Purpose Of Cash Flow Statements

Preparation of a cash flow statement serves various purposes like stating the cash movements concerning cash inflows and outflows, the performance of strategic decisions taken by the management, and providing relevant information about the financial well-being of an organization.

Such disclosure helps understand the liquidity status of the business through its financial statements. This is useful in interpreting if the firm’s core business is self-sustainable and has long-term growth prospects. Because of its clarity, a cash flow statement is considered an important document demanded by regulators and investors. Thus, it gives a true picture about the financial condition of the business.

• A financial statement that details these transactions throughout an accounting period is the cash flow statement. It paints a precise picture of how much money is coming into and leaving the company.
• Such information aids in determining if the company's main operations are autonomous and have promising long-term growth potential. A cash flow statement is a crucial document that investors and authorities want due to its clarity.
• A cash flow statement is made for: explaining changes in cash, providing information about non-cash and investing activities, explaining the financial condition, and providing a view of management strategy and legal requirements.
• Cash flow statements can create a safe frontier for investors and help them understand the conversion of profits in a company and the financial health of a company.

The Cash flow statement is a financial statement that depicts the details of such transactions during an accounting period. It gives a clear picture of the amount of cash flowing into the firm and the amount flowing out of the firm. Additionally, along with the information on cash inflow and outflow, it also provides the sources of these activities.

The cash flow statement is an indicator of the liquidity of the firm. It provides useful information to investors about the cash inflows and outflows. More importantly, providing how this cash was generated helps eliminate any creative accounting illusion provided and identify if the firm is solvent or facing a cash crunch.

Now, let us look at the main purpose of cash flow statement.

#1 - The Explanation For The Changes In Cash

The purpose of preparing a cash flow statement is to provide a detailed description of how and in what amounts the cash flows in and out of the firm. In addition, it explains how the cash was generated and used further during a particular accounting period.

#2 - Information About Non-Cash Investing And Financing Activities

It describes the money spent on non-core activities like investing and financing activities. These activities, even though non-core, have a significant effect on the current and future cash flows of the firm.

Reporting such information is along with additional exposures, if any, as both regulators and investors closely follow it.

#3 - Financial Condition Of The Firm

The purpose of preparing a cash flow statement is to focus on financial numbers and how these numbers have been achieved. There might be a case where the cash flow numbers look promising but are only one time and might not repeat in the future.

#4 - Provides A View Of Management Strategy

The primary purposes and uses of the statement of cash flows is to indicate the firm’s management strategy and future outlook.

Sometimes, the business may liquidate the valuable assets when it is not able to earn revenue. The investors should look for and should be able to analyse such negative circumstances. Thus, the purposes and uses of the statement of cash flows is to help identify such alarming situations.

There might be a scenario where the firm finds it difficult to find investors or raise money from the market. Management in such a scenario is trying its best to remain solvent. It requires further investigation, and investors should follow management commentary closely to dive in further.

#5 - Legal Requirements

Firms must report the cash flow statement by accounting standards. These are required and closely watched by regulators to ensure that the investor's money is safe. If the detection of any financial fraud happens in the initial stages, it removes any catastrophic events in the future.

Here are a few examples to understand the concept.

Example#1

Changes In Cash

Consider the following cash flow statement. It depicts the cash generated, cash distributed, and what activities it was done.

Non-Cash Investing And Financing Activities

On analyzing our cash flow statement example, it can be depicted that the cash flow from these activities was 12000 and -2000, respectively, as shown below.

Financial Condition Of The Firm

Consider the following cash flow statement. Looking at the final numbers, one might say that the firm is doing well as it has a cash surplus of 27000. Such an interpretation should be enough for the stock price to shoot upwards.

However, analyzing further, a prudent investor should be able to identify that the firm’s core activities have posted negative numbers. It’s only the non-core activities like the sale of land and old machinery because the final number looks better. Such activities are only one-time payments and have to be taken with a pinch of salt. If we remove the cash generated from these activities, the situation changes, and it’s clear that the firm has posted bad results for the current financial year. Once this is clear, it won’t take much time for the stock euphoria to disappear and stock price to go southwards.

View Of Management Strategy

Consider the following example.

Here the management is trying to liquidate its assets when the core operating activities of the business are yielding negative numbers, which should raise alarm bells. Investors should take a clue that such negative numbers are not at the expense of a growth strategy, thus, identifying the purpose of the statement of cash flow.

Example#2

There is a common debate about the financial crisis of 2008-09. However, if the regulators worldwide had been more vigilant, identifying and diagnosing the effects of the recession would have been done at the right time. E.g., in the SATYAM scam, much money was being spent on MAYTAS rather than on any operational activities. Thus if SEBI could have analyzed the cash flow statement of SATYAM, they would have detected the scam much earlier. Therefore, a lot of investors’ money could have been saved. This situation points out the purpose of statement of cash flow.

This article has been a guide to what is the Purpose of Cash Flow Statement. We explain its objective o purpose along with some examples. You can learn more about Accounting from the following articles –

• Cash Flow from Operations Ratio
• Cash Flow Analysis
• What is Cash flow from Operations?
• Cash Flow from Investing
• Cash Flow vs Fund Flow