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Cash Flow Statements- What They Are and Why They Are Important

by Brett Backues on December 12, 2016

Every quarter, publicly traded companies need to file a cash flow statement to the public and the US Securities and Exchange Commission (SEC). The cash flow statement contains information about investments, spending on business activities, and flows of cash from any of the businesses investments or regular operations. To fully understand the cash flow statement, the different forms of cash flow needs to be broken down into their specific natures.

Cash Flow from Investing
Any amount of capital that the business spends on equipment, plants and property is calculated in cash flows from investing. By examining cash flows from investing, any shifts in capital expenditures can be accurately analyzed. As a rule of thumb, it is more beneficial for business to profit from its business operations cash flows than cash flows from investing, though positive cash flows from investing are far from a negative thing.

Cash Flow from Operations
The operations that a business’s cash flow is derived from include depreciation, amortization, accounts payable, and any prepaid elements that count as an expense but have no cash flow association. 

The company’s sales, production purchases, product delivery and revenue collected from paying customers all count as operations. Some of the cost attributed to operations may include the base material required to develop the products, funds used to advertise the product, or the expenses of physically transporting the product overseas. 

In a cash flow from operations, receivables are deducted from the net income. To determine the full cash flow from operations, net income alone is not enough. After taking the net income, every non-cash item and cash item must be reconciled.

Cash Flow from Financing
The final activity that a cashless statement gives information on is the cash flow from financing. In this final section, there is a general overview of all cash that was used in general financing activities for the business. 

By analyzing cash flows from financing, analysts can accurately determine the approximate amount that has been paid in either share buybacks or dividends. In addition to the amount paid out in dividends, cash flows from financing also reveals any amount of cash that has either been paid or obtained in the form of debt or equity.

Accrual Accounting
Most companies that are publicly traded will have an income statement in their annual report that is not synonymous with their cash position; this is described as accrual accounting. Accrual accounting applies whenever a company obtains something that, while recognized as a form of revenue, does not pay in cash until a certain amount of time has passed.

Parties Interested in Cash Flow
There are several kinds of people that will be interested in a company’s cash flow statement. Future employees or freelancers may want to see cash flow to understand whether a company will be able to pay them or not. The company’s shareholders will need to know the cash flow to determine whether it’s truly performing well enough to have their confidence.

Third parties who may potentially lend the company finances may want to see the cash flow statement to determine whether the company would be in a good position to pay back its balance. 

Any potential investors in the company can use the cash flow statement to see if a company has the financial standing to serve as a profitable investment. The company’s own accounting personnel will need an accurate picture of cash flow to determine how the most immediate expenses and payroll can be covered.

Cash flow was once referred to as the flow of funds statement, but our modern interpretation of the cash flow statement originally manifested as something that was called the comparison balance sheet, coined by the manager of the Dowlais Iron Company in the year 1863. 

At the time, the Dowlais Iron Company had managed to get back on its feet and profit after a particularly rough quarter, but it still lacked the cash to invest in certain new pieces of equipment. The manager of the company drafted the comparison balance sheet as a way of explaining why the company lacked investable funds despite being in profit.

Reporting cash flow statements was not mandated by the Financial Accounting Standards Board (FASB) until the year 1987. The FASB had already updated the Generally Accepted Accounting Principles (US GAAP) to make it necessary for firms to report the sources and uses of the funds in 1972, though the exact definition of “funds” wasn’t completely clarified. 

Five years after the FASB made it mandatory for cash flow statements to be reported in the United States, the International Accounting Standards Board (IASB) issued a standard that made it necessary for all firms across the globe to provide cash flow statements; this went into effect two years later, in the year 1994.

Benefits of cash flow statement analysis
By taking its cash flow into account, a company can determine its own solvency and liquidity. There will likely be several changes in a company’s liabilities and assets throughout the year, and a cash flow statement can provide a helpful amount of information for tracking these changes.

By keeping an accurate record of all present cash flow statements, analysts can accurately predict future cash flows as well. Though there may be several different methods of accounting, the cash flow statement can serve as a common denominator that makes all different methods more comparable.

Understanding the importance of a cash flow statement and its components is vital for understanding a company’s true financial well-being. Even if a company’s net income may seem profitable at face value, it could still be short on cash if certain contracts haven’t manifested into revenue yet. Before a contract pays in cash, the company will still have to pay income tax.

No matter how profitable a company may be, it never becomes any less important to accurately analyze cash flow. Even top-performing businesses can sometimes fail to account for the nuances in their cash flow, which makes dependable analysts essential to have on board.