What is Cash Flow?
Cash flow is a generic term that can be used differently depending on the context. It can refer to actual past flows or projected future flows. It can refer to the total of all flows involved or a subset of them - for example, net cash flow, operating cash flow, and free cash flow.
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These terms will be defined later, but for now we will concern ourselves only with actual cash flows for a period of time in the past. It is important to define what is meant by 'cash':
Cash includes all of the money that the organization has in bank accounts and short-term investments that can quickly be turned into available cash.
It is common for a balance sheet to show only a tiny amount for cash because businesses often operate with an overdraft and only petty cash is included.
A Cash Flow Forecast
There are two completely different accounting documents that have the words 'cash flow' in the title and it is important to avoid confusing the two of them. These documents are a 'cash flow forecast' and a 'cash flow statement.' A cash flow forecast, which has already been mentioned, is an internal document produced on an ad hoc basis to help with budgeting. In contrast, a cash flow statement is one of the principal financial reports that an organization publishes each year in accordance with international accounting standards.
As a manager, you may be asked to produce a cash flow forecast to show your known and anticipated cash expenditure for some future period of time, usually the next budgetary period or the remainder of the current one. You will usually be expected to add an element of contingency into your cash flow forecast to cater for any unexpected costs that may arise.
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This forecast is an important aspect of your planning and is an essential part of budgeting as it helps you to identify potential areas where a lack of cash may become an issue. It also offers you the opportunity to review and where necessary amend your planned expenditure.
Regular monitoring and reviewing of your cash flow forecast is essential because you never know when your budget may be threatened or cut. You will be able to protect your original budget better if you already have arguments for why your budget should not be affected and exactly what the consequences will be if it is.
The better prepared you are, the more protected your budget will be in such circumstances. It also enables you to communicate accurately and objectively to senior management the consequences of any budgetary changes.
A Cash Flow Statement
In order for a set of financial statements to be complete the accounting profession includes a cash flow statement. Like all other financial statements it has to adhere to accepted accounting principles.
The cash flow statement goes beyond what you include in your regular reports showing what cash has come in and what cash went out. A Cash Flow statement can be defined as a reconciliation of the differences between the:
Accrual basis balance sheet and Income statement and Cash flow.
This statement uses historic data and is usually dated at the end of an organization's financial year. In simple terms it shows how the final cash balance occurred, how much money flowed in and from where, and how much went out and why.
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The cash flow statement reflects a firm's liquidity. It includes only inflows and outflows of cash and excludes transactions that do not directly affect cash receipts and payments. Being a cash basis report, this financial statement details three types of financial activities: operating activities, investing activities, and financing activities.
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This statement is extremely valuable to management and investors because it is intended to:
- Provide information on an organization'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 organizations' operating performance by eliminating the effects of different accounting methods.
- Indicate the amount, timing, and probability of future cash flows.
The valuable information and data a cash flow statement provides ensure it plays a key role in an organization's decision making. This is why it is essential for managers to have an appreciation of how it is compiled and how to interpret it.
The cash flow statement has been adopted as a standard financial report because it eliminates some of the problems that occur when trying to compare accounts that have been prepared using different accounting methods, such as various timeframes for depreciating fixed assets.
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It is this compilation and integration of facts that draw savvy managers and investors to utilize this often overlooked financial statement. It is important to remember that all the figures in a cash flow statement can be found somewhere in the income statement, balance sheet, statement of shareholders equity, or any one of the financial statement notes provided.
If you looked at an income statement prepared using the accrual basis of accounting you could see a figure for reported revenues, but you would not know if they have been collected yet. Similarly, the expenses reported on the income statement might or might not have been paid.
Alternatively, you could review the balance sheet changes to determine the facts, but the cash flow statement has already integrated all that information.
There are many ways you can utilize the information a cash flow statement presents. For example, if an organization's cash generated from operations is consistently above its net income or earnings they are referred to as 'high quality.'
In circumstances where the opposite is true then the organization's earnings have a 'red flag' raised against them. This informs anyone looking into the organization that they need to investigate further why its reported earnings are not turning into cash.
Where an organization consistently generates cash in excess of what it needs on a day-to-day basis, it has the ability to offer its investors a higher dividend or buy back some of its own shares. Such an organization is considered to have 'good stockholder value' by investors.
This is not the only option and they may choose to use this excess cash to reduce debt or acquire another organization. In the case of nonprofit organizations, a positive cash flow allows them to expand their operations and offer additional or improved services. If you need a basic financial accounting principles pdf then download our free eBook now.
You may also be interested in:
Cash Flow Analysis Definition | Managing Working Capital | Changes in the Cash Account | Direct Format Cash Flow Statement | Indirect Format Cash Flow Statement | Cash Flow from Operations | Cash Flow from Investments | Cash Flow from Financing.
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