Cash Flow Accounting



Importance of Cash Flow Accounting

The statement of cash flows provides insight that the balance sheet and income statement do not, particularly in regard to a company’s cash position.

Learning Objectives

Summarize why cash flow accounting is important

Key Takeaways

Key Points

  • Without positive cash flow, a company will not be able to meet its financial obligations, thereby leading to a cash crunch or bankruptcy.
  • Cash flow is the movement of money into or out of a business, project, or financial product.
  • The statement of cash flows is a valuable reporting tool for managers, investors, and creditors.
  • Being profitable does not necessarily mean being liquid.

Key Terms

  • liquidity: An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.
  • net income: Net income also referred to as the bottom line, net profit, or net earnings is an entity’s income minus expenses for an accounting period.
  • cash flow: The sum of cash revenues and expenditures over a period of time.

Importance Of Cash Flow Accounting

Cash flow is the movement of money into or out of a business, project, or financial product from operating, investing, and financing activities. It is usually measured during a specified, finite period of time, or accounting period. The measurement of cash flow can be used for calculating other parameters that give information on a company’s value, liquidity or solvency, and situation. Without positive cash flow, a company cannot meet its financial obligations.

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Cash Flow: Cash

Management is interested in the company’s cash inflows and cash outflows because these determine the availability of cash necessary to pay its financial obligations. In addition, management uses cash flow for the following:

  • To determine problems with a company’s liquidity
  • To determine a project’s rate of return or value
  • To determine the timeliness of cash flows into and out of projects, which are used as inputs in financial models such as internal rate of return and net present value

Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash even when it is profitable. Cash flow is often used as an alternative measure of a company’s profitability when it is believed that accrual accounting concepts do not represent economic realities.

For example, a company may be profitable but generate little operational cash (as may be the case for a company that barters its products rather than selling for cash or when its accounts receivable turnover is long). In such cases if needed, the company may derive additional operating cash by issuing shares, raising additional debt finance, or selling its assets. In addition, cash flow can be used to evaluate the “quality” of income generated by accrual accounting. When net income is composed of large non-cash items, it is considered low quality.

Key Considerations for the Statement of Cash Flows

The statement of cash flows highlights the activities that directly and indirectly affect a company’s overall cash balance.

Learning Objectives

Summarize what items are represented on the statement of cash flows

Key Takeaways

Key Points

  • The statement shows changes in cash and cash equivalents rather than working capital.
  • The statement of cash flows consists of three primary categories: operating activities, investing activities and financing activities.
  • The statement of cash flows lists all cash inflows and outflows during a reporting period.

Key Terms

  • equity: Ownership, especially in terms of net monetary value of some business.
  • liquidity: An asset’s property of being able to be sold without affecting its value; the degree to which it can be easily converted into cash.
  • working capital: A financial metric that is a measure of the current assets of a business that exceeds its liabilities and can be applied to its operation.

The Statement of Cash Flows

A cash flow statement provides information beyond that available from other financial statements, such as the Income Statement and the Balance Sheet, through providing a reconciliation between the beginning and ending balances of cash and cash equivalents of a firm over a fiscal or accounting period.The main purpose of the statement, according to the Financial Accounting Standard Board (FASB) is to provide information about the changes of an entity’s cash or cash equivalents in the accounting period.

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Statement of Cash Flows: Balancing the Statement of Cash Flows by hand.

Structure of the Statement of Cash Flows

The statement shows historical changes in cash and cash equivalents rather than working capital. It provides information about a company’s borrowing and debt repayment activities, the company’s sale and repurchase of its ownership securities, and other factors affecting the company’s liquidity and solvency. It does not predict future cash flows.

In addition, the statement is used to assess the following: the company’s ability to meet its obligations to service loans, pay dividends, etc.; the reasons for differences between reported and related cash flows; and the effect on its finances of major transactions in the year. The statement of cash flows lists all cash inflows and outflows during a reporting period from operating, investing and financing activities.

It has three primary categories from which cash flows derive:

  • Operating activities – principal revenue-producing activities of the company and other activities that are not investing or financing activities. Cash inflows include cash receipts from sales of goods or services; interest received from making loans; dividends received from investments in equity securities; and cash received from the sale of securities that were held for trading purposes, issued by other businesses. Securities that are held for trade are generally investments that a business holds for a very short period of time with the intent to sell for a quick gain.
  • Investing activities – the acquisition and disposal of long term assets and other investments not included in cash equivalents. Transactions include the sale and acquisition of property, plant, and equipment; the collection and granting of long-term loans to others; and the trading of available-for-sale and held-to-maturity securities of other businesses. Securities that are held-to-maturity are those that a business plans to hold onto until the security’s term is up. An available-for-sale security is an investment that does not qualify as “held-to-maturity” or “trading”.
  • Financing activities – activities that result in changes in the size and composition of the equity capital and borrowings of the enterprise. Transactions include cash received by the company issuing its own capital stock and bonds, as well as any other short- or long-term borrowing it may do.