The importance of the Statement of Cash Flows

By John M Seeram

John M. Seeram is a Financial/Audit Consultant

International financial reporting standards require entities to produce a Statement of Finan-cial Position (SFP) formerly known as the balance sheet, a Statement of Comprehensive Income (SCI) and a Statement of Cash Flows (SCF). From a financial management perspective, each of these statements is significant and they are inter-related. However, the focus will be on the SCF.

Managing cash resources are of utmost importance, whether it be a public or private entity. It is the view that the emphasis on evaluating an entity’s financial performance is more focused on the SFP and the SCI by the financial ratios being computed for making decisions accordingly.

A SCF became mandatory since 1987, as it records the amount of cash and cash equivalents entering and leaving an entity. This statement allows investors to understand, for example in the case of a corporate entity, how its operations are running, where the money is coming from, and how it is being spent.

It is distinct from the SFP and the SCI, since it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Hence, it must be emphasized that cash is not the same as net income, which on the SFP and the SCI includes cash sales and purchases and sales and purchases on credit, as examples.

Cash flows are determined by looking at three components by which cash enters and leaves an entity whether it be public or private and they are for operations, investing and financing.

 Operations

The operations component of cash flow reflects how much cash is generated from an entity’s products and services from its inflows and outflows. Briefly, cash flow from operations is calculated by making certain adjustments to net income by increasing and decreasing differences in income and expenses, and credit transactions, resulting from transactions that occur from one period to another. These adjustments are made because non-cash items are included in the net income on the SCI, and in the total assets and liabilities on the SFP. As a result, since not all transactions involve actual cash items, they have to be re-evaluated when it comes to calculating cash flow from operations, hence the difference from net income.

Once credit transactions are included in those statements, the net income and the cash inflow or outflow will differ. In simplest terms, an entity shows a net income of $100,000 and after adjustments are made for credit and non-cash transactions, its cash flow from operations can be a negative (-) $50,000 (outflow) or positive (+) $130,000 or $40,000 (inflow).

This is important information for stakeholders such as investors, creditors, shareholders, government officials, including tax officials, etc on the ability of the entity to generate its cash resources to meet its outflows.

Investing

On the investing component, changes in assets such as equipment and building as examples, relate to cash from investing. Usually cash changes from investing are a cash-out item, because cash is used to buy assets such as equipment and building(s). However, when a company divests of an asset, that transaction is considered cash in for calculating cash from investing as is currently being done by GuySuCo, a public entity.

 Financing

Changes in debt loans, grants or dividends are accounted for in cash from financing. Changes in cash from financing are cash in when capital is raised, and they are cash out when the debt is serviced, and grants and dividends are paid as examples.

Concluding remarks

Managing the cash resources of an entity is very important and this is reflected in the SCF which complements the more familiar SFP and the SCI. The trend appears to focus on those two statements in determining the key performance indicators (KPI) on the financial health of an entity.

From a stakeholders’ point of view, they need to know, among other things:

1) the cash generated from the entity’s operations despite showing the net income which includes credit transactions.

2) the cash used to acquire assets such as equipment, investments and to do major repairs to its plant, as well as divesting of assets which is considered cash in.

3) the extent of its borrowing to finance its operations, as well as to service its debts and to pay dividends.

Users of financial statements are apparently misled to some extent that if the entity shows a net income, then it should be paying dividends. It is this SCF which will indicate the entity’s ability to pay dividends and how much to pay.

An entity can use a SCF in order to predict future cash flows which helps with matters in budgeting. For stakeholders, the cash flow reflects an entity’s financial health. Basically, the more cash available for operations, the better. However, this is not a hard and fast rule. Sometimes a negative cash flow results from an entity’s growth strategy in the form of expanding operations.

With regard to public entities in Guyana, KPIs are required to be done on the SCF of those entities, in a meaningful manner for effective decision-making purposes, among others, as was revealed above in determining how the entity is performing, and whether or not, it may be on the brink of bankruptcy or of success.

Stakeholders need to get a very clear picture of what is considered one of the most important aspects of an entity’s operations, which is how much cash it generates and, particularly, how much of that cash stems from its operations. Hence, if adequate focus on this SCF is indeed lacking, let’s get it right from a financial management perspective. There are many questions that can be answered from the SCF once it is properly analysed and interpreted.

 

Around the Web

Comments