommended to include them on the same page as the statement of cash flows but in a separate schedule at the bottom of the statement of cash flows. Otherwise, the transactions may be reported elsewhere in the financial statements, clearly referenced to the statement of cash flows. Some other transactions are generally reported in combination with statement of cash; these include stock dividends, stock splits, and appropriation of retained earnings.
2.6 Classifications/ Presentation of cash flow statement
Nearly all business transactions completed during the fiscal year impact cash flow in one way or another, and in summary form they are factored into the year's cash flow statement. Exactly where on the statement depends on the nature of the transaction. As noted, the three essential categories of cash flow are operating activities, investing activities, and financing activities. The components of each of these will be addressed separately.
2.6.1 Operating activities
Operating activities are the fundamental transactions that keep the business running. Most notably, they include incoming revenue (also known as net income) from the sale of goods or services and most kinds of outgoing payments. Cash flow from operating activities doesn't include principal paid on or received from loans, and only includes transactions that were completed during the period. This simply means that an operating transaction is not considered cash flow until the cash is actually received or paid, as opposed to just being recorded as accounts receivable or payable. In general, if an activity would appear on the company's income statement, it would be a candidate for the operating section of the cash flow statement. Net changes in balance sheet categories from period to period also represent cash flow; thus, a net decrease in accounts receivable from year to year normally suggests an increase in cash flow for that period. Sometimes goods or services are paid for prior to the period in which the benefit is matched to revenue (recognized). This results in a deferred or prepaid expense. Items such as insurance premiums that are paid in advance of the coverage period are classified as prepaid. Sometimes goods or services are received and used by the company before they are paid for, such as telephone service or merchandise inventory. These items are called accrued expenses, or payables, and are recognized on the income statement as an expense before the cash flow occurs. Operating activities include the production, sales and delivery of the company's product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product.
Under IAS 7, operating cash flows include:
- Receipts from the sale of goods or services
- Receipts for the sale of loans, debt or equity instruments in a trading portfolio
- Interest received on loans
- Dividends received on equity securities
- Payments to suppliers for goods and services
- Payments to employees or on behalf of employees
- Interest payments (alternatively, this can be reported under financing activities in IAS 7, and US GAAP)
- Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the Income Statement) to arrive at cash flows from operations generally include:
- Depreciation (decline in value of assets and, loss of tangible asset value over time)
- Deferred tax
- Amortization (loss of intangible asset value over time)
Any gains or losses associated with the sale of a non-current asset, because associated cash flows do not belong in the operating section.(unrealized gains/losses are also added back from the income statement
2.6.2 Investing activities
Investment activities represent the cash flow from the purchase of long term assets ( such as property and equipment) required to make or sell goods and services. Investment activities also include purchases of stocks or other securities, loans made to other businesses. A major issue that potential investors have with the investing activities section is that the money listed here represents activities paid for in cash. In other words, it includes only the principal or book value of the investment. So, if an example of company that wanted to purchase $5 million dollars worth of equipment with only $1 million cash and $4 million in financing, only the $1 million will show up under investing activities. Interest and depreciation are classified as operating cash flow, as are net gains or losses on investments. Because of these distinctions, cash flow from investment activities is typically more complex to calculate than that from other categories. Examples of investing activities are
Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities, etc.)
Loans made to suppliers or received from customers
2.6.3 Financing activities.
Financing activities consist of transactions affecting a company's liabilities and shareholder equity. Mainly involving how the company obtains capital and enhances the value of its stock, they include such things as issuing bonds, payments on debt, paying dividends, and issuing and buying back stock.
Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash to shareholders as dividends as the company generates income. Other activities which impact the long-term liabilities and equity of the company are also listed in the financing activities section of the cash flow statement.
Under IAS 7,
Proceeds from issuing short-term or long-term debt
Payments of dividends
Payments for repurchase of company shares
Repayment of debt principal, including capital leases
For non-profit organizations, receipts of donor-restricted cash that is limited to long-term purposes
Items under the financing activities section include:
Sale or repurchase of the company's stock
Payment of dividend tax
Disclosure of non-cash activities
Under IAS 7, noncash investing and financing activities are disclosed in footnotes to the financial statements. Under US General Accepted Accounting Principles (GAAP), noncash activities may be disclosed in a footnote or within the cash flow statement itself. Noncash financing activities may include
Leasing to purchase an asset
Converting debt to equity
Exchanging noncash assets or liabilities for other noncash assets or liabilities
Issuing shares in exchange for assets
Wrongly recommends the direct method but allows either method. The International Accounting Standard Committee (IASC) considers the indirect method less clear to users of financial statements. Cash flow statements are most commonly prepared using the indirect method, which is not especially useful in projecting future cash flows.
The cash flow statement was previously known as the flow of funds statement. The cash flow statement reflects a firm's liquidity.
The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These noncash transactions include depreciation or write-offs on bad debts or credit losses to name a few. The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. Noncash activities are usually reported in footnotes.
The cash flow statement is intended to
provide information on a firm's liquidity and solvency and its ability to change cash flows in future circumstances
provide additional information for evaluating changes in assets, liabilities and equity
improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods
indicate the amount, timing and probability of future cash flows
The cash flow statement has been adopted as a standard financial statement because it eliminates allocations, which might be derived from different accounting methods, such as various timeframes for depreciating fixed assets.
2.7 Cash and Cash Equivalent
2.7.1 Cash inflows and cash outflows
The concept of cash flow can be broadly divided into two categories, namely the inflow and outflow. The cash inflow, which is also known as inward cash flow or just cash flow, is generated as a result of financing, ventures and sales. The cash outflow which is also known as onward flow of cash is seen as a result of many factors such as purchases, investments, salaries and administrative expenditures. The importance of cash flow statement was realized in the wake of the 2007 recession cycle. Business organizations have realized the importance of cash flow analysis, and have started regular audits of cash outflows as well as inflows. This study of inflow and outflow tends to play a highly instrumental role on general financial planning and financial management.
Ideally, during the business cycle, money flows in than flows out. This allows manager to build up cash balances with which to plug cash flow gaps, seek expansion and reassure lenders and investors about the health of their business.
A point to note is that income and expenditure cash flows rarely occur together, with inflows often filling behind. The aim of this knowledge was to speed up the inflows and slow down the outflows.
Cash inflows key elements
Payment for goods or services from your customers.
Receipt of a bank loan.
Interest on savings and investments.
Increased bank overdrafts or loans.
Cash outflows key elements
Purchase of stock, raw materials or tools.
Wages, rents and daily operating expenses.
Purchase of fixed assets - PCs, machinery, office furniture, etc.
Income tax, corporation tax, VAT and other taxes.
Reduced overdraft facilities.
Many of your regular cash outflows, such as salaries, loan repayments and tax, have to be made on fixed dates. You must always be in a position to meet these payments in order to avoid large fines or a disgruntled workforce.
Cash flow model
2.8 Methods of preparing cash flow statement
FASB Statement No. 95 allows the preparer a choice of the direct or the indirect method of cash flow statement presentation, although the FASB prefers the direct method. The difference lies in the presentation of the operating cash flow information.
2.8.1 Direct method.
Companies that use the direct method are required, at a minimum, to report separately the following classes of operating cash receipts and payments:
Cash collected from customers
Interest and dividends received
Other operating cash receipts, if any
Cash paid to employees and suppliers of goods or services (including suppliers of insurance, advertising, etc.)
Income taxes paid
Other operating cash payments, if any
Companies are encouraged to further break down any operating cash receipts and payments that they consider meaningful.
2.8.2 Indirect method.
The indirect method, by contrast, reports operating cash flow based on changes in the balance sheet (the distribution of assets and liabilities) from period to period as they relate to net income. Thus, instead of reporting the total cash received from customers, an indirect statement only lists the change in cash received from the previous period. The net cash flow reported should be the same as in the direct method, but in the indirect method the level of detail tends to be less.
The key elements of the operating activities section using the indirect method are as follows:
Depreciation and amortization
Deferred income taxes
Change in accounts receivable
Change in accounts payable
Change in inventories
Net gains from sale of investments or assets
A few additional categories are used in some circumstances. Each category is either added or subtracted from net income depending on whether it corresponds to an inflow or outflow of cash. When all of these factors are combined, they equal the net operating cash flow for the period.
As an alternative, some cash flow statements using the indirect method report operating cash flow as a single line item and present the reconciliation details elsewhere in a supplementary schedule. According to FASB standards, the direct method also requires a supplementary schedule that essentially incorporates the indirect measures into the statement. Due to this added burden, the majority of companies tend to use the indirect method only, despite the FASB's stated preference for the direct. Figure I shows a modified statement of cash flows from the Coca-Cola Company using the indirect method.
Regardless of whether the direct or the indirect method is used, the operating section of the cash flow statement ends with net cash provided (used) by operating activities. This is the most important line item on the cash flow statement. A company has to generate enough cash from operations to sustain its business activity. If a company continually needs to borrow or obtain additional investor capitalization to survive, the company's long-term existence is in jeopardy.
The presentation of the investing and financing sections of the statement is the same in each method.
2.9 Balance sheet accounts and cash flow
Every balance sheet account reflects specific activity. There are only a few distinctive transactions that affect each account. Following are examples of some of the common changes in balance sheet accounts that register as cash flow.
Accounts receivable increases when the company sells merchandise or does a service on credit, and decreases when the customer pays its bill. Accounts receivable is associated with sales or revenue on an income statement. The change in accounts receivable or the cash collected from customers is classified as an operating activity.
Inventory increases when the company buys merchandise for resale or use in its manufacturing process, and decreases when the merchandise is sold. Inventory is associated with the income statement account cost of goods sold (COGS). The change in inventory or the cash paid for inventory purchases is classified as an operating activity.
Prepaid insurance increases when the company pays insurance premiums covering future periods and decreases when the time period of coverage expires. The change in prepaids or the amount paid for insurance is classified as an operating activity.
Land, building, and equipment accounts increase when the company purchases additional assets and decrease when the assets are sold. The only time the income statement is affected is when the asset is sold at a price higher or lower than book value, at which time a gain or loss on sale of assets appears on the income statement. The amount of cash used or received from the purchase or sale of such assets is classified as an investing activity. The gain or loss is reported as operating cash flow.
Accumulated depreciation increases as the building and equipment depreciates and decreases when building and equipment is sold. Depreciation expense does not appear on a cash flow statement presented using the direct method. Depreciation expense is added back to net income on a cash flow statement presented using the indirect method, since the depreciation caused net income to decrease during the period but did not affect cash.
1.4 significance of cash flow
There is a significant importance of cash flow to a business. Cash flow as defined above is the inflow and outflow of cash or liquidized finances. The following are some advantages of inward and outward flow of cash.
Income Assurance: The biggest importance of cash flow is that the business organization tends to have an assured income irrespective of the outside economic condition. Many business corporations have a very well balanced and uniform inward and outward cash flow.
Ensures Timely Payment: The uniform and assured cash flow, in both the directions, ensures two principal payments, namely, the salaries of employees are paid on time and instalments of all loans are made on time. This safeguards the trust of employees and upholds the credit rating.
Return Ratio: The analysis of cash flow ensures that the business is not investing finances in the wrong avenues, and investments already made are paying off well. This ratio is often termed as return over asset ratio.
Keeps You Out of Debt: The timely cash inflow plays a very instrumental role in keeping you out of debt, as a timely inflow of cash prevents you from taking small loans.
Saves Unnecessary Expenditure: The use of inward and outward cash flow prevents all unnecessary expenditure such as piled up interest, late payment charges, etc.
Timely Investments: As the inflow and outflow of cash is on time, you are left with adequate free and liquid finances, which you may invest in time bound instruments and securities.
Good cash flow practices ensure smooth operation of the company when accrued revenue is still sitting in accounts receivable. Often an increase in sales does not automatically mean an increase in cash flow at least not right away. for instance, a company with £3 million annual revenue and 30day gap days between the day of payment and the day of sales is likely to be more cash rich than the company with£5 million in sales and a 3 days float. By using cash flow forecasting practices, the company can anticipate when they are most likely to be cash flush and when they are most likely to be cash-strapped so that they can plan their capital purchase.
Effective cash flow management is vital to every organisation; it is an important aspect when planning business functioning. Earning income is (or should be ) one the main focus of company objectives. It can be profitable in and of itself. Cash shortages result in increased cost, such as interest charges on loans, late payment penalties, and loss of vendors discount for paying bill promptly. Cash flow improvements can eliminate these costs and create the opportunity for more favourable payment terms on some type of payments. A better understanding of cash flow management can be benefit to many organisation with a comprehensive guide for:
Identifying and understanding organisation's cash flow characteristics, strengths and weaknesses
Improving cash flow through implementing relevant strategies
Improving overall performance by using cash flow.
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