Without cash your business won’t run, your employees become cranky and suppliers stop shipping you, and believe it or not you can run out of cash while your business is very profitable.
A cash flow statement tells you where the money went. A profit and loss statement says nothing about principal payments you make to the bank. You could have reasonably good profits, but the amount of money you pay your bank every month could be putting you out of business.

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Cash flow statements tell you where you spent your money. If you increased inventory you used cash. If you extended more credit to customers you used cash. If you bought lots of capital equipment you used cash. All three of these issues won’t show up on your profit and loss statement.

A cash flow statement can help you focus on creating excess cash. Having profits is important. Profits are one of the things that help create cash. There are other things that can also help you create cash.

If you can pay less for capital equipment you need you are creating cash while spending money. If you can collect receivables from your customers faster you are creating cash. If you use inventory more efficiently you create cash. Concentrating only on your profit and loss statement makes it difficult to focus on cash.

Purpose of the Statement of Cash Flows

The purpose of the statement of cash flows is to report cash receipts (inflows) and cash payments (outflows) during a period. This includes separately identifying the cash flows related to operating, investing, and financing activities. It is the detailed disclosure of individual sources and uses of cash that makes this statement useful. The statement of cash flows helps users answer questions such as:

  • What explains the change in the cash balance?
  • Where does a company spend its cash?
  • How does a company receive its cash?
  • Why do income and cash flows differ?
  • How much is paid in dividends?
  • Is there a cash shortage?

Importance of Cash Flows

Information about cash flows influences decisions. For instance, we prefer a company to pay expenses with cash from operations rather than by selling assets. Information about cash flows helps users decide whether a company has enough cash to pay its debts. It also helps evaluate a company’s ability to pay unexpected obligations and pursue unexpected opportunities. Managers use cash flow information to plan day-to-day operations and make long-term investment decisions.

Measurement of Cash Flows

Cash flows include both cash and cash equivalents. The statement of cash flows explains the difference between the beginning and ending balances of cash and cash equivalents. We continue to use the phrases cash flows and the statement of cash flows, but remember that both phrases refer to cash and cash equivalents.

A cash equivalent has two criteria: (1) be readily convertible to a known amount of cash and (2) be sufficiently close to its maturity so its market value is unaffected by interest rate changes. American Express defines its cash equivalents as including “highly liquid investments with original maturities of 90 days or less.”

Classification of Cash Flows

Distinguish between operating, investing, and financing activities, and describe how non cash investing and financing activities are disclosed.

Because cash and cash equivalents are combined, the statement of cash flows does not report transactions between cash and cash equivalents, such as cash paid to purchase cash equivalents and cash received from selling cash equivalents.However, all other cash receipts and cash payments are classified on the statement in one of three categories — operating, investing, or financing activities. Individual cash receipts and payments for each of these three categories are labeled to identify their originating transactions or events. A net cash inflow (source) occurs when the receipts in a category exceed the payments. A net cash outflow (use) occurs when the payments in a category exceed the receipts.

Operating Activities

Operating activities include those transactions and events that determine net income. Examples are the production and purchase of inventory, the sale of goods and services to customers, and the expenditures to operate the business. Not all items in income, such as unusual gains and losses, are operating activities lists common cash inflows and outflows from operating activities.

Point: Cash dividends received and cash interest received are reported as operating activities.

Investing Activities

Investing activitiesgenerally include those transactions and events that affect long-term assets — namely, the purchase and sale of long-term assets. They also include (1) the purchase and sale of short-term investments, except trading securities, and (2) lending and collecting money for notes receivable. lists examples of cash flows from investing activities. Cash from collecting the principal amounts of notes is classified as investing. However, the collection of interest on notes is reported as an operating activity; also, if a note results from sales to customers, it is classified as operating.

Financing Activities

Financing activitiesinclude those transactions and events that affect long-term liabilities and equity. Examples are (1) obtaining cash from issuing debt and repaying the amounts borrowed and (2) receiving cash from or distributing cash to owners. These activities involve transactions with a company’s owners and creditors. Borrowing and repaying principal amounts relating to both short- and long-term debt are financing activities. However, payments of interest expense are classified as operating activities.

Link between Classification of Cash Flows and the Balance Sheet

Operating, investing, and financing activities are loosely linked to different parts of the balance sheet. Operating activities are affected by changes in current assets and current liabilities (and the income statement). Investing activities are affected by changes in long-term assets. Financing activities are affected by changes in long-term liabilities and equity. These links are shown bellow:

Exceptions to these links include (1) current assets unrelated to operations — such as short-term notes receivable from noncustomers and marketable (not trading) securities, which are considered investing activities, and (2) current liabilities unrelated to operations — such as short-term notes payable and dividends payable, which are considered financing activities.

Where in the Statement Are Cash Flows?

Cash flows can be delayed or accelerated at the end of a period to improve or reduce current period cash flows. Also, cash flows can be misclassified. Cash outflows reported under operating activities are interpreted as expense payments. However, cash outflows reported under investing activities are interpreted as a positive sign of growth potential. Thus, managers face incentives to misclassify cash flows. For these reasons, cash flow reporting requires scrutiny. ■

Noncash Investing and Financing

Some important investing and financing activities do not affect cash receipts or payments. One example is the purchase of long-term assets using a long-term note payable (loan). This transaction involves both investing and financing activities but does not affect any immediate cash inflow or outflow, so it is not reported in any of the three sections of the statement of cash flows. Such transactions are reported at the bottom of the statement of cash flows or in a note to the statement — common examples of Noncash Investing and Financing Activities:

  • Retirement of debt by issuing equity stock.
  • Conversion of preferred stock to common stock.
  • Lease of assets in a capital lease transaction.
  • Purchase of long-term assets by issuing a note or bond.
  • Exchange of noncash assets for other noncash assets.
  • Purchase of noncash assets by issuing equity or debt.
  • Retirement of debt by issuing equity stock.
  • Conversion of preferred stock to common stock.
  • Lease of assets in a capital lease transaction.
  • Purchase of long-term assets by issuing a note or bond.
  • Exchange of noncash assets for other noncash assets.
  • Purchase of noncash assets by issuing equity or debt.

Content from:
http://www.stage2planning.com/blog/bid/60143/4-Reasons-A-Cash-Flow-Statement-Is-Important
Wild, Shaw, and Chiappetta Fundamental Accounting Principles 23rd Edition

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Diego Fornazier Gozer

Written by

SAP Consultant https://www.linkedin.com/in/diegogozer/

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