What is a cash flow statement and how to prepare it?

Operating activities are a part of cash flow statements. When a cash flow statement is prepared, operating activities are depicted in the initial section. It shows the amount of money flow that comes into the business because of its day-to-day business operations, known as operating cash flow.

In other words, it is the income generated by a business from its ongoing business activities, such as selling, manufacturing, and providing services to customers. Payment of dividends is not considered a part of operating activities.

The main concern of operating activity is the core business. It does not include long-term investments and capital expenditure.

When revenue is generated in a business through investments, it becomes a part of investing activities in the cash flow statement. Revenue through investment is generated when businesses sell/purchase their assets

Purchasing assets, long-term investments in government bonds and securities, and selling physical assets are part of investing activities. Through the investing activities section, businesses can learn about their profit and loss ratio of assets and securities.

The primary focus of financing activities is to understand the fundraising process of a business and the way it repays to the investors. In short, it is about analyzing the process of raising capital through capital markets.

Financing activities consist of dividend payments, equity issuance and repayment, repayment of debts, and obligations associated with the capital lease.

This part of the cash flow statement shows the net income generated by a company. Further, it transforms it to a cash basis which was previously noted on the accrual basis.

This is done by employing the amendment in the balance of current liabilities and current accounts. It includes prepaid insurance, supplies, bills receivable, wages payable, and others.

When amendments are found in the balances of long-term securities and assets, it is mentioned in this section of the cash flow statement. It includes all the physical assets such as buildings, machinery, land, vehicles, and furniture.

Investing activities include the sale/purchase of assets such as equipment, plant, and property.

When changes occur in the balances of stockholders’ equity accounts and long-term liabilities, it comes under the section of financing activities in cash flow statements. It includes preferred stock, bonds payable, retained earnings, common stock, and a few others.

To sum up, it includes short-term and long-term repayments and borrowings of a company.

The payment of income tax by a company and the amount of interest is mentioned in this section. Mostly, businesses use indirect methods to prepare a cash flow statement. If this method is employed, the company's balance sheet differences provide sufficient information.

The initial step involved in the preparation of a cash flow statement is to dictate the initial balance. A company must determine the initial value of cash and its equivalents at the starting point of the reporting statement. This balance can be extracted from the income statement of the associated accounting year.

While employing the indirect method of finding out the income generated from operating activities, mentioning the initial cash balance becomes mandatory. It is not essential to mention this entry if a direct method is employed to calculate cash flow.

Now, when you have the initial balance, you need to find out the revenue generated from operating activities. This step is significant as it reveals the amount of income generated by a company from its daily operations.

The simple way of finding out cash flow from operating activities is through direct or indirect methods.

Direct Method: The immediate technique for computing income generation from operating activities is an effortless process that includes taking all the money assortments from operations and deducting all the money payments from operations.

This approach records every one of the exchanges that brought about cash paid or received during the reporting time frame.

Indirect Method: To calculate cash flow from operating activities through the indirect method, you need to extract the value of net income. The net income generated by a company is found in the income statement.

To cancel the impacts of the accruals during that accounting period, companies need to make adjustments in the statement. For example, amortization and depreciation need to be adjusted in the accounting report.

Both methods will provide the same output. It is the process involved that is different in the case of the direct and indirect methods.

While the direct method is more prominent, it's additionally tedious in light of the fact that it requires representing each exchange that occurred during the reporting time frame.

Most organizations favor the indirect method of cash flow statement since it's quicker and firmly connected to the monetary record. In any case, the two methods are acknowledged by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

Once the cash flow from operating activities is calculated, the next step in the cash flow statement is to calculate the cash flow from investing activities.

This portion of the cash flow statement deals with the selling and purchasing of long-term assets such as equipment, properties, and facilities. Debt is not included in cash flow from investing activity.

The third segment of the cash flow statement analyzes cash inflows and outflows connected with financing activities. This incorporates incomes from both equity financing and debt — incomes related to raising funds and repaying debts to creditors and investors.

While utilizing GAAP, this segment likewise incorporates payment of dividends, which might be a part of operating activities while utilizing IFRS norms. Interest paid is a part of the operating segment under GAAP, yet now and again in the financing activity under IFRS too.

When the revenue generated from the three fundamental kinds of business activities is represented, you can decide the ending balance of cash and its equivalents towards the end of the reporting period.

The adjustment of net income for the period is equivalent to the amount of revenue from operating, investing, and financing activities. This value shows the aggregate sum of income a company acquired or lost during the reporting time frame.

A positive net income demonstrates that a business had more cash flow into it than cash outflow, while a negative net income shows it spent more than it procured. Additionally, reviewing the debt to equity ratio can provide insights into how well the business is managing its financial structure in relation to its cash flow.

The final step of preparing the cash flow statement is to find out the net increase/decrease in the cash and cash equivalents of the business during that particular reporting period.

The cash flow statement is unable to reflect the net income generated by a business for the accounting period as it excludes items that are non-cash. Such items are taken into consideration by the Profit and Loss Statement.

Also, the cash flow statement does not assist with finding out the profitability of the business because neither revenues nor cost are a part of it. Well, it can be utilized as an add-on to the income statement.

The Cash flow statement cannot perform the functions efficiently done by the income statement or by the funds flow statement. It is unable to replace these two statements.

As the cash flow statement doesn't gauge the effectiveness of the firm, comparison with other inter-industry is beyond the realm of possibilities. A firm having less capital venture will have less cash flow than the business which has more capital investment bringing about higher income generation.

In a functional situation, the cash flow statement doesn't survey the liquidity or dissolvability position of the firm as it presents a money position just on a specific date. It just assists with understanding what measure of obligation can be met. In a nutshell, it doesn't address the genuine liquidity position.